Years ago, Mary Macdonald warned of the potential limits to full maturation of the Canadian venture capital market in light of too small a stock of management professionals with the knowledge, skills and backgrounds necessary to foster development.Endnote 141 This perspective is just as applicable to other private capital markets or market segments - some that remain undeveloped or under-developed — given distinct specializations for distinct financial functions. Considering how integral the quality of managers is to interpreting market signals, to adding value and to producing risk-adjusted returns, pension fiduciaries remain concerned about how much access they have to the larger, but still finite, number with solid track records.
As Figure 16 shows, a total of 73 percent of PIAC respondents rated this barrier as important (36 percent) or very important (37 percent). Large pension funds gave it overwhelming emphasis (92 percent important/very important).
The organizational tool of pooling in American private equity markets has seen continuous refinement over time, much of it at the instigation of influential pension funds. As a consequence, the latter have established increasing confidence in pooling vehicles that delegate costly and management-intensive duties to external specialty managers. Prominent among these vehicles is the limited partnership, a mechanism (like that in Canada) wherein the general partner - or the external specialists - administer the pooled assets of the limited partners - or the pension funds and other investors. In the United States, close to 80 percent of venture and non-venture equity and mezzanine capital flows through limited partnerships.
As this partnership model took hold, it also began to see qualitative adaptations. Some of these were advocated by pension fiduciaries concerned about imperfectly aligned interests between general and limited partners as embodied in contracts and investment management practices. Recently, nine public sector plans, including CalPERS, CalSTERS and the New York State Common Retirement Fund, hired William M. Mercer to research this issue. Mercer found that many limited partnerships were moving in the direction of better alignment, but that specialty managers had more to do on such financial items as fees, profit-sharing and general partner equity stakes. Also reported was a need for more pension control through advisory boards, improved terms for pool liquidation/wind-down, and methods for terminating partnerships or partners due to unsatisfactory performance. The Mercer report is considered to be a statement of "best practices" by its pension sponsors for market-wide recommendation.
CalPERS has incorporated several of these best practices into its Alternative Investment Management (AIM) program. In receipt of hundreds of proposals annually from new and existing partners, a five-step screening procedure was recently implemented for AIM that includes standards for aligning general-limited partner interests. For CalPERS, alignment priorities include significant general partner equity and fees that are consistent with expenses. Other elements are pool sizes, performance-to-date, management quality and reflection of AIM's strategic priorities, such as exposure to multiple market niches and industries, long-term relationships, substantial stakes and some California-based investing. If a prospective limited partnerships passes this screen (few do), CalPERS initiates its due diligence process.
American pension funds are also diversifying their participatory means. Along with more direct investing and co-investing, this includes new vehicles, such as the "fund-of-funds", that pools assets for subsequent, strategic commitment to limited partnerships. This model offers pension funds lower costs, investment diversification for those of smaller size, and a relatively safe entry point for those new to markets. They also aim to give pension participants access to the best specialists. For these reasons, fund-of-funds have enjoyed an upswing in recent years, raising close to $4 billion in 1997. The gatekeeping firm Abbott Capital Management sponsors two fund-of-funds which disperse pension and other assets to between 15-25 limited partnerships.
Sources: CalPERS, AIM Program, 1997; Mercer, William M., Key Terms and Conditions for Private Equity Investing, 1996; The Private Equity Analyst, Vol. VII, Issue 11, November, 1997; CLMPC interviews