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PENSIONS - External Ambitions
Dupont Capital Management has delivered solid returns for its parent’s pension plan. Can it do the same serving other defined-benefit-plan sponsors?
Last summer, after the pension protection act of 2006 went into effect, E.I. du Pont de Nemours and Co. wasted little time in announcing that it would freeze its defined benefit plan, reduce benefits and switch new employees into a souped-up 401(k). It joined a growing list of companies doing so to contain costs, tamp down earnings volatility and clean up their financial statements as new pension funding and accounting rules come into play. But the company that invented Corian and Teflon is also looking to profit from this period of rapid change in the pension landscape: DuPont Capital Management Corp., the Wilmington, Delaware, subsidiary that manages the company's top-performing pension plan, is ramping up efforts to sell its money management skills to other plan sponsors faced with similar challenges.
DuPont's emphasis on winning outside mandates is driven by the evolving dynamics of pension fund management. Squeezed by underfunding as well as the demands of managing frozen plans and mark-to-market accounting rules, which heighten the risks that pension obligations pose to corporate finances, many plan sponsors are searching for ways to increase returns, limit volatility and manage liabilities. DuPont Capital has already developed new investment management strategies to bolster its own pension fund -- and aims to further capitalize on that success by marketing them externally.
DuPont Capital's products are a "hidden gem," says Valerie Sill, the 45-year-old CEO and president of the unit, which employs a team of 58 investment professionals and oversees $27.8 billion in assets. "There's significant growth opportunity ahead of us," she adds.
Sill speaks softly and doesn't toot her own horn, but she has big plans for the effort. The first outsider to run DuPont's money management division, she was recruited in April 2004 from the Boston Co., a unit of Mellon Financial Corp., with orders to drum up more outside business. In July 2005 she hired a new marketing chief, Donald Pepin, 48, from Gartmore Global Partners. Last year, the duo added 12 new mandates representing $600 million in assets. The business plan now calls for the operation to bring in at least $3 billion in additional external assets over the next five years, a figure that would nearly double outside assets under management from the $3.3 billion that it had gathered by year-end 2006.
The ultimate goal for Sill and Pepin is to have half of all assets at DuPont Capital come from outside clients. That would give the unit the same ratio of third-party funds as GE Asset Management, which manages $197 billion. GE Asset Management and General Motors Asset Management are the only other corporate plan sponsors currently seeking to expand their external businesses.
Validation for DuPont's expansion drive came in a 2003 study by an outside consultant that the money manager hired, in an ironic twist, to look at whether it should outsource its own pension fund management, as many of its peers now do. Instead, the study showed that outsourcing would be far more expensive than keeping it in-house because DuPont already had the infrastructure and a strong track record of managing its assets internally -- and was saving lots of money by not paying fees to outside managers. DuPont's returns rank in the top 10 percent of corporate pension funds with assets of $1 billion or more for the past one- and three-year periods, and in the top 20 percent for the five- and ten-year periods through year-end 2006, according to Mellon Analytical Solutions. Given such sterling performance, the study concluded, DuPont should step up efforts to gather assets from other plan sponsors, rather than offload its own, and pocket the incremental profit.
"We have generated billions of dollars in excess value for the DuPont Co. through outperformance, and we are doing it at cost," says Sill, a value manager who gets animated when talking about DuPont's investment strategies. "The business has incredible operating leverage, so it makes perfect sense to bring in additional assets."
The potential profits are certainly hard to ignore. Although DuPont Capital Management won't talk about what it earns from its external business, except to say that its fees are in line with the industry, the average institutional manager brings in 37 basis points in net revenue yield, with profits on that of 30 percent or more, depending on the firm's operating leverage and asset mix, according to the latest asset management benchmarking survey by McKinsey & Co. and Institutional Investor's U.S. Institute. That means at least $3 million in profit -- and likely more, given DuPont Capital's actively managed and alternative-product mix -- if the money manager meets its target and brings in $3 billion from outside clients.
