COVID-19 has had a different impact on the various segments in the private equity sector. We speak with OPTrust’s Sandra Bosela about the fund’s experience pre and during the pandemic.
Private equity investors seek to generate above market returns by taking an active role in the management of a company: cutting costs, expanding into new markets and attracting new talent.
But in the context of a broader multi-asset portfolio, private equity also functions to smooth out returns. Since they are unlisted, these assets are not subject to the whims of the news cycle or the sometimes erratic behaviour of the retail market.
In this context, investors often look for businesses that are not beholden to the economic cycle, but produce stable profits in any environment.
Dental businesses are a good example of this. Recession or not, most people still value clean teeth, devoid of any holes. But the coronavirus pandemic challenged even these otherwise robust businesses.
“We have invested in a couple dental businesses; we really like that industry. Dental has been very stable over many recessions, partly because a lot of people are not paying for dental services themselves, they have healthcare plans and they just want to practice good hygiene,” Sandra Bosela, Managing Director and Global Head of Private Equity at Canadian pension fund OPTrust, says in an interview with [i3] Insights.
Dental has been very stable over many recessions, partly because a lot of people are not paying for dental services themselves, they have healthcare plans and they just want to practice good hygiene. But in the early days of the COVID pandemic dental was probably near the top of the list of perceived high risk businesses
“But in the early days of the COVID pandemic dental was probably near the top of the list of perceived high risk businesses given the aerosols that come out of someone’s mouth during dental and hygiene services. This resulted in most dental services, other than emergency services, being prohibited during initial lockdowns in the spring which had an impact on businesses across the industry.
OPTrust’s dental businesses have since reopened and recovered as initial lockdowns were eased in many parts of the world and people have once again returned to the dentist, with additional precautions being taken and even more PPE used to protect dentists and hygienists. But it proved to be a reminder that risk can hide in unexpected places.
“We do a lot of scenario analysis prior to making investments to truly understand downside risk. Recession cases are certainly part of that analysis. Now I think pandemic scenario analysis will be something that investment teams will look at as they go forward. We certainly will,” Bosela says.
“We are always trying to analyse what could go wrong with a business, what could disrupt its performance and will any negative impact be short term, or long term? In a pandemic scenario there could be things that happen that are just very different than what you would see in an economic recession,” Bosela says. “So, it is important to understand these risks”.
Planning for a Recession
Bosela and her team have an impressive track record, clocking up returns in the 20 per cent range over the last number of years, including last year when the private equity portfolio produced a return of 24.7 per cent.
“The outsized performance in 2019 came from multiple deals, across different geographies and sectors,” Bosela says. “It wasn’t just one deal that made that return; it was also a combination of actual realisations, as well as increases in our mark-to-market valuations as a result of organic growth and strategic growth initiatives.”
And although this year certainly proved to be a challenge, OPTrust managed to avoid some of the hardest hit sectors during the pandemic.
We’ve tended to focus our investments in the portfolio over the last number of years more on essential service type businesses and industries. We didn’t do that with a pandemic in mind, but because we were thinking that we were late in the cycle and if a recession was imminent then we wanted to invest in recession resilient businesses
“We don’t have a lot of exposure to retail or restaurants, travel or tourism, large scale event businesses, commodities or other industries that were hardest hit,” Bosela says.
“We’ve tended to focus our investments in the portfolio over the last number of years more on essential service type businesses and industries. We didn’t do that with a pandemic in mind, but because we were thinking that we were late in the cycle and if a recession was imminent then we wanted to invest in recession resilient businesses that would have stable demand characteristics that could help to minimize volatility in our portfolio. These types of businesses often have more limited downside risk but offer strong upside potential. We like investments where we see that asymmetric return profile.”
With the potential of a recession in the back of mind, the team has taken a very disciplined approach to valuations for new investments, especially as valuations have continued to rise across the board.
“When I think back to when I first started in this industry, we were buying businesses at four to six times EBITDA and today you are often paying 10 to 15 plus times EBITDA, so we are really in a different environment,” Bosela says.
“When you pay those types of valuations for businesses, you can’t assume multiple expansion on exit; in fact, we are often factoring multiple contraction into our investment cases given where we think we could be in the cycle and what more long term sustainable valuation levels could be. The ability to successfully execute on value creation opportunities becomes critically important and plays a much larger role today in generating returns.”
But even with the portfolio positioned defensively, 2020 has been a more challenging year for OPTrust’s private equity portfolio. It might have avoided the hardest hit sectors, but the pension fund still saw the performance of many of its portfolio companies impacted by the lockdowns globally in the Canadian spring.
Growth was temporarily put on hold for many of our businesses through the second quarter as we worked with our companies to preserve liquidity until their business operations returned to more normalised levels. We were very fortunate in our direct portfolio that we didn’t have any rescue capital calls to support operations through those challenging months
“A number of our investments were certainly impacted; some businesses were virtually completely shut down for a few months earlier this year and other businesses had negligible to no impact, and then a range were in between where there was some level of demand softness for a period of time.
“Growth was temporarily put on hold for many of our businesses through the second quarter as we worked with our companies to preserve liquidity until their business operations returned to more normalised levels. We were very fortunate in our direct portfolio that we didn’t have any rescue capital calls to support operations through those challenging months and we are quite proud of that,” Bosela says.
“We think that was really driven by the flexible and conservative capital structures that we put in place in our companies, as well as the ability for our management teams to conserve cash through the cost-saving programs that were implemented across the portfolio.
“Throughout the summer and into the fall most of our businesses have seen a gradual recovery to near pre-pandemic levels and in some cases we are actually seeing growth above pre-pandemic levels.
