Simply put, private capital markets are information-problematic. This fundamental trait necessitates the gathering and analysis of data on a constant basis by reputable firms with personnel knowledgeable about them. This is the only way to conduct appropriate due diligence and discover strong prospects for high-yield deals. In addition to absorbing some of the up-front costs of the external specialty manager - and/or other market agents and intermediaries - in conducting this task, the pension fund must incur supplementary oversight and review costs (or incur all of these costs in-house). While ultimate returns from investing may validate the exercise, undertaking it may be difficult for cost-sensitive pension fiduciaries, especially at the outset.
This was the top-rated barrier, as seen in Figure 15. A total of 78 percent of PIAC respondents rated it as important (36 percent) or very important (42 percent). Large pension funds gave this barrier considerable emphasis (85 percent important/very important).
PIAC respondents made it plain that trustees expect investment returns that are not only risk-adjusted, but cost-adjusted. For those that might utilize external pooling vehicles, such as limited partnerships, costs include management fee structures and other financial/profit-sharing items. These, many fiduciaries believe, are frequently disconnected from actual budgets and operating expenses of pools. Past experience in private capital markets (e.g., merchant banking and venture financing in the 1980s) has contributed to these criticisms of financial charge practices. Of course, performance monitoring and evaluation also entail costs implied in internal staff time, attention and resources. On balance, many respondents found total direct and indirect expenditures excessive for what is, after all, a modest asset allocation.
It seems clear from the foregoing that many Canadian pension fiduciaries will not be convinced about the legitimacy of up-front and overhead costs until they have confidence in superior returns. They must also have certainty in the value-added over and above costs, including the cost of giving incentives to professionals. Some large Canadian pension funds may be more comfortable here given their capacity for controlling expenditures through in-house management of alternative/non-traditional asset programs and by limiting exposure to a few sizeable transactions. This strategy is less viable for private capital markets focussing on smaller projects and dollar amounts (e.g., much SME term lending, venture financing) for which externally-managed pools and syndications are generally the only option open to pension funds, irrespective of size.
In considering this question, Canadian fiduciaries may be well-advised to look at recent market developments in the United States. For instance, it was partially a motivation to effect cost savings that led American pension funds to recently seek much more influence over the operation of partnerships/pools and negotiate reforms. In so doing, such funds have urged a more clearly-articulated, equitable and transparent balance of interests between themselves as suppliers and external managers.Endnote 139
Given the clout the former exercise today in American venture and non-venture equity and subordinated debt markets, this effort has translated into substantial reform of the limited partnership model of relevance to these same Canadian markets. Among emerging "best practices" are new approaches to the disclosure of actual partnership expenses and alternatives to calculating fees that are more acceptable to pension funds. Cost sensitivities are also addressed in changes to management compensatory provisions, including performance-based incentives. One feature that is increasingly found in partnership agreements is the "hurdle rate" or a minimum rate of return achieved prior to sharing profits with managers.