"That's the compelling part of the math" for pension fund managers looking to bring in new business, says Ben Phillips, managing director at Putnam Lovell NBF Securities. "The question is, 'What happens next?'"
Over the years, many pension fund managers have decided to compete for third-party assets. Some, like GE Asset Management, have remained divisions of their corporate parents. Others, such as the money management divisions of Bechtel Corp. and General Dynamics Corp., have ended up being spun off as separate entities. Still others have been sold to deep-pocketed financial players. For these operations, success requires shedding what can often be an insular culture and prioritizing the development of new competencies in marketing and client service.
Jack Boyce, head of institutional sales at GE Asset Management, says it took his firm nearly a decade to change its mind-set from being a subsidiary of GE with some external clients to viewing itself as an asset manager in its own right. "The important thing we have recognized is that you really have to market," he says. "We don't get hired just because we're GE."
Will DuPont Capital succeed in effectively serving its major internal client while adding outside assets, as Boyce and his colleagues at GE Asset Management have been able to do? Sill and Pepin are optimistic. In fact, DuPont's marketing chief says the corporate committee that oversees DuPont Capital cut back his original forecast in an effort to be conservative about the division's goal.
Nonetheless, any plan sponsor looking for outside business faces sluggish growth in the defined benefit market, increasing competition for institutional assets and tighter pricing on many investment products. "There are a number of in-house teams and pension funds that have had the temptation to go third-party over the years," says Denis Bastin, an asset management consultant at Mercer Oliver Wyman. "It has always been an uphill struggle."
Now that DuPont's pension plan is frozen, that struggle may prove to be especially tough. "People are going to question their motives," Bastin contends. "When they present themselves to the boards of trustees of pension funds, people are going to say, 'Why should we help you when you've turned against the industry?'"
DUPONT IS ONE OF THE WORLD'S LARGEST chemical companies, with $27.4 billion in revenues and 60,000 employees in 70 countries. For more than half a century, DuPont Capital and its predecessors have run the company's pension plan, long considered among the country's most generous. In the beginning the pension plan was tucked inside the finance department. But over the years the workforce and assets grew, and in 1974 the Employee Retirement Income Security Act tightened plan sponsors' fiduciary responsibilities. The following year DuPont separated pension management duties from the finances of the corporation. Then, in 1993, the company set up DuPont Capital as a registered investment adviser and wholly owned subsidiary.
DuPont's pension plan has long been ahead of its time in seeking out new sources of alpha. In 1980 it began allocating overseas, well before international investing became a hot area. In 1989 it became an early corporate investor in private equity, a move that has since been widely copied.
As defined benefit plans grew more complex, DuPont -- which had multiple plans spread across the globe -- wanted more control. In 1995 it initiated a sweeping program to consolidate much of its pension management in Wilmington. DuPont Capital took over the internal management of the pension assets of oil company Conoco, then a DuPont subsidiary, in the U.K. and many other far-flung operations. In its efforts to centralize pension operations of a massive global enterprise, DuPont was a pioneer.
DuPont Capital's parent has long had a reputation for promoting talent from within, and it applied the same approach to the leadership of the subsidiary. As its first head of the unit, the company appointed Edward Bassett, a DuPont veteran who had come on board in 1977 as an equity analyst in the finance department and had been running pension management since November 1990. By 1999, when DuPont had more control over its own assets and more products available, Bassett had started to look outside the company for new business, marking the firm's first foray into third-party management at a time when other large plan sponsors, such as General Electric, General Motors Corp. and American Airlines' parent, AMR Corp., were also looking for external assets. Bassett set up a marketing department and hired Joseph Haley, previously at Legg Mason, to head the effort. Bassett focused on courting consultants and told the press at the time that DuPont Capital, which then had 49 investment professionals on staff, could expand with little added expense.
Bassett also continued DuPont's tradition of investment innovation. He launched new market-neutral strategies and kicked off a pilot study on quantitatively driven long-short equity strategies; the pilot later led to the introduction of a portable alpha strategy.
