LP Profile: British Fund Likes Distressed Opportunities

Its private equity program is less than three years old, but the $37 billion Universities Superannuation Scheme (USS), the second-largest pension fund in the United Kingdom, has already developed an appetite for U.S. buyout funds, distressed debt funds, and for co-investments alongside them.

Since September of 2006, when the current head of alternatives, Michael Powell, joined London-based USS in order to create the program, the limited partner has made $1.8 billion in funded commitments. It has another $1.9 billion in outstanding commitments not yet drawn down. That translates to a commitment pace to the asset class of about $1.5 billion per year.

All this activity is designed to get USS to its medium-term target allocation to alternative assets of 20 percent, or $7.4 billion. About half the LP’s private equity portfolio consists of buyout funds, with another third dedicated to turnarounds, distressed debt and debt-related opportunities, such as loan-to-own, senior bank loans and mezzanine strategies.

“The current alternatives portfolio contains investments across private equity, infrastructure, commodities and absolute return strategies,” said Powell. “We continue to see significant opportunities within all these asset classes as a result of the current distress in financial markets.”

Although USS plans to slow its commitment pace down in 2009, it still intends to commit roughly $1.1 billion this year, including a possible $224 million to U.S. buyout funds. That marks the pension fund as a sizeable oasis of money in a market bereft of liquidity.

The main thrust of the 2009 program is likely to be the U.S. distressed debt market, where USS plans to pledge roughly $336 million, Powell told Buyouts. The pension fund expects to move quickly on these commitments, with allocations to distressed debt pegged for the first and second quarters. These would come on top of pledges already made to MHR Fund Management, a New York firm that targets distressed opportunities in the middle market; Oaktree Capital Management LP, which invests in companies facing bankruptcy, debt restructurings, reorganizations and liquidations; and WL Ross & Co., which invests in and restructures financially distressed companies.

Another area of focus this year for USS is the secondary market. In addition to committing to secondary funds, the pension fund may also buy limited partnership interests directly, although Powell has not yet gotten comfortable with secondary-market pricing and is waiting to evaluate year-end 2008 valuations before pulling the trigger. USS is not considering venture capital funds, said Powell, but it could happen at some point. Powell characterizes his private equity strategy as one that will remain flexible, in order to take advantage of opportunities nimbly as they arise. He cites his large allocation to special situations and various debt strategies as one such example.

Funds of Funds

USS intends to foster core, long-term relationships with fund managers in various regions of the world by using its eight-person professional team to find the appropriate general partners and vehicles to back. However, if a particular opportunity stretches its resources, USS would turn to funds-of-funds sponsors, as it has in the past.

Powell, for example, felt that his staff could not effectively delve into the U.S. mid-market from its London base. Thus followed a $750 million commitment last year to a mid-market captive fund of funds run by Massachusetts-based Constitution Capital Partners, formed in 2008 by veterans of Standard Life Investments Private Equity USA. The deal, in which USS received a 10 percent stake in the management company, included a $600 million capital commitment and a $150 million warehouse line.

With about $350 million of the mandate Constitution Capital plans to back growth-oriented North American buyout funds of $250 million to $2.5 billion in size. With the other $300 million it expects, over the next three years, to co-invest alongside of fund managers, investing $10 million to $45 million at a time in companies valued at $100 million to $1 billion. Among funds evaluated so far by Constitution Capital are ones managed by American Capital, Avista Capital Partners, Nautic Partners, Sun Capital Partners, Towerbrook Capital Partners and Wind Point Partners.

In fact, a big part of the private equity strategy for USS consists of co-investing alongside its core managers, and the ability to do so is taken into account when choosing a manager. Outside of the Constitution Capital program, USS plans to co-invest globally on its own, intending to place about $200 million in 2009.

Powell has developed his private equity program based on a belief that, because his investment strategy is long-term in character, it makes more sense to deploy capital in parts of the world where he sees long-term opportunities, rather than allocating assets based on the current makeup of the private equity fundraising universe.

For now, roughly half of the USS private equity portfolio is invested in Europe, with most of the other half committed to U.S.-based fund managers. The pension fund has backed mega-buyout firms Bain Capital, The Carlyle Group, Goldman Sachs, TPG and Warburg Pincus. The LP also likes the energy and power sector, having made pledges to energy funds run by First Reserve Corp. and Riverstone/Carlyle. Technology also seems to have caught the attention of USS. It pledged to two separate vehicles managed by technology shop Silver Lake.

USS has also committed to a number of buyout firms that invest outside of the United States, including Advent International; Apax Partners; Climate Change Capital, which specializes in opportunities generated by a low carbon economy; mid-market buyout firm Bridgepoint; CVC Capital Partners, a global private equity and investment advisory firm; mid-market shop Doughty Hanson & Co.; and Scandinavia-focused Nordic Capital, which makes control investments in Denmark, Finland, Norway and Sweden.

The pension fund also has some exposure to Asia through Baring International Equity’s Baring Asia Private Equity Fund IV, earmarked for investments in alternative energy, media, financial, consumer and industrial companies located in China, India, Japan, Singapore, Hong Kong, Taiwan and elsewhere in Southeast Asia. Powell noted that private equity opportunities in Asia are looking more attractive, and he intends to increase his exposure there, especially in Japan.