CDPQ’s Etroy on the indirect benefits of going direct

The way the Canadian pension giant's Stephane Etroy sees it, pushing into directs has a positive effect on the whole private equity programme

There are many reasons limited partners choose to make the leap into direct investment: better economics, more control over the types of businesses that receive their capital, the option to hold onto good businesses for longer.

Stephane Etroy, executive vice-president and head of private equity at Canadian pension plan Caisse de dépôt et placement du Québec, has one more very good reason to add to the list, and it might not be one you’ve spent too much time thinking about: it improves the performance of the fund investment portfolio.

“By creating a team that is able to source and generate direct investments into companies, you become less reliant on co-investment from general partners, and therefore you are more selective on your GPs,” he explains. “You are not only selecting the ones that are big enough that they’ll give you co-investments, but you’re selecting GPs because you are looking for this GP to give you something specific.”

With roughly C$39 billion ($30 billion; €26 billion) invested in the asset class, private equity represents around 13 percent of CDPQ’s C$308 billion in global assets under management. That capital is managed by two teams: the first invests roughly C$13 billion into Quebec, and the second – Etroy’s team – invests C$26 billion everywhere else.

Of that C$26 billion, roughly 50 percent is invested in the US, 30 to 35 percent in Europe, and 15 to 20 percent in Asia and the rest of the world. Around $10 billion is invested in funds, and the remaining $16 billion in direct investments and co-investments, with a significant majority of it – more than 80 percent – in direct investments.

That proportion is where the fund wants to be, says Etroy. The private equity programme is expecting 50 percent growth over the next three to four years and “there’s no way we can achieve that growth if it’s not across the board”.

“Even though today funds is a minority of what we do, funds and co-investments and direct investments are all going to grow with us over the next three years by 50 percent on average.”

While increasing its dollar exposure to private equity funds, CDPQ has been gradually reducing its core fund relationships over the last 10 years, from more than 100 in 2008 to between 20 and 25. To do this the pension has been an active user of the secondaries market.

“Even if you sell at a slight discount to NAV, my view has been over the last two years that the market has been so high, NAVs are so high, that it’s been a good moment to sell your non-core assets.””

Etroy says CDPQ “may have gone too far on the concentration end”, and may slightly increase its GP relationships in the coming years.

Managers CDPQ invests with through its funds programme include India-focused Kedaara Capital, secondaries giant Ardian, European powerhouse EQT and tech specialist funds such as Silver Lake and Vintage Investment Partners, according to PEI data.

CDPQ’s total equity investments – which include public and private equities – delivered a half-year net investment return of 4 percent against a 4.4 percent index, and a return over five years of 13.5 percent, above an index of 11.8 percent, as of 30 June 2018.

Etroy declined to comment more specifically on the performance of the private equity portfolio, but added that thus far, the direct investments portfolio is outperforming the funds portfolio.

“That’s kind of natural; if that wasn’t the case I don’t think we would have invested in the new team and opened international offices,” Etroy says. “It’s a big investment in people, offices, infrastructure and systems.”

However, now the fund strategy can be more selective, Etroy expects this to change.

“Ultimately we should able to have better returns from our funds portfolio in the future, because we’ll target the best performers in very specific niches that give us, for example, an exposure to China or to India or tech or healthcare, and we know exactly why we’ve chosen these funds. There’s no reason there should be a completely different return profile, it’s just different ways of covering different parts of the market.”

Getting personnel

When it comes to building out a successful directs programme, Etroy echoes the sentiments of several of CDPQ’s Canadian peers: the biggest hurdle is attracting and integrating the right people.

“You’re looking to hire people that have direct sourcing and execution skills, so a lot of them come from standard private equity firms,” Etroy says, pointing out that such people tend to have “different DNA” to typical limited partners.

“[You must] make sure the new type of people you’ve hired to do the direct programme can integrate well with the co-investment and the funds people that we have in the PE team.”

Then comes building out the systems and processes – not just investment committees, but how the programme measures and quantifies risk, and the ability to both monitor and create value in the portfolio.

Part of the reason behind CDPQ’s desire to invest directly is it allows for longer hold periods. This requires a different mindset.

