Investing in Private Equity | Harvard Business School Online

Section 1 of 24

Introduction

In this two-part lesson, you’ll explore how private equity investing is evolving and different approaches for entering this growing alternative investment space through the example of Denmark’s largest private pension fund, PFA Pension.

Section 2 of 24

For larger investors, co-investing alongside a traditional fund structure and direct investing (i.e., skipping the fund structure entirely) have become ubiquitous in the alternative investment space.

Two main factors are behind the trend: (1) It is an expensive asset class, and high net returns are not guaranteed, and (2) a global low interest rate environment appears unlikely to reset in the foreseeable future. The aftermath of the 2008 global financial crisis that brought near zero, if not negative, interest rates for many economies has pushed many investors to move aggressively into the alternative asset classes. At the same time, many of them were asking “Why can’t I just do this myself? Do I really need a fund, or a fund of funds to access this asset class?” This movement has put a lot of pressure on the industry and has changed many of the ways in which they operate. Next, we’ll examine these changes and their implications.

Section 3 of 24

Section 4 of 24

PFA’s decision to expand into alternative investments was based on the following views:

Low global interest rate environment
Shrinking public market and increasing opportunities in the private space
PFA’s competitive advantage as one of the largest pools of capital in Europe

PFA’s clients made their decisions about which fund to invest with based on a five-part balanced scorecard:

Net returns
Administrative cost
Cost of insurance benefits connected to pension plans
Total cost, including traditional costs such as rent and administration, and all costs associated with investment management
Service level

For corporate clients, a consultant would review the above criteria every three to five years and make investment recommendations. At this time, if PFA remained the preferred fund, their corporate clients (the companies investing their pensions with PFA) would renew their contracts. If not, they would leave for a different fund.

How PFA expanded into the alternative space had to account not only for the net returns but also for the cost of investing in this space, which is why PFA decided to lever its scale to come out with a customized strategy of alternative investing.

PFA is a private pension fund, which means that it manages the money on behalf of current and future retirees. (Although we will not dive into the implications of the type of funds for investment management, PFA is primarily a defined contribution (DC) pension plan.) The liabilities of these clients (the pensions) are often decades into the future.

Section 5 of 24

Does this mean that PFA’s horizon for tackling these challenges is also long term?

Section 6 of 24

To meet their investment needs, they created a program called Strategy 2020.

It contained three main initiatives:

Find new sources of investment return
- Unlisted investments
- New markets and asset classes
- Extension of strategies
Expand investment areas
- Focusing on exploiting economies of scale
- Upscaling "in-house asset management" and adding new investment skills (alternatives)
- Having stronger risk management and developing/improving systems
Focus on risk-adjusted return
- Focus on absolute real return
- Move away from the benchmark mindset
- Maximize long-term return in a cost-effective and responsible manner

Section 7 of 24

Section 8 of 24

As a way of achieving their strategic investment goals, PFA intends to become a co-investor and direct investor in the alternative space.

Section 9 of 24

Section 10 of 24

Regionally, PFA is a very large, highly capitalized pension fund. What edge do you think this might give it?

Peer responses

" "

1) Economies of scale 2) Access to capital and ability to hold illiquid assets 3) Ability to employ leverage 4) Specialization in certain markets/industry segments

E, Abu Dhabi

" "

PFA can achieve economies of scale through pooling investments and increased skills in alternative investments. It can take advantage of ad hoc inefficiencies in the markets.

M, France

" "

They can basically run an internal private equity firm - no fee or carry to external managers.

J, United States

" "

1) The talent pool and the expertise in the research in certain industry. 2)The cost of funding is cheaper, as its directly from the contributions from DC plan, and they usually have very good relationship with banks. 3) Their long-term investment horizon and diverse portfolio in other asset classes. 4) Their good reputation. The private company would love to have PFA to be their investors as this will give confidence to the rest of the market.

Y, Canada

" "

It probably has the capital to buy certain companies outright, without needing to incur cost of capital (other than opportunity cost).

S, United States

Section 11 of 24

Section 12 of 24

So that’s what PFA can bring to the table. Now let’s consider the other side. What are the potential challenges of PFA’s new initiative to invest in alternative investments?

