US pension funds & PE: Public service remit
Asian Venture Capital Journal | 06 July 2017|
US public pension funds are active investors in private equity, but their asset allocation policies are influenced by stakeholders’ input and limited internal resources, as well as the desire for returns
Private equity accounts for $4.69 billion of the $92.2 billion held by North Carolina’s state pension fund. New commitments are unlikely to be forthcoming in the near term, though, with the asset class under attack from a treasurer who ran for office on a promise to reduce fees paid to investment managers. Accountability is a fact of life for US public pension funds, and it can lead to difficult exchanges with stakeholders, but North Carolina is an extreme case of how politics can disrupt investment.
The state is one of the few in which the treasurer serves as sole fiduciary with ultimate oversight of the pension fund. As a result, Dale Folwell, who was elected last November, directs investment decisions for a pool of capital that Willis Towers Watson ranks as the 26th largest pension or sovereign fund globally. He has vowed to lower management fees by $120 million over the next four years, through a combination of contract terminations, redemptions, and renegotiations.
North Carolina paid $59.6 million in management fees and $44.5 million in carried interest to its private equity managers during the 12 months ended June 2016. The fee-to-market-value ratio was 2.38%, compared to 0.22% for public equity. Folwell claims that total fees, incentives and related costs paid to external managers across all asset classes in 2016 amounted to $600 million – a 1,363% increase on the 2000 figure, despite the pension fund only growing by 51% over the same period.
The treasurer said in mid-April that he had already shaved almost $25 million in fees from the budget by transitioning to lower-cost index-tracking funds that will "add value and reduce complexity." As of June 2016, private equity was North Carolina’s best performing asset class, net of fees, on a 10-year basis and second to real estate on a five-year basis. But fees appear to be an intractable issue.
"Fees are an open discussion point. There is an argument for lower fees, but there is also an argument that you get what you pay for in terms of performance," says Peter Martenson, a partner and head of global distribution at Eaton Partners.
The debate is by no means as clear-cut in other states as it is in North Carolina. Industry participants say they see no discernible decline in private equity interest among public pension funds. If anything, activity is increasing as – like many other investors – these LPs look for returns in the knowledge that debt markets are uninspiring and recent buoyancy in public equities is unlikely to last.
The 50 largest public pension funds in the US control more than $3.6 trillion in assets and have about $270 billion invested in private equity, according to AVCJ Research. But this group represents a mixed bag of mandates. The likes of the Federal Retirement Thrift and the Teachers Retirement System of Georgia have no exposure to the asset class, while Washington State Investment Board tops the list with a 15.5% allocation. Local political sensitivities add another layer of complexity.
The mantra of "reducing costs and complexity, increasing transparency and accountability" espoused by Folwell in North Carolina bears some similarities to that heard in California. Last month, Ted Eliopoulos, CIO of California Public Employees’ Retirement System (CalPERS) told his investment board that there may need to be a much lower allocation to private equity unless the pension fund could find an effective governance system to oversee the asset class.
"[The] fish bowl of CalPERS may have reached a tipping point for us in private equity," Eliopoulos added. "Over the course of the past two years and frequently in these monthly investment committee meetings, CalPERS staff is attacked and denigrated for our decision to invest in these funds."
The pension fund’s involvement in private equity came under intense scrutiny two years ago when it admitted to being unable to provide a full breakdown of all fees received by managers, notably carried interest. CalPERS later revealed that it had paid out $3.4 billion in performance fees since 1990. As the largest investor in private equity, with $25.9 billion – from an overall pool of $332.7 billion – deployed in the asset class, the pension fund inevitably attracts attention.
"Public pension plans have an element of dialogue where individuals and plan participants, partially influenced by the media, ask why – for example – they are continuing to allocate to hedge funds when some brand name investors are not," says Hank Gurley, a principal at Atlantic Pacific Capital. "It is difficult for staff to answer those questions in an easily accessible manner without having to dive into the nuances of portfolio construction and their own views on asset class opportunities."
In this sense, concerns about alignment of interest and transparency that are shared by a broad range of LPs become accentuated in a CalPERS context, to the extent they no longer accurately reflect views held across the industry. What CalPERS and other large pension funds appear to be trying to do is make private equity work for them in a way that recognizes the priorities of their varied stakeholders, the need to drive returns, and their limited in-house bandwidth. Consolidation is the common theme.