“Despite the challenges of 2020, we feel very good about the resilience of our private equity portfolio and the ability for it to continue to deliver attractive risk-adjusted returns in line with our expectations over the longer term.”
The transport sector has been one of the hardest hit sectors during the pandemic. As lockdowns became commonplace, airports saw traffic volumes collapse by up to 90 per cent. Toll roads were less impacted as many people avoided public transport and opted for their private vehicle, but even here the greater use of cars hasn’t made up for the overall drop in traffic.
OPTrust owns investments in this sector, including Kinetic Group, which started out with a single bus route from Melbourne Airport to the city’s CBD under the SkyBus brand.
“When we acquired our bus business, it operated a single bus route from the Melbourne airport into the downtown. That would feel like a high-risk business in today’s environment, but if you fast forward from our initial investment to today that business is now Australia and New Zealand’s largest diversified bus, mass transit operator,” Bosela says. “Today, that aviation segment represents only 10 per cent of the business.”
Not only is Kinetic a well-diversified business today, its revenues are also largely tied to government contracts, which has made it more resilient during the lockdown.
“The vast majority of the business comes from government contracted bus services, so it is not linked to passenger or fare risk. Even if people in Australia, New Zealand weren’t riding the bus we would still have a stable demand, because it is contracted.”
Allocation to Private Equity
As with many pension funds that have adopted the Canadian Model, private equity is an important part of OPTrust’s portfolio. The internal team of 19, which manages both the private equity and infrastructure programs for OPTrust, runs about 50 per cent of the assets directly or via co-investments, which helps reduce costs, influence the composition of the portfolio by overweighting certain sectors and allows the team to have a more active management style.
“Active management and governance provide a lot of benefits including access to real-time information, something that was especially valuable during the early months of the pandemic this year. Having more control over our investments and a voice at the table in shaping strategic plans and other value creation initiatives allow us to better influence the outcomes of our investments, which is important to us”, Bosela says.
“We are targeting a long term allocation to private equity of approximately 15 per cent of OPTrust’s total Plan assets; we are slightly below that at about 13 per cent right now. We hope to get to 15 per cent over the next year or so, but as with any private equity portfolio you have a natural level of churn, where every five to seven years you are selling investments, so our actual allocation ebbs and flows.
We are targeting a long term allocation to private equity of approximately 15 per cent of OPTrust’s total Plan assets; we are slightly below that at about 13 per cent right now. We hope to get to 15 per cent over the next year or so, but as with any private equity portfolio you have a natural level of churn
“In 2016, we added a long-term equities strategy to our portfolio. The assets under this strategy are lower risk private equity assets, with more stable growth and cash flow profiles that have the potential to be longer term holds, up to 10 years or longer. We like having a component of the portfolio in these longer-term investments, to complement our traditional buyout strategy from a risk perspective and average hold period”.
When asked what industries OPTrust favours for its private equity portfolio Bosela says, “We like healthcare and healthcare services businesses because they are generally needs-based services and have resilient business models with stable demand characteristics.
As an example, we own a veterinary services business. It doesn’t matter what economic environment you are in, if your pet gets sick, you are still going to the vet.
“We focus on sectors where there is a large market opportunity with a stable reimbursement environment or revenue model, in sectors with room to execute consolidation strategies and by providing clinical services that can address growing consumer demand with better quality solutions.
“There are also businesses we like that combine healthcare and information technology, doing thing such as improving the quality, integrity, security, compliance and timing of information and data flow, providing secure payment solutions, creating end-to-end solutions or taking cost out of the healthcare system. We believe businesses that offer better solutions through the use of technology offer great opportunities to earn very attractive risk adjusted returns.
“We like a lot of other essential services businesses and industries outside of healthcare, such as transportation, education, telecom and power sector service providers, insurance, banking and other financial solutions, among others.
“Businesses in all of these industries tend to be relatively stable and perform well throughout cycles, without a whole lot of volatility. They also have the ability to generate very attractive risk-adjusted returns through various growth and other value creation initiatives. Again, we like that asymmetric payoff curve.
“And then we try to complement the portfolio with some higher risk, higher growth opportunities that we believe have real outsized potential, such as in the software, financial and information technology sectors, among others”.
Private for Longer
Since the global financial crisis there has been a clear trend that companies stay private for longer, before listing on the stock exchange. As a result, much of their growth takes place before their IPO.
Asked whether this has helped private equity companies in achieving their performance, Bosela answers that this dynamic has been somewhat of a double-edged sword for the industry.
“I think one of the main reasons why companies stay private for longer is that they are actually able to raise the capital outside the public markets from private market investors,” she says.
“It is obviously attractive to them for a number of reasons: they avoid the volatility of public stock markets, they don’t have the distraction of quarterly reporting cycles, they maintain more control and it is less expensive for the business.
“While it definitely creates more opportunities for private equity investors, there is a lot of capital trying to gain access to these opportunities and it is a very competitive landscape.
According to a Bain & Co. report, there was US$ 2.5 trillion in dry powder at the end of 2019 and US$830 billion of that was committed to buyout funds.
“With companies staying private longer, private equity investors have the opportunity to either invest in a business at an earlier stage and generate an attractive return by professionalizing the business and identifying profitable growth initiatives or invest at a later stage, buying a business from another private equity investor that has de-risked the business.
“By coming in later, they might be paying a higher valuation for the benefit of scale and lower business risk, but private equity investors are still able to generate an acceptable return through ongoing growth and other value creation initiatives.
As companies are staying private longer and often not choosing to go public at all, there are many more sponsor-to-sponsor transactions happening than there were 10-15 years ago,” she says.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.