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Institutional Investor Profile: Jim Leech, Senior Vice President of Teachers' Private Capital

Jim Leech on being primarily a direct investor, having the intellectual property to discern which are the better investments, and why they are not the passive 'phone us up after the deal' type of co-investor.

The Ontario Teachers' Pension Plan was created in 1990 and currently has assets under management of approximately C$80bn. Teachers' Private Capital manages all the plan's mezzanine and private equity investment, as well as infrastructure and venture capital assets. Its private equity portfolio is worth an estimated C$5bn. Most of the bank's activity is in direct investing but it has a substantial fund portfolio comprising a limited number of established groups in key markets and sectors. Jim Leech joined to oversee all these activities in 2001.

How did Teachers develop its private equity strategy from its inception as an independent entity?

Almost immediately the plan started investing in private equity and doing it directly rather than through funds. In Canada back then, the market didn't really offer many funds in which the plan could invest so it went out on its own. It was really a matter of necessity. We have been primarily a direct investor ever since. Then in 1992 the strategy was refined a bit more when the plan went international. It was decided that the most effective way to do that would be to find partners in various geographies to work with instead of trying to do direct deals ourselves in unfamiliar territory.

We went out and found, for example, BC Partners in the UK. We liked their track record and we liked the people. We became a major investor in BC Partners funds and have co-sponsored several transactions with them. Most recently we have invested with them on Sanitec, Grohe, Cantrell and Cochrane, and Mark IV. BC Partners found these opportunities and did all the heavy lifting up front; but they then determined that the investments were too big to do alone. So we sent our due diligence team to Europe to work with them until the investments were finalized.

Why did you decide to stick with this strategy rather than the more conventional approach of investing in a larger number of primary funds?

There are three things that inform our strategy. First, the pension plan overall is pushing more and more to actively manage its investments. Second, our record and our belief suggests that we will do better with fewer but larger bets. We think we have the intellectual property to discern which are the better investments. And third, it is cost-driven. Paying two per cent and 20 per cent carry is exceptionally expensive and I think that pension funds rarely look at that to the detail they should.

We have the advantage of being relatively imaginative and close to the fully private sector model with regard to the way we can incentivise our employees. We wouldn't embark on this strategy if we couldn't afford to attract the right intellectual capital. A lot of public sector investors kid themselves into thinking it is cost efficient to invest through funds because it would be politically difficult for them to repatriate those costs to pay for the necessary internal resources. These issues are particularly important now that it looks like returns are going to be coming down. It all comes down to the quality of the internal resources you have. That is what enables your strategy.

Would you expect to see more institutions move towards co-investing as sensitivity to fees grows?

Feeling that co-investing is a panacea for higher returns in the asset class is a mistake. Some pension funds think that because they are making fund investment decisions they can also make decisions about co-investments. There is a huge difference between choosing managers who will build a portfolio of investments and making a single large bet alongside them. There is also a responsibility that goes with that - changing management and going on the board, for example. Most pension plan organisations are ill-equipped to do that. Writing off a big investment is very different from being invested with a fund that has to write off a single portfolio company. If you don't have the talent or the culture, then you should stay out of co-investing.

How do identify new opportunities or relationships that you might want to develop?

Basically we are proactive. We don't respond to knocks on the door. Recently, for example, we created Park Square Capital Partners. We followed the model we used in the US where we wanted exposure to mezzanine but we couldn't find a group that we were overly excited about or that was fundraising at the right time. We learned that Robin Doumar was thinking of leaving Goldman Sachs. He was going to have to go to ground for a while, work out his business plan and then spend maybe 18 months fundraising. So we said we'd arrange to raise the entire amount. In effect, we underwrote the raising of €1bn so he's back in business four months after leaving the bank.

Does your large-bet approach mean that you can negotiate a preferential relationship with fund managers?

We have never owned a stake in the GP. We believe in maintaining the ordinary GP/LP relationship with them. But we don't pay fees or carry on co-sponsored transactions and that is where the difference to our returns is really made. What we have been able to prove to our partners is that we bring "value add". We are not passive 'phone us up after the deal' type of co-investors. We get involved in the transaction early on and work shoulder to shoulder - no different from any other Private Equity firm.

We underwrite co-investments exactly the same way we do our direct investments. Quite often transactions come to us directly but we feel they could be better executed in association with one of our private equity relationships. We make referrals to our managers thus helping with deal origination.

Are there limits to this strategy, either in terms of the size of groups you can work with or the sectors you invest in?

We can't really back groups that do smaller deals. To make an impact on our portfolio - and our buy-out portfolio is about C$5bn - our minimum transaction really needs to be more than C$50m. Once you get over to Europe and start looking at smaller deals it gets expensive. And in venture we run only a fund and co-investment strategy. We do not do VC directs, only investing alongside our partners.

How do you expect your strategy to evolve over the medium term?

We are starting to push the model from a geographical point of view to broaden our horizons. One of the advantages we have is that in 1992 we were one of the very first North American investors to go to Europe. The onslaught from North America came four or five years later. We are endeavouring now to determine where is the next place we need to go. For instance, we are taking a good hard look at Asia. How can we benefit from the growth that is going on there? Teachers' Private Capital has been expanded to include infrastructure activity as well as timber around the world. We have, for example, been part of gas distribution auctions in the UK and toll road actions in Australia.

We think Europe will stay strong for a number of years but there are other emerging markets we need to explore. Many warn that you have got to be cautious about driving wholesale into China but there will be great opportunities in these markets. If you are an early mover, and prudent, then there is plenty of opportunity.

How might you approach Asia?

We have some legacy exposure from some fund investments we made four or five years ago - about C$100m. They have had mixed results. So three years ago, we effectively put Asia on hold until recently. We have just completed a very intensive study and identified a couple of groups we would consider partnering. We are in negotiations and would expect to be in a position to announce one of those groups before the end of the year. They are indigenous groups. That's been our approach. We've had success, as with BC Partners, in that way. Asia may not even be where Europe was when we first arrived in 1992 but it is moving very quickly.

What are the characteristics you look for in a new fund opportunity?

They have to have a very, very good track record. We don't go into first or even second time situations. And they have to give us access to a market that we couldn't otherwise access ourselves. That means either geography or specialism. A good example would be Providence in the US that has provided us with a telecom and media expertise. Another example would be Ares, with their distressed debt angle. We are very selective about backing people who have a particular expertise.

What do you think are the main risks to private equity investing at the moment?

Prices have moved up dramatically in the last three years as everything goes to the auction. Auctions can be very frustrating because you spend a lot of time, money and emotion on something and then come up short. The toll it takes on people can be very significant. On the other hand, if you win you find yourself thinking 'oh my God, I paid more than anyone else.' I worry whether prices are being bid up too high. Credit is pretty easy to come by these days and I wonder whether we are drifting towards a bubble. That's why we are spending time on less competitive areas like infrastructure and regions that are less crowded.

What is your outlook for private equity returns?

Our track record since 1991 on our private equity investing, is an IRR of 28.6 per cent. Private Equity stands out as a good place to go and it is obvious why a lot of pension plans have decided they want to diversify out of stocks and bonds. The fact is there is a lot more money chasing transactions today. We're working very hard now not to dilute our record. But clearly, three years ago, everyone was saying their hurdle rate for returns was around 25 per cent. That has dropped, without doubt, now to about 20 per cent and some people are starting to say it should be even lower. My fear is that people are starting to kid themselves about the level of risk in private equity. It is not for the faint of heart.

Chris Davison is director of research at Almeida Capital

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