Study shows how four large Canadian pension funds have taken control of the value-creation process
Pension funds spend billions on active investments that aim to generate “alpha” – the extra value above and beyond risk-adjusted returns. The problem is that in the long and complex chain of industry players connecting the real economy to the financial sector, pension funds are at the bottom of the value-creation chain. Upstream, entrepreneurs and developers launch projects and create value, followed downstream by venture capitalists and private equity funds, who provide financing and oversee the value-creation process, and further downstream by mutual funds and hedge funds. Finally, at the tail-end, pension funds enter as limited partners, allocating billions to these specialized intermediaries. The fees pension funds pay to upstream players are such that their active investment returns are often comparable to those of passive investments. In other words, any alpha they generate is absorbed by the fees they pay out.
In my recent study, done jointly with Barbara Zvan and Eduard van Gelderen, we show how four large Canadian pension funds have taken control of the value-creation process in order to capture a greater proportion of the upstream value. Their landmark projects include Ontario Teachers Pension Plan (OTPP)’s acquisition of Cadillac Fairview, a major real estate operator and developer, Public Sector Pension Investments (PSP)’s development of Mahi Pono, a large-scale agricultural operation in Hawaii, Caisse des Dépots et Placements du Quebec (CDPQ)’s development of REM, a new metro system in Montreal, and CPP Investments’ acquisition of Antares Capital, a major private credit platform in the US. These projects are noteworthy for their size, complexity, and diversity – spanning four asset classes: real estate, natural resources, infrastructure, and private credit. The projects’ size, complexity, and variety provide insights into how the funds created and captured value in four important ways.
The first way is to achieve meaningful scale in markets that bring strategic value to the funds. For example, Antares Capital acted as the platform through which CPP Investments could consolidate and grow investments in the lucrative US mid-cap loan market, where deploying large amounts of capital is difficult.
The second way toward value capture is vertically integrating parts of the value chain and thus reducing fee drag. The funds did this by acquiring controlling stakes in established operators who brought expertise in identifying opportunities and in management. For example, when OTPP acquired and privatized Cadillac Fairview, it became the subsidiary responsible for managing the fund’s real estate portfolio.
A third way of creating value is by becoming an anchor investor. Anchor investors provide stability, structure, and leadership, which is necessary to coordinate multiple stakeholder groups. In the cases of Mahi Pono and the REM, the large and long-term capital commitments of PSP and CDPQ gave credibility to each development project and made it possible to coordinate local communities and public authorities whose buy-in was critical to their long-term success.
A fourth means of value creation is developing internal synergies. The pension funds leveraged their operators to create value elsewhere within their organization. PSP leveraged its Mahi Pono operator, Pomona Farming, OTPP leveraged Cadillac Fairview, CDPQ utilized CDPQ Infra, and CPP Investments leveraged Antares Capital, using each operator's on-the-field expertise to pursue active investment strategies in related markets.
It needs to be emphasized that these in-house projects are not for the faint of heart. They come with considerable risks that require careful management. Four primary sources of risk became evident. The first is the reputation risk that is characteristic of large and illiquid ventures. Each fund managed this risk by carefully building a distinct business model and ownership structure that aligns the incentives of the different stakeholders. There is no cookie-cutter approach to these transactions, and each has to be handled according to its individual contexts.
The second is operational development risk, which the funds addressed by using well-established operators and the productive involvement of the different stakeholder groups.
The third source of risk is government interference, which would dictate that funds would have to be short-term focused and modify or exit the projects early. This risk is mitigated for large public Canadian pension funds because they are not subject to strict solvency requirements as in the EU. The funds also benefit from a strong governance structure, allowing them to operate at arm’s length from their public sponsors. Importantly, they have agile professional boards with clear authority delegation structures, allowing them to invest in complex projects in private markets.
The fourth risk is not having a proper governance structure that clearly outlines the roles and responsibilities of the different actors along the value chain. This can lead to a pension fund being too involved in the day-to-day operations of its operator without understanding the underlying business. The pension fund may also lack sufficient capital to meet the operator’s needs. The four funds have handled these risks by investing in and partnering with operators who run their operations independently as separate entities in which the funds act through the operators’ boards and commit to providing ongoing financing.
What about smaller funds? In our study we also analyze the case of University Pension Plan Ontario (UPP), a new fund that manages the pension assets of Ontario universities. Unlike the larger plans, UPP does not have the capacity to invest in large development projects by itself. Because of this limitation, UPP has instead established a more flexible strategy focused on building strategic relationships with general partners and identifying smaller mid-market deals that align with their expertise and don’t receive as much attention from the larger funds.
Despite the risks, our study shows that it is possible for institutional asset owners to invest differently and directly create and capture value. For long-term pension funds and their millions of members, alpha may not be so elusive after all.
Sebastien Betermier is associate professor of finance at the Desautels Faculty of Management at McGill University and executive director of the International Centre of Pension Management. The views expressed in this article do not necessarily reflect the views of either organization.