Nonetheless, the technology bubble made the late 1990s a rotten time for a value-oriented player like DuPont Capital to market itself externally. "We stuck to our discipline," Sill says. "It's not like we had horrible performance -- we do have risk controls in place -- but we weren't in the top 10 percent." From January 1, 1995, to December 31, 2000, the pension fund was, in fact, ranked in the 58th percentile.
After the stock market cratered, DuPont regained lost ground. But the dot-com-era marketing efforts left DuPont with something of a hangover. Although the bubble burst, favoring value, markets were still unsettled and plan sponsors jittery.
"From 2000 to 2004 the external marketing was reactive," says Pepin. Rather than schmoozing consultants and getting on planes at 6:00 in the morning to meet face-to-face with external clients, he adds, DuPont Capital was often simply responding to requests for proposals. "A lot of time was spent explaining, 'Who is DuPont Capital?' and 'How can a chemical company manage assets?'"
During those years, DuPont did have an advantage. As was the case with other pension managers taking on third-party business, DuPont Capital, according to press reports, was able to land "external" clients that were in fact spin-offs of its parent: Conoco and Consol Energy. From 2000 to 2002, it brought in a total of $1.4 billion in external assets, giving DuPont Capital -- at least in theory -- a solid base from which to begin selling to others.
In 2003, though, DuPont Capital won no new business. Neither Sill nor Pepin will discuss what happened before they joined DuPont, and Bassett declined repeated requests from Institutional Investor for an interview. Around that time, external consultants were brought in to look at whether DuPont Capital was on the right track, and, in September 2003, Bassett, then approaching 60, retired.
For the first time in its history, DuPont Capital decided to look outside the company for someone to run the operation and hired an executive recruiting firm. After a six-month search, during which time DuPont Capital treasurer and vice president John Jessup acted as interim CEO and Bassett remained as nonexecutive chairman, Sill got the nod.
Sill began her career as a health care and utilities analyst at State Street Research & Management Co. At Mellon Financial she chaired Boston Co.'s equity policy group and was director of its large-cap value strategies. She also managed fellow Mellon subsidiary Dreyfus Corp.'s Premier Core Value Fund, earning what Morningstar describes as "respectable returns." During her tenure the fund delivered an average annual return of 8.97 percent, versus 8.83 for the large-cap value category and 9.18 for the Standard & Poor's 500 index.
For Sill, the DuPont job offered the chance to run her own show and the opportunity to move, along with her husband and young daughter, to the Delaware side of the historic Brandywine Valley, where she now chairs the finance committee of Longwood Gardens, the nonprofit horticultural garden once owned by Pierre du Pont, the great-grandson of DuPont's founder. She also works with the finance teams of the Delaware Community Foundation and the Diocese of Wilmington.
Hiring an outsider like Sill was a big change for DuPont. Chief executive Chad Holliday Jr. started at the company in 1970, and chief financial officer and executive vice president Jeffrey Keefer has worked there since 1976. "It's a very insular community," says Jeffrey Lauterbach, the former CEO of the Capital Trust Co. of Delaware, a longtime observer of the Wilmington financial community.
Shortly after Sill's arrival, marketing chief Haley retired, allowing the new CEO to create her own marketing team. That year DuPont brought in $75 million in external assets; in 2005, it garnered $93 million.
By 2006, the momentum was building even further: DuPont Capital exceeded its $500 million target by $96 million, notching a 22 percent jump in external assets and 12 new mandates, bringing its total to 40. One of the new mandates was from the State of Michigan Retirement Systems, which hired DuPont to run $50 million in a core fixed-income strategy. It was the first time that Michigan had looked to outsiders to manage assets for its $9.3 billion fixed-income portfolio. (In addition to DuPont, it hired Delaware Investments, Dodge & Cox Funds, Fidelity Investment's Pyramis Global Advisors and Metropolitan West Asset Management.)
So far, so good, according to Michigan senior portfolio manager Jane Weidman, who points to DuPont's investment results and its responsiveness in sending reports formatted the way she needs them. "I would give DuPont higher marks on efficiency than most," she says. "We've never had to ask them for anything twice."