Peer responses

" "

PFA has a ton of flexibility with capital and mainly looks to co-invest together with the owner/family business for many years. Challenges can arise if the owner/family business doesnt see eye-to-eye with PFA - especially if PFA has a minority stake, which often do.

J, United States

" "

1) It might also be hard for PFA to invest in early stage companies (VC targets) due to their long term commitment to the future retirees. 2) PE firms have extensive deal sourcing systems and network, it also seems challenging for PFA to build that in short term. It could also be challenging to hire the managers with that domain expertise. 3) PFAs corporate client is looking to renew contract in 3-5years, its also possible that the private investments only start to generate return after 3-5years. So the timing is also challenging.

Y, Canada

" "

PFA now has to manage its investment, which is... a full-time job for a PE firm.

S, United States

" "

1) Growing competition 2) Strategic focus/specialization given broad advantage of size 3) Risk mitigation strategies

E, Abu Dhabi

" "

PFA must bring the network and non-financial added value during its co-investments. In addition, alternative investments require the long term to create value.

M, France

Section 13 of 24

Section 14 of 24

PFA’s goal was to increase allocations from 2% to 15% within five years.

For private equity, this is a dramatic increase in a very short period of time. To do this, PFA needed a plan.

Section 15 of 24

Which of the following strategies will be most important in getting PFA to the 15% allocation?

Section 16 of 24

Section 17 of 24

You can see that scaling up presence in the alternative space, especially if you try to keep costs low and cash flow profile relatively smooth, is difficult. It is even harder to become a successful direct investor! One potential strategy, Henrik notes, is for PFA to become a co-investor.

Section 18 of 24

Why do you think that GPs would allow (or encourage) their LPs to co-invest alongside them?

Peer responses

" "

Co-investment allows GPs to share risks, access more asset classes and investment opportunities while benefiting from the pension fund network

M, France

" "

1) Less fundraising effort required / opportunity to raise more capital 2) Established relationships and trust 3) Understanding/alignment of the company and Investment strategy

E, Abu Dhabi

" "

Yes I think GP would encourage for co-investment opportunities, because this shows the alignment of the interest the the GP and LP, it also gives GP the confidence that this is a good investment decision. Together the GP and LP represents a larger ownership of the target company, and will have more power influencing the company operations.

Y, Canada

" "

Capital aid and diversification!

J, United States

" "

They may need the capital for certain deals, and it may de-risk the investment for them in certain ways.

S, United States

Section 19 of 24

Section 20 of 24

Do you think co-investing is worth the trade?

Section 21 of 24

Section 22 of 24

In 2020, the Strategy 2020 program came to an end, and PFA needed to articulate a new strategy for the next three to five years. The result was Commercial Responsibility 2023. This new strategy articulated three new goals:

Be the best at generating sustainable returns
Have the highest customer loyalty in the market
Have a solid foundation and profitable growth

Compare the goals of the updated strategy with those of Strategy 2020:

Focus on risk-adjusted return
Find new sources of investment return
Expand investment areas

Section 23 of 24

How do you think the new strategy reflects the triumphs and challenges of Strategy 2020?

Peer responses

" "

PFA has successfully deployed their capital in the alternative space and expanded the network there, so now the investments are expected to generate returns. However, generating sustainable returns requires a well diversified and customized portfolio that can provide return constantly, so the challenge would be keep find good investment opportunities that fit the time horizon.

Y, Canada

" "

It seems like a natural extension of the success of the previous strategy.

S, United States

" "

The 2020 strategy has fully achieved its objectives. The second step, with this new Commercial Responsibility 2023 plan, aims to capitalize on the results obtained by gaining customer loyalty and to perpetuate the results obtained over the long term.

M, France

" "

Triumphs - seems that their efforts to expand investment areas and find new sources of investment return may have been successful and now the focus is to sustain that. Challenges - it seems that they may struggle with short term expectations of their customers (3-5 years) relative to their longer term alternative investment strategy so by focusing on customer loyalty and foundational portfolio, they will be able to retain capital and achieve returns over the longer term time horizon

E, Abu Dhabi

" "

Strategy 2020 was all about finding returns and diversification. Commercial Responsibility 2023 is geared to retention, loyalty, and sustainability. In order to be an industry leader, you need to have a solid foundation and a plan to execute in place. Retention and customer loyalty are aiding factors.

J, United States