The demise of the BCE buyout puts another nail in the coffin for institutions acting like merchant banks — but the model is not dead yet.
While some large Canadian pension funds had been acquiring firms whole and later selling them off, the collapse of what would have been the largest deal in history — the C$51.7 billion (US$43 billion) buyout of Montreal-based BCE Inc., led by the C$108.5 billion Ontario Teachers' Pension Plan — might sour them on the concept.
Industry watchers caution that one spectacular failure does not indict an entire strategy. Most of the recent deals were made during the past two or three years, and therefore it is too early to tell how the direct investments will fare.
For instance, Ontario Teachers' C$570 million purchase of close to 70% of Esval SA and its subsidiary Aguas del Valle SA, a Chilean water services operator, closed Dec. 24, 2007. The fund also joined with Ares Management LLC, a private equity firm, to buy GNC Parent Corp., the parent company of General Nutrition Centers Inc., for C$1.65 billion in February 2007.
But earlier experiences of some U.S. pension funds that made large direct investments in companies have not gone well, said Joshua Lerner, Jacob H. Schiff Professor of Investment Banking, Harvard Business School, Boston.
“Most of the efforts have fallen flat on their faces,” Mr. Lerner said. One example is the investment in US Airways Group Inc., Arlington, Va., by the Retirement Systems of Alabama, Montgomery, before the airline filed for bankruptcy protection for the second time in 2004.
The BCE saga — which lasted some 18 months — might not deter large institutional investors from trying out the strategy, Mr. Lerner said. With private equity fund investments expected to produce disappointing returns, sovereign wealth funds might be tempted by direct investment, he said. For example, one of Singapore's sovereign wealth funds, Temasek Holdings, has been busy making direct company investments on the Indian subcontinent.
The strategy of leading an LBO has its attractions. Some costs, such as transaction fees, that come with fund investing are eliminated. However, turning a pension fund, endowment or foundation into a private equity firm is not a trivial business, Mr. Lerner said. It requires a large staff with specialized knowledge.
To retain the staffers requires pension funds, endowments and foundations to pay executives at least in the same range of what they could earn at a management firm. Those relatively large paychecks can create problems, such as the protests endured by the executives at the Harvard Management Co. for their comparatively rich pay packages.
In recent times, most U.S. pension plans, in contrast, opted to co-invest alongside their private equity fund managers when they could, taking small slices of deals in return for lower fees.
“Sponsors often need co-investment capital to manage their own portfolio concentrations. It's another source of capital, it often makes more sense to team up with an existing limited partner than another control-oriented sponsor or a bank, said Stephen Moseley, Stepstone, a La Jolla, Calif.-based private equity consulting firm.
Even making co-investments — large or small — requires different skills, he added.
“It's more labor intensive and the labor is different from the work for which most pension funds are designed and staffed,” he said. “It's not something to do unless you are really committed.”
Still, over the last couple of years, direct investing and co-investing were widespread, noted Mario Giannini, chief executive officer at Hamilton Lane, Bala Cynwyd, Pa.
Co-investing and direct investing “has been reduced, but probably more because of allocation (constraints) or the reduction in deal flow right now. It remains to be seen whether that reduction will be permanent in the next upswing,” he said.