Looking for the next big things

Life doesn't always go exactly according to plan – and the same can sometimes be said of investment strategies. But if Michael Powell is worried by this, he is hiding it well. Powell, head of alternative assets at the Universities Superannuation Scheme (USS), reveals that the UK's second-largest pension scheme had “expected to put £750 million (€827 million; $1.2 billion) to work in private equity in 2009, and we're materially below that”. He adds, with a calm demeanour, that his organisation is “driven by opportunities not targets”. As far as he is concerned, USS' five-year private equity programme – which he was appointed to oversee in 2007 – is very much on track.

Powell points out that much has been accomplished over the last couple of years in terms of the investment programme's building blocks. “The development of our infrastructure is ahead of plan. It was just me to start with. Now we have 12 people dedicated to alternatives and 5 to private equity and we are still recruiting. We have developed a customised CRM system that allows us to track and analyse our deal flow and we now have a formal decision-making process with an investment committee in place. It's difficult to say the private equity strategy has gone to plan as no one could have planned for the past 12 months but the core philosophy has been executed as expected.”

That “core philosophy” is opportunistic – meaning that USS wants to give itself the flexibility to invest in the most attractive strategies of the day, which Powell describes as “tactical opportunities and niche areas”. He says that, in 2009, USS placed emphasis on three themes in particular: distressed debt, secondaries and China. As yet, few funds in these areas have merited commitments from USS – explaining why it has fallen short of its expected annual outlay. Of secondaries, Powell says: “Secondaries has been quite slow; the anticipated deal flow has not come to pass. So we have been in due diligence with secondaries funds but have made no commitment so far this year. We currently have a shortlist of two.”

In distressed debt, too, something of a lull is being experienced after an initial burst of activity. “We made a lot of commitments going into the crisis,” says Powell. “Forty-five percent of our private equity portfolio is now in debt, the vast majority invested during the peak of the crisis.” He says the distressed opportunity can be viewed as three distinct phases: distressed prices, non-control debt restructuring; and loan-to-own. He says this evolution has moved into the third phase now “but the credit rally has been enormous and the door to liquidity is open.”

However, he does not think the opportunity in either secondaries or distressed has gone away – in both cases, it has merely been delayed. He predicts “a lot more activity next year” in secondaries due to the pressure created by meeting capital calls as the rate of new investment increases. He adds that “we have acquired a couple of single LP interests ourselves where we have picked up 25 percent-funded interests for next to nothing”.

In the distressed space also, he believes a big opportunity is in store. “Our economic outlook is still quite bearish. End demand is anaemic so we see low growth for the next few years and default rates remaining high. Big companies have access to the high yield bond market but the mid and small ends of the market will be squeezed. Therefore, we're looking to invest in funds that give us exposure to that segment of the market”.

The firm's China strategy, meanwhile, is at an early stage. “We've been to China a couple of times, met GPs and portfolio companies and that's given us an understanding. It's an interesting market but there are issues. We will make a commitment to a Chinese fund at some point in order to get a toehold.” Powell says funds targeting state-owned enterprises – of which there are only a small number – are of particular interest. He believes that “the buyout market in China is currently a niche play but the long term outlook is encouraging”. He insists that the more common pre-IPO investment strategy is not something USS wishes to be involved in.

But, while the three areas of focus in 2009 have not yielded much in the way of fund commitments, Powell is happy that USS had already put in place what he describes as “core relationships” with selected GPs. Because of the immaturity of the programme, only around 30 percent of USS' private equity commitments have been drawn to date. “There's a lot of dry powder still in buyout funds and, in terms of the rollout of that, we're pretty confident,” he says. Powell adds that USS currently has a 4 percent allocation to private equity and 9 percent to alternatives against a medium-term alternatives target of 20 percent.

The big test is when the high-profile funds come back to market in 2010/11. We need our ducks in a row on terms and conditions and to be explicit with GPs

Michael Powell

Over the last couple of years, USS has made ripples in the private equity market that have extended beyond the mere quantum of its capital commitments. For one thing, it has been building up its team during a period of contraction for the industry generally. Another notable facet has been its promotion of certain principles, including responsible investment. The organisation now has a team of five dedicated to responsible investment who participate in fund due diligence. It is also represented on the United Nations Principles for Responsible Investment (UNPRI) Board and British Venture Capital Association's Responsible Investment Advisory Board. Referring to the positive response of many US GPs to responsible investment guidelines produced by the Private Equity Council, Powell says: “The big players have signed up to the initial phase of acceptance; now comes the more difficult phase of implementation. But GPs do see it as an advantage to take it seriously. Our view is that it should help long-term returns.”

Powell speaks robustly of the need for transparency, which goes beyond responsible investing to other areas. Asked about the placement agent scandal in the US, he says a total ban on the activity is not desirable, especially given the “beneficial” role placement agents play for GPs and LPs alike at the smaller end of the market where good funds may have trouble getting in front of potential investors. However: “The placement agent industry needs to tidy up its act. There are many good ones but there are some that have clearly not played by the rules. But I do think the industry has a role to play in private equity.”

His focus on fair play extends to fund terms and conditions: “We want managers to cover their costs and nothing else.” In this spirit, he calls for 100 percent offset of transaction fees (a position shared by 41 percent of LPs in a survey conducted by placement agent Probitas Partners at the beginning of 2009). While applauding signs of movement in this respect, it is clear he is not resting on his laurels: “The big test is when the high-profile funds come back to market in 2010/11. We need our ducks in a row on terms and conditions and to be explicit with GPs. Historically, the LP community has been pretty poor in expressing its opinions to GPs and raising its head over the parapet.”