As Sill reshaped DuPont Capital, she hired two new portfolio managers, four sector analysts and two marketing professionals, raising the head count to 106. The new marketing hires -- Laura Kirkpatrick, who managed consultant relations at Delaware Investments, and William Rizzo, who ran institutional services at Pitcairn Financial Group -- doubled the size of the staff charged with drumming up external business. Pepin says there are no plans to add any more marketing or client services people this year, but says there's "no pushback" from corporate to do so.
"As we build this out, it can snowball," he says. "It's a matter of getting people comfortable with us and understanding what we're trying to do. Other outside managers double their assets, so why shouldn't we? We have more product."
DuPont's offerings are certainly diversified. Its $27.8 billion in assets at year-end 2006 were spread among roughly 20 products that encompass all of the major asset classes, including $6.9 billion in large-cap equity, $6.2 billion in stable value, $5.4 billion in fixed income, $4 billion in international equities and $3.2 billion in private equity. In addition, DuPont runs midcap, small-cap, emerging-markets and asset allocation strategies, as well as distressed debt, real estate funds and liability-driven investing strategies. It is incubating several hedge fund strategies.
DuPont Capital also boasts scale and experience. According to Seattle-based consulting firm Milliman, it ranks as the 11th-biggest corporate defined benefit plan. Among the nearly 60 investment professionals running its assets are 14 portfolio managers, who have an average tenure at DuPont of 16 years, and more than 30 analysts, who have an average tenure of 12 years.
WHEN PEPIN ARRIVED AS THE NEW MARKETING CHIEF, not all of DuPont's products were in consultant databases. His first move was to make sure that they were; his second was to figure out which products to push.
"What I tried to do when I came was to say, 'How do we break through the clutter?'" Pepin explains. "Across the board, we have nine strategies, and you can't focus on nine strategies and do it well."
Pepin says he decided to emphasize investment strategies that can deliver solid alpha and that benefit from strong demand because of limited capacity in the industry. Among those that are selling well, he says, are small-cap, with a five-year average annual return of 13 percent, versus 11.4 percent for the Russell 2000 index; high-yield fixed income, which returned an average annual 17.7 percent over five years, versus 10.2 percent for the Lehman high-yield bond index; and core fixed income, which was up an average annual 5.8 percent, versus 5.1 percent for the Lehman aggregate bond index.
One relatively new win is the Alaska Permanent Fund Corp., which hired DuPont Capital in February 2005 to manage a $58 million slice of a $900 million small-cap pool that it divided among 11 managers. The mandate has since grown to $77 million. Maria Tsu, the fund's manager of equity investments, says that part of DuPont's appeal was that its investment approach combines quantitative analysis with fundamental research. "We liked that DuPont was targeting a higher active risk profile with the belief that they could deliver higher returns," she says. She adds that because Alaska had previously hired GE Asset Management, the fund was already comfortable working with a corporate plan sponsor that managed third-party assets.
"DuPont is certainly earlier in their evolution than GE and is still trying to get its arms around this," she says. "The business risk with DuPont is that when you interact with them, they are still making the transition from worrying about managing their own money to managing clients' money."
So far, though, results have been promising. In the 12 months ended March 30, DuPont outperformed its benchmark by 142 basis points and ranked fourth among the 11 managers hired by Alaska, Tsu reports. "In a year when it was tough across the board for small-cap managers, I couldn't be happier," she says.
Still, there have been stumbles. In September 2005 the Employees Retirement System of Texas terminated an international equities mandate of $1.4 billion that DuPont had overseen since February 2003, following a period of underperformance, according to minutes of the Texas plan's investment committee's meetings. Although it remains a client, the Firefighters' Retirement System of Louisiana has terminated a $45 million domestic midcap mandate for performance reasons. In May 2006, DuPont suffered a different kind of blow when Artisan Partners, an asset management firm based in Milwaukee, poached DuPont's emerging-markets team, which was led by Maria Negrete-Gruson. Sill brought in Sandra Yeager, a former global research chief at Morgan Stanley Investment Management, as the new head of international equities and emerging markets. Since Yeager joined in June, DuPont's emerging-markets strategy has returned 27.02 percent, versus 26.11 percent for the MSCI emerging-markets index.
