Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

When it comes to at least one type of investing, U.S. pension funds should take a (maple) leaf out of their Canadian counterparts' playbook. 

Despite being among the largest private equity investors, U.S. pension funds such as the California Public Employees' Retirement System and the California State Teachers' Retirement System have been slow to transition from a hands-off approach to one that involves actively participating in select deals, a feature known in the industry as direct investing. 

A More Direct Approach
Co-investments have mostly delivered private equity investors returns above what they would have otherwise earned
Source: Preqin, per September 2015 survey

The benefits of direct investing are lower (or sometimes no) fees and the potential to enhance returns, and that makes it an attractive proposition. But so far, U.S. pension funds have been pretty content as passive investors for the most part, writing checks in exchange for indirect ownership of a roster of companies but without outsize exposure to any. 

State of the States
State pension funds are comfortable writing checks to private equity firms but could bolster their returns by investing directly in some of those firms' deals.
Source: Pitchbook

Not so Canadian funds. A quick glance at the list of the private equity investors -- commonly referred to as limited partners -- that have been either participating in deals alongside funds managed by firms such as KKR & Co. or doing deals on their own since 2006 shows that these funds have had a resounding head start over those in the U.S.

Notably Absent
Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns
Source: Pitchbook
*2006 through 12/05/2016

Canadian funds' willingness to pursue direct investing is driven in part by tax considerations: they can avoid most U.S. levies thanks to a tax treaty between the two North American nations, while they are exempt from taxes in their own homeland. But U.S. pensions would still benefit from better returns, so it's curious that they haven't been more active in this area.

There's plenty of opportunity for direct investing. Private equity firms are generally willing to let their most sophisticated investors bet on specific deals in order to solidify the relationship (which can hasten the raising of future funds). It also gives them access to additional capital.

Rattling the Can
Private equity firms recognize that offering fund investors the right to participate directly in their deals bolsters their general fundraising efforts
Source: Preqin; per August 2015 survey

The latter point has been a crucial ingredient that has enabled larger transactions and filled the gap caused by the death of the so-called "club" deals (those involving a team of private equity firms) since the crisis.

Seal the Deal
U.S. private equity deals which are partly funded by direct investments from so-called limited partners reached their highest combined total since 2007
Source: Pitchbook
*Through 12/05

There are some added complications. Because some of the deals involve heated auction processes, limited partners must do their own diligence and deliver a verdict fairly quickly. That could prove tricky for U.S. pension funds, which would need to hire a handful of qualified executives and may find it tough to match the compensation offered elsewhere in the industry. Still, the potential for greater investment gains may make it worth the effort -- even for funds like Calpers that are reportedly considering lowering their overall return targets.

With 2017 around the corner, one of the resolutions of chief investment officers at U.S. pension funds should be to evolve their approach to private equity investing. They've got retired teachers, public servants and other beneficiaries to think about. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. In one recent example, Caisse de dépôt et placement du Québec, or CDPQ, in September announced a $500 million investment in Sedgwick Claims Management Services Inc., joining existing shareholders KKR and Stone Point Capital LLC.

     

  2. This similarly applies to deals that are syndicated after an auction has been won and a deal has been agreed upon.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net