Cutting the chaff
Between 2005 and 2015, CalPERS reduced its number of GP relationships from 275 to 102. By 2020 it expects to have $30 billion in the asset class with just 30 managers. This means CalPERS will be writing bigger checks to a smaller group of GPs, and the pension fund will no doubt want fee discounts and coinvestment – anything that brings down the cost of investment – in recognition of the scale of its commitments.
Teacher Retirement System of Texas has already gone one step further, formalizing partnerships with a handful of managers that cover multiple asset classes. The pension fund has $15.9 billion invested in private equity – out of an overall portfolio of $133.4 billion – and 35% of that is earmarked for 2-4 firms described as strategic partners. The rest is spread out across about 40 GPs. The PE team is large by US standards, with five people at senior investment manager level or above, but industry participants say third-party consultants are used so that in-house staff can focus on core relationships.
In 2012, Texas Teachers launched its strategic partnership network (SPN) in the private markets space, signing up KKR and Apollo Global Management to manage assets across private equity, real assets and credit. A tactical opportunities vertical was added to the remit two years ago. As of August 2016, the private markets SPN had a net asset value of $3.8 billion, with commitments totaling $10 billion.
"Some big pension plans have their largest positions with these global GPs, and the bar is set very high for adding new managers. They want to make more concentrated bets with fewer managers, and if the 20 best names for the various strategies they are executing on are delivering returns, there will be little change," says Lori Campana, a managing director with Monument Group. "At the same time, some of these LPs are resource-constrained and this approach can help on the fee side as well."
It plays into the hands of global firms that are capable of creating ever more products to meet their clients’ needs, recognizing there is a strong chance these LPs will take the easy option and stick with a manager they know. However, it is unclear whether this is a definitive or a cyclical trend. Andy Hayes, a principal at First Avenue Partners and formerly a PE investment office at Oregon State Treasury, believes it is the latter, citing a tendency among LPs to move back and forth between different strategies.
"Everything works in cycles: you start off doing generalists; you move into specialists until you find you have exposure to too many GPs; and then you go back into generalists," he says. "For some groups, the beta of the asset class is good enough, but at other pension funds the CIO is going to point at another fund with similar performance and ask how it can be bettered. People then have to think about how they can add more alpha."
There is already evidence that some groups are willing to look further for dislocation that can drive returns. Eaton’s Martenson says he is seeing LPs enter new areas, and not only established asset classes like infrastructure but also music royalties and commercial litigation financing. The overriding goal is to secure recurrent yields, typically in the mid-teens, from assets that are uncorrelated to the stock market.
As to which pension funds are being the most proactive, Gurley of Atlantic Pacific claims to see "a bifurcation in the marketplace between mature plans and those that are still in a growth phase." If CalPERS is the classic seasoned operator looking to trim its GP relationships and effectively double down on certain managers, groups with younger portfolios – or even those restarting private equity programs after a period of dormancy – are generally more opportunistic.
State of Michigan Retirement Systems is cited by multiple sources as an example of a mid-tier pension fund that has set an aggressive target for private equity – it wants the allocation to climb from around 15% to 18% by 2018 – and is willing to be agile and creative in getting there. Meanwhile, the smaller Utah Retirement Systems is said to be transitioning from a fund-of-funds model to making direct investments in funds through an in-house team, with fresh capital to deploy in 2018.
Having the ability to pursue these strategies with conviction largely depends on internal resources. "Trustee boards change and you might find they become less friendly to alternatives and retreat from the asset class," says Heidi Poon, a senior vice president at TorreyCove Capital Partners. "But it is typically the staff and general consultants that recommend the overall allocation, so they are a big driver as to how much a pension fund participates in alternatives."
Team composition and structure, as well as the processes they must go through to make investments, are therefore integral to a PE program. The most successful pension funds tend to be those that are willing to bear the financial cost of recruiting experienced professionals who can execute strategies. But performance also rests on creating a system that observes fiduciary responsibilities while enabling these teams to function without unnecessary intrusion.
"There is a very good value proposition to private equity, but stakeholders who aren’t in the weeds every day might not see that and they will raise questions about compensation," says First Avenue’s Hayes. "As an LP you have to play that game of stakeholder management and be cognizant of all the different stakeholders and their views."