"Obviously, it's not something that you want to have happen, but if you look at our organization as a whole, it's more stable than most," says Pepin, who declined to elaborate on the team's departure, as did Sill. (Negrete-Gruson did not return calls seeking comment.)
Alaska manager Tsu says that even though the defection didn't directly affect her investments, it raised concerns. "It's not a good sign," she says. "I have to think that's harmful to them, and, yes, I'm concerned about the overall business implications of something like that. But I'm also encouraged by their determination to not let it deter them from their longer-term goals. The message that was delivered was, 'We're going to rebuild.'"
Despite the setbacks, Pepin and Sill believe that DuPont's track record and history of creativity will give it an edge, especially among underfunded pension plans that are seeking new sources of alpha without the volatility. "The level of innovation here at DuPont Capital is very attractive," Sill says. "Because we are managing the pension plan for DuPont, as well as our other clients' assets, we have an obligation to explore emerging avenues of alpha generation."
A case in point, she says, is the firm's 130/30 product, a strategy that uses leverage to invest 130 percent long and 30 percent short. Although 130/30 strategies have taken off recently, DuPont Capital started testing the approach more than five years ago in a pilot study, using a small amount of its pension assets. As its managers experimented -- figuring out what risk controls were needed, for example -- DuPont began to increase the amount of assets it allocated to the strategy. Today its 130/30 portfolios account for $1.4 billion in mostly internal assets, and DuPont has begun marketing the product externally. Over the past five years, it has returned an average annualized 10.7 percent, compared with the S&P 500's 2.9 percent.
"There are a lot of asset management firms that have this product, but not a lot of them with a track record," says Sill, who is considering conducting another pilot study to see if the strategy could add value in fixed income. "We need to be on top of these new developments and have informed opinions based on actual studies," she adds. "We think it through really carefully."
Another strategy that Sill believes has "big potential" is portable alpha. In 2005, DuPont began using a structured product with six different streams of alpha, based on the pilot study of quantitative long-short equity strategies that former CEO Bassett commissioned in 2000. A follow-up study in 2004 found that the managers needed to increase their allocation to long-duration bonds to reduce risk. Still, DuPont's portfolio managers feared the change would hurt returns. "We were somewhat uncomfortable because we felt that we had a fair amount of alpha generation within equities that would disappear completely," recalls Rafi Zaman, senior portfolio manager and director of U.S. equities. The result was a new pilot study on portable alpha that began with $40 million in assets in late 2005. By July, DuPont had raised its allocation to $110 million and, this summer, expects to increase that amount to $200 million.
"We have beaten our benchmark by 398 basis points [since inception] with a fairly tight risk tolerance," says Zaman. "This is an ongoing process -- we continue to look to other areas where we can port alpha onto these long bond positions."
Pepin says it is too soon to market the portable alpha strategy to external clients. Other products that have been around longer -- such as emerging-markets debt, introduced internally in 1998, and market-neutral strategies, launched in 2000 -- are likely to come out of the gate sooner. The money manager's strategy is to move slowly, testing new products internally with a small amount of funds and developing a track record before selling them to others.
"The real advantage from a marketing standpoint is that we have a number of products that we have already been managing internally that have not been marketed externally," Pepin says. "My strategy is to stay focused on two or three things; if you're trying to sell ten things at once, you diminish your success."
