Seeing another way

The Ontario Teachers' Merchant bank is no ordinary pension private equity programme, and Jim Leech wouldn't be interested in heading it if it was. Having once run a major Canadian merchant bank, as well as a number of large businesses across vastly different industries, Leech is the right man to lead a private equity operation that other pensions should, but can't, emulate.

For starters, Leech has a knack for envisioning the extraordinary in what others view as mundane. When, in 1985, Leech became CEO of an unassuming local Ontario natural gas distribution company called Union Energy, he immediately set to work convincing the employees that they did not, in fact, merely work for a gas distribution company. “If you asked them what they did, they'd tell you they delivered gas to the Widow of Wallaceburg” – the proverbial humble customer in Anywhere, Canada. “I said, ‘Well, if you look at it another way, you are also an integral part of the movement of gas around North America.”

Leech succeeded at having the 2,700 employees of Union Energy see their company another way. Through aggressive internal growth and acquisition, the utility became a major “wellhead to burner tip” energy provider and its share price doubled over 8 years. In 1993, the company was acquired by Westcoast Energy and, later, by Duke Energy.

In his current role as head of the Teachers' Merchant Bank, the private equity arm of the $45 billion Ontario Teachers' Pension Plan, the casual observer might guess that Leech now oversees mundane GP-monitoring duties on behalf of the proverbial Teacher of Tillsonburg. But this would be a marked underestimation both of the strategy of Ontario Teachers' and the mission of James Leech. In fact, Leech is aggressively expanding his pension's unusual role: both as an active, direct investor in private companies, and as an investor on equal footing with the world's most powerful private equity firms.

While Leech, who joined Teachers' Merchant Bank in 2001, is not solely responsible for Ontario's mould-breaking approach to private equity, he is certainly the right man for ramping up an audacious strategy that has been in place since the early 1990s.

The architect of the merchant bank is current pension chief investment officer Robert Bertram, who, in establishing a private equity programme for the pension, specifically did not seek to mimic the programmes he saw at other retirement systems. “[Bertram] was aware of what other pensions were doing,” says Leech. “But he didn't like the fees and promotes and things like that.”

Bertram and the pension board felt that placing pension money in private companies was a very suitable investment activity, and, moreover, an activity to which the pension was well suited to doing on its own. In Ontario, active money management trumps passive management.

Money matters
Bertram's vision stands at odds with private equity programmes established at other major pension plans, which, despite being major sources of capital for private equity funds, do not always effectively leverage that heft to their advantage. Put bluntly, pensions chronically underpay in-house investment professionals to monitor the activities of large private equity firms, which in turn charge enormous fees to manage the pension plans' capital. In this scheme of things, pension boards are constrained politically from directly employing adequate investment talent, but get away with enriching independent money managers because their remuneration figures do not appear directly in the pension budget.

Take, for example, the situation faced by another large pension plan in California. The private equity staff at the California Public Employee Retirement System – known to one and all as CalPERS – had battled unsuccessfully to push their compensation closer to what investment professionals in the private sector make. In 2001, the pension was sued by California controller Kathleen Connell, who argued that the investment professionals at CalPERS, as public employees, were earning too much money. The suit prompted the resignation of CalPERS chief investment officer Daniel Szente and resulted in pay cuts for the pension's alternative investment team. CalPERS, one of the world's largest private equity backers, pays its alternatives staff a total of less than $1 million per year to oversee capital commitments of roughly $20 billion. But the pension paid an estimated $9 million in management fees to GPs for its 2002 private equity commitments alone. As underlying investments from the 2002 vintage year are exited, CalPERS will relinquish approximately 20 per cent of those profits to outside managers. Such, it seems, is the price of controlling jealousies among civil servants.

We're not buying a syndication of a deal after it's done

The politics that have hampered CalPERS and most other public pensions have not affected Ontario Teachers' private equity programme, which recently increased its target allocation to private equity to 10 per cent from 5 per cent. Whilst CalPERS has found itself in the eye of a media storm in connection with its private equity allocations and its seeming reluctance to reveal performance data on these investments, Ontario has remained out of the spotlight. “The press has never taken a shot at us, but I think that's partly because of performance,” Leech says.