“We think as an industrial investor more than a financial investor. We are not preoccupied by multiple arbitrage or financial engineering,” he says. “Over three years, multiple differences and financial engineering will make a big impact on returns; over 10 years, you realise the impact on returns is tiny. The absolute dominating driver is revenue and EBITDA growth.”

As a co-lead or lead on a transaction, the level of governance, impact and control CDPQ has over a company’s board becomes significant, and with that extra power comes a need for experience. As well as recruiting dealmakers, CDPQ has embarked on recruiting a team of operating partners with specific experience in managing large portfolios, interacting with company chief executives and boards, and driving value creation initiatives.

“If you don’t do that, it’s a big risk factor because you are going to accumulate direct deals and then if there is a market downturn or a recession or something happens, then suddenly you don’t know how to manage the direct portfolio. It’s essential that as you build up this direct portfolio you think about how the companies are going to be managed in case anything happens down the line.”

While co-investment is a small proportion of CDPQ’s private equity allocation today, it is nevertheless an important one.

“It’s a very strong way of continuing to strengthen the relationship with those GPs that we’ve kept,” Etroy says.

“It’s very important for us to be able to continue to be helpful to GPs by continuing to say, ‘Even if we don’t lead the transaction or co-lead it, because we know you know exactly what you’re doing and we have actively decided to keep you in our programme, we want to be a helpful LP and we want to be there when you have a bigger transaction that requires a co-investment.’”

Luxury of choice

Aggressive fund terms are only really an issue for those investors which have no choice but to put their capital with funds, Etroy says.

“Thanks to our direct and co-investment strategy, we are not price takers. We [have GPs in the portfolio] because we have chosen to invest with them, and the terms they have is all part of the decision for us,” Etroy says.

“We look at net returns and we know precisely why we want to invest some money with that GP because they give us an exposure to something we want or that we like.”

This gives the pension plan “a way to protect ourselves from just complaining about the fact fees are going up” because it has a different way to play the market.

“Therefore, when we do invest with GPs, we are a happy LP.”

In it for the long haul

That preference for long-term investing is evidenced in recent activity from the pension plan. In October CDPQ teamed up with former US vice-president Al Gore’s investment firm Generation Investment Management to launch a joint venture focusing on “sustainable equity”. The CDPQ-Generation Partnership will invest an initial $3 billion and aims to hold assets for between eight and 15 years.

CDPQ is set to provide the majority of the capital alongside commitments from existing Generation Investment partners. The partnership will invest between $500 million and $1.5 billion in deals.

The pair’s first investment was global fintech firm FNZ, a deal valuing the company at £1.65 billion ($2.2 billion; €1.9 billion).

CDPQ also has a partnership with KKR focused on long-term investments. In March 2017 they acquired US insurance brokerage and consulting firm USI Insurance Services from Onex for $4.3 billion.

Etroy finds longer hold periods a more efficient way to invest. “To give you an idea, we have $10 billion in funds. Every year we receive roughly $2.5 billion to $3 billion back, so every three to four years, the whole funds portfolio comes back,” he explains.

“That’s a high-quality problem to have, but that was one of the reasons for us to say, ‘Enough, it’s just too short-term’. Every time it comes back and you need to reinvest it, you suffer transaction costs, a distraction for the management teams and the companies involved, additional fees, additional carry, and so on.”

To hold an investment in a company with long-term growth for 10 years means buying and selling that company three times – incurring not just friction costs and distraction, but potential additional loss of value, because every time the company goes through a sale process, information about it is disclosed to the market, benefitting competitors. A longer hold also builds more value, Etroy says.

“When you’re there with a mindset to stay three or four years you are not going to invest much in R&D or in projects which will have a return of, say, five, six, or seven years. If you’re there for 10 years, you are going to invest for the long term.”

That longer term vision is naturally attractive to certain founders and CEOs.

“We are seeing entrepreneurs that say, ‘I’ve been there [with a private equity fund], it’s great, but now I really feel I want to invest more longer term for my business and I need someone who is able to have a little bit more patience and longer-term vision.’ That’s been quite consistent across continents.”