ON A RECENT FRIDAY IN WILMINGTON, PEPIN WAS SLATED to give an update on his marketing efforts at DuPont's monthly town hall meeting, one of a series of internal dialogues that Sill uses to foster what she calls "a think tank environment." Sill has also put together a new advisory board for the pension fund that meets once a year, comprising Peter Aldrich, the former chairman of AEW Capital Management; John Castle, chairman of private equity firm Castle Harlan; Russell Olson, a former chief investment officer of the Eastman Kodak Co. pension fund; and Arthur Laffer, the supply-sider who heads Laffer & Associates, an economic research and consulting firm. In addition, Sill holds monthly meetings with the investment staff for informal discussions on topical issues, such as, recently, the low level of risk aversion in the market and the impact of troubles in the subprime mortgage market.
"Changing cultures is never easy, but we've made great strides," Pepin says. "One of the things that Valerie is doing is really bringing in a performance culture."
Director of U.S. equities Zaman, who has been at DuPont Capital since 1998, says that the cultural changes are visible in the flattening of DuPont's traditional hierarchical structure, as well as the blurring of the lines between analysts and portfolio managers in a way that creates more collaboration between the two groups. "We used to have a pyramid structure, with one portfolio manager and a team of analysts," Zaman explains. "The analyst would come up with the numbers, and the portfolio manager would take those numbers and decide whether to invest in the company or not." But with the addition of new products, such as sector long-short portfolios, Zaman says, analysts now have a far greater role in stock selection. "We have pushed decision making down to the analyst level," he says. The result is more collaboration. Last year, for example, a group of analysts, on their own initiative, created an ad hoc team to figure out how to profit from the big gap between crude oil prices and gas prices.
Perhaps more important than the changes in the analysts' role and the new meetings to foster collaboration, Sill's transformation of the compensation structure has promoted the external marketing effort. In January 2006 she introduced phantom equity shares in DuPont Capital that rise or fall based on the firm's success in attracting outside assets. Those shares replaced a previous incentive compensation program that awarded employees restricted units of DuPont stock.
Sill's reasoning was straightforward: DuPont Capital is far too small a part of the parent company to make any difference in its stock price, so the phantom equity shares are a better way of rewarding employees for helping the money manager reach its goals. The shares vest based on DuPont's external growth targets and convert to cash, and thus provide a strong incentive for managers and marketers to get with and stay with the program. Based on DuPont Capital's expansion last year, the shares have already doubled in value.
"They're up a lot," Sill says, laughing. "People can see that there is a tangible benefit to this change."
DuPont Capital's goals are big, and its strategy makes sense. But the competition is fierce, and the money manager must surmount what consultant Bastin calls "a wall of indifference and cynicism from your typical gatekeeper" that isn't easy to overcome. Three years after Sill's arrival and eight years after DuPont first announced its decision to market externally, the operation is just now beginning to make meaningful inroads among outside plans. But whether DuPont can make the necessary cultural shift and learn to effectively serve its internal pension plan while balancing the needs of a growing business remains an open question.
Ever the optimist, Sill disputes the idea that freezing DuPont's own pension plan will hurt its standing among fellow plan sponsors. She points out that existing employees will continue to accrue benefits in the plan, though to a lesser degree beginning in 2008. "Our liability is growing," says Sill. "We still have a lot of assets to manage, and we will for many decades to come."
In fact, with the freezing of its pension plan, DuPont will ramp up its 401(k); starting in January, it will contribute 3 percent of every employee's pay to his or her account and match 100 percent of the first 6 percent of employee contributions, double its current 50 percent match. The money manager already oversees $5.6 billion in stable-value assets for DuPont's 401(k) plan. Sill figures that as defined contribution offerings become increasingly institutionalized, DuPont will be well positioned to benefit by picking up outside assets.
So Sill and Pepin look to the outside, knocking on doors and stepping up efforts to sell DuPont Capital's expertise to fellow plan sponsors. Their plan's track record is impressive, as is its history of innovation. And for the money manager's corporate parent, the strategy makes sense even if DuPont never becomes a major third-party player, like GE Asset Management.
"Five years from now, we will be a lot bigger," Sill declares confidently. But in an era of sweeping change in the pension fund industry -- and rapid innovation at competitor firms, which are straining to stay one step ahead of old rivals and recent entrants alike -- exactly how much bigger remains to be seen.