Leech oversees a staff of 23 investment professionals, whose pay, he says, “doesn't resemble anything like the salary of civil servants.” Teachers' Merchant Bank professionals are paid a base salary plus an annual bonus that reflects a blend of the performance of the overall fund plus their personal performance. The pension has also created a benchmark system that mirrors carry. “It looks at your performance over a four-year period, and if you've exceeded your benchmark, you will be rewarded,” says Leech, who hastens to add: “Our compensation plan is very competitive, but it isn't carry. During the heyday of private equity returns [in the late 1990s] we couldn't beat the standard two-andtwenty system.”

Still, compensation at Leech's group is one key factor that has prevented the turnover endemic across pension-sponsored private equity programmes. Leech notes that he recently placed an advertisement for two associate positions at the firm and received 475 resumes over one weekend.

Direct investing
A relatively sizeable, wellpaid staff allows Teachers' Merchant Bank to act like a bona fide private equity firm and less like a passive allocator. The firm seeks out direct investments across a broad range of industries and stages. Teachers' Merchant Bank will only commit capital to third-party funds where the GP team can offer access to markets and expertise the pension cannot source on its own. Significantly, GPs must offer what Leech defines as real co-investment opportunities. “We're acting more as a cosponsor than a co-investor,” says Leech. “We're not running a fund-of-funds. Our definition of co-investing is very different than most other people's. We're not buying a syndication of a deal after it's done. We send due diligence teams early in the process; we're side-byside with the fund partners; we're there at closing.”

In Canada, roughly 88 per cent of the merchant bank's capital is directly invested in private companies. Of its non-Canadian private equity holdings, 31 per cent is directly invested, with the rest of its capital split between US and European fund managers.

The funds to which Ontario has committed include DLJ Merchant Banking, Heartland Industrial Partners, Providence Equity Partners, Hicks Muse Latin America, BC European Capital, Wellspring Capital Partners and Wind Point Partners. Notable by their absence are the big names typically found in major pension portfolios – Blackstone, Carlyle, Thomas H. Lee, etc. Leech says he will gladly do a direct investment alongside a major firm, but unless that firm can offer significant, direct access to deals beyond his own team's areas of expertise, he will pass on committing to the fund.

A case in point is Teachers' Merchant Bank's relationship with New York giant Kohlberg Kravis Roberts & Co., a firm that Leech hails as an investment partner, but doesn't need as a money manager. The two firms first met in 1999 as rival bidders to Shoppers' Drug Mart, Canada's largest drugstore chain, then owned by Imasco. KKR was leading its own syndicate while Teachers' Merchant Bank led a syndicate that included Bain Capital. “The night before the final bid we said to each other, ‘Why should we make the vendor rich?’” Leech says. “So we did a shotgun marriage.” The newlyweds, including Teachers' Merchant Bank, KKR, Bain Capital, Charlesbank Capital Partners and DLJ Merchant Banking, acquired Shopper' Drug Mart for $1.7 billion.

When KKR next came to Canada to do a deal, it again called Ontario Teachers'. The two firms joined forces last September to acquire the directories business of Bell Canada in a $1.9 billion buyout. “The first time we did a deal with KKR, I'm sure they were thinking, ‘Oh God, we've got this silly pension along with us now,’” says Leech. “But Shoppers' Drug Mart has turned out to be a very good investment, and they watched the contributions and value added that we brought to the table throughout that transaction. When the yellow pages deal came along, they basically said, ‘Do you want to do this thing together?’ We both needed a partner.”

But Ontario has little inclination to grow the relationship with the big buyout firms in any other direction. Leech says that his firm, unlike some other institutional investors – notably CalPERS – does not believe in taking stakes in the management companies of private equity firms. “Our view, very firmly held, is that we want to have our interests very clear,” says Leech. “If we're dealing with a GP and he's sitting on that side of the table and I'm sitting on this side, I don't want to be running over there every once in a while.”

Other partners Leech's team has worked with recently include Citigroup Venture Capital, which joined Ontario in the purchase of travel technology company Worldspan from Delta, American and Northwest Airlines. In Europe, Teachers' Merchant Bank has committed €500 million to BC Partners, and has already co-invested roughly €300 million alongside the firm. Ontario Teachers' recently joined a group of investors, including Dutch pension NIB, in the purchase of the former Deutsche Bank direct private equity portfolio, now managed by a spin-out group called MidOcean Partners. That deal, in which Ontario Teachers' invested $335 million, involved only the underlying portfolio companies.

Leech is still not satisfied with his group's profile in the broader private equity market, and has launched an aggressive marketing campaign to, in the words of an official Teachers' Merchant Bank brochure, make his group “Your First Call.” The Ontario pension is already a recognised, dominant private investor within the Canadian market, thanks to a decade of high-profile deals, including the buyout and restructuring of the Toronto Maple Leaf and Toronto Raptors sports franchises. Now it's time for international investment groups to recognise Ontario Teachers' capabilities, says Leech.

“Our marketing in Canada has been to refine our image and get a message out to management teams saying, ‘Listen, if you see an opportunity, make us your first call,’” he says. “In the US and Europe, it's been much more of a focus on having other private equity funds bring us into deals. If you want a $75 million cheque in Canada, you've got three phone calls you can make – Caisse de Depot [et placement du Quebec], [Canadian buyout firm] Onex Corp., and us.”

Leech himself is no stranger to publicity. During the 1980s, he was president and CEO of Unicorp Canada, a publicly traded merchant bank which made headlines with the hostile takeover of Union Energy, then called Union Enterprises. Unicorp was a major player in real estate investment trust roll-ups. Leech also led Unicorp's $150 million takeover of New York-based Lincoln Savings Bank. Famously, Unicorp pursued, but did not acquire, Dunkin' Donuts and Montreal grocery chain Steinberg. In 1988, Unicorp divested all divisions except Union Energy. Leech remained head of this business until 1992, after which he took up a series of leadership positions at technology companies. The last venture, an application service provider called InfoCast, suffered in the tech meltdown, and proved more of a reorganisation job than a growth job.

At the beginning of 2001, Leech, in his early 50s, and his wife, also a veteran senior executive, found themselves thinking more about travelling the world than plunging back into corporate life. Then an executive recruiter called with an offer to head up another merchant bank, this one aimed at building long-term value for the teachers of Ontario. “They said, ‘Would you like to join an organisation that already has a stellar record,’” says Leech. “I felt it would allow me to put together all the business experiences in my past and bring them to bear to get financial returns for the pensioners.”

Like Leech, a number of other senior staff members at the Teachers' Merchant Bank have run large companies. The firm has a top-to-bottom approach to due diligence and a strong operating focus after a deal is done. Leech assigns a three-person deal team to every transaction, and the entire staff meets on Monday to go over every transaction. Leech says he encourages a consensus approach, where junior staff members are free to disagree with senior professionals.

This everybody-has-a-say approach was likely not picked up by Leech during his first career – as an officer in Canadian Armed Forces. After graduating from the Royal Military College of Canada in 1968, Leech served for a time in Germany, where he specialised in communications equipment. In 1971, Leech broke away from the “family business” – his father, uncle and brother all became generals – and went to business school. “After I became captain, I decided there were greener pastures,” he says.

In the US and Europe, it's been much more of a focus on having other private equity funds bring us into deals

Leech knows other pension funds have an interest in the programme he now heads: a number have sought to learn more about both the theory and practice that shapes it. Unfortunately, emulating the Teachers' Merchant Bank would require fundamental changes in thinking at many pension boards. “Other pensions have come and talked to us, but then they go away knowing that the issue of compensation and staffing is difficult,” says Leech. They also go away knowing that emulating the talents of Jim Leech is no easy task either.