By David G. Barry
Despite
generating strong returns from private equity investments, the $314 billion California
State Teachers’ Retirement System (CalSTRS) and the $440 billion California
Public Employees’ Retirement System (CalPERS) see a need to change their
approach to private markets in the future.
CalSTRS Chief Investment Officer Christopher Ailman and CalPERS CIO Nicole
Musicco have expressed desires to deploy less of their capital into funds
and more into deals alongside existing managers. Because of their size, moves
by the pension funds are monitored closely by other institutional investors.
Ailman told Markets Group that over the next five years, he expects the
co-investment portion of CalSTRS’ private equity portfolio to grow 100% to $15
billion. Musicco, who just joined CalPERS this spring, said during a recent
press briefing that a “reasonable goal” is for CalPERS’ private markets’
portfolio to have a “50-50” split between fund and deal investing in five years.
The interest by CalSTRS, CalPERS and others in increasing their co-investment
activity is due, in large part, to the potential cost savings. While PE firms
typically charge a 2% management fee and a 20% performance fee for the right to
invest in a fund, they generally do not charge LPs who co-invest in their
deals. This can add up. The Pew Charitable Trusts, for instance, found that the
fees that five pension funds pay out exceeds
on average 2.75% of the value of their PE holdings.
Pension funds also are attracted to co-investments because of their ability to
deploy larger amounts of capital to private markets and potentially generate
greater returns than might come from investing.
Ailman, in fact, said that while private equity partnerships delivered a
five-year internal rate of return (IRR) of 18.9%, co-investments generated an
IRR of 27.1%.
“Co-investments are a key part of the CalSTRS Collaborative Model investment
strategy,” he said.
That model, which has saved CalSTRS more than $780 million since 2017, focuses
on managing more assets internally to reduce costs, control risks and increase expected
returns, and leveraging external partnerships to achieve similar benefits.
Musicco said CalPERS hopes to build on the “great relationships” that the
system’s private markets teams have developed over the past three years with not
only private equity managers, but real estate, and infrastructure managers as
well. CalPERS, which has $440 billion in assets, has begun implementing a new
asset allocation strategy which increases its private equity target to 13% from
8%, its real assets target to 15% from 13%, and introduces a private credit
target of 5%. The system also recently generated $6 billion through a secondary
sale of private equity fund stakes.
Other Funds Taking Note
CalSTRS and
CalPERS are hardly the only institutional investors seeking to ramp up their
co-investing efforts – especially as they view the sizable fees they are paying
to managers. Amy McGarrity, CIO of the $76.8 billion Public Employees’ Retirement
Association of Colorado (PERA), tells Markets Group that the pension fund has investigated
direct investing, but realized it didn’t fit with what the plan is trying to
accomplish. PERA also, she said, “can’t necessarily” do what CalSTRS and
CalPERS are planning, “but we are definitely thinking creatively about how best
to invest those assets for the long term at the lowest possible cost, while
still partnering with the best asset managers.”
Steven Hartt, a managing principal/private markets consultant with
industry advisor Meketa, said many of the firm’s clients are considering
co-investing as a means to add to their portfolio, and because of the “concept
that investing additional capital with high-conviction managers often lowers
fees and expenses at a rate greater than a co-mingled structure.”
Hartt, however, emphasized that moving from concept to execution can take time.
“Putting in new strategies and approaches for private equity investors –
particularly large pension plans – can be like moving a battleship,” he said.
“You don’t make tactical turns all that often once you have a strategy and plan
in place. It takes a while to make strategic changes.”
Both Ailman and Musicco, however, realize that there are necessities to
building successful large-scale co-investment programs.
A key one is staffing. Finding and keeping individuals with the knowledge and
insights to successfully find, review and execute such transactions can be
difficult. It is even more so in the current environment.
The challenges of doing such transactions are why many public pension funds
limit themselves to either doing a few co-investment transactions a year in
house or opting to utilize an outside manager.
The Connecticut Retirement Plans and Trust Funds (CRPTF), for instance,
committed up to $125 million in 2021 for Morgan Stanley Investment Management
(MSIM) to invest in real estate, infrastructure and natural resources – a
partnership that will allow CRPTF to co-invest transactions by MSIM. It also
committed $300 to HarbourVest Partners for co-investment opportunities in debt
and private equity.
Earlier this year, Teachers’ Retirement System of Louisiana (TRSL) also
selected HarbourVest Partners for a $300 million mandate to locate, evaluate
and commit to co-invest opportunities by private market investment funds. It
marked the first time that TRSL had issued such a mandate.
HarbourVest Managing Director Seth Palmer said institutions use firms
like HarbourVest to manage or augment their co-investing activities because of
limited resources, the pace of deals and/or a desire to diversify their
portfolios. The firm provides institutions with the option of investing in its
larger co-mingled fund or through a separately managed account.
Palmer said more institutions are generally interested in co-investing because
they recognize the “two-fold opportunity” to bring down costs and provide
equity support to some of their more important general partners.
“The large sophisticated public pension funds appreciate the magnitude of the
opportunity,” Palmer said.
The Cost of
Attrition
The Teacher Retirement System of Texas (TRS) has one of the more
successful co-investing programs in the United States, with 37% of its private
markets portfolio designated as “principal investments.” Those investments
generated a one-year return of 30.7% and a five-year return of 15.1%. Eric Lang, TRS’ senior managing
director of private markets, told the TRS Investment Committee that his goal is
to have 40% of the portfolio going into non-fund transactions.
But pulling off such transactions means having a large and stable staff. As
Lang and TRS CIO Jase Auby described during the meeting, TRS has had
significant turnover over the last year. At its current pace, TRS’ investment
management division will see a third of its staff turn over between January
2021 and December 2022, Auby said. Specifically, it has lost 21 people since
the start of 2021, many of whom have been recruited to join private markets
firms.
“Being an industry leader comes at the cost of attrition,” Lang said. “The
market has realized we have good people. We’ve had a lot of people leave for
private markets, unfortunately.”
Auby said that TRS has a “great training program. We train them well. We would
just like to hold onto them longer. They are leaving earlier than our strategy
planned.”
Such departures, he said, means TRS is not only missing that expertise but also
needs remaining team members to spend increasing amounts of their time on
recruiting and interviewing.
Neil Randall, a TRS managing director who heads private equity, told the
investment committee that the departures have had a “tangible cost to us.” Specifically,
he pointed out that they’ve had four different people cover one of their
general partner relationships over the four years – a situation that he said,
“does not allow us to have the type of consistency that we want to bring and
that becomes a challenge.”
Musicco indicated that CalPERS’ co-investment ambitions will be decided
in part by its ability to staff appropriately.
Ailman told Markets Group that CalSTRS has grown its private equity team “by
nearly double since 2018, in large part to hire staff with specialized
experience in co-investments.” He is now trying to further grow the private
equity team.
Ailman told the CalSTRS Investment Committee that by spending an additional $15
million annually on personnel and travel costs and an additional $25 million on
consultants and advisors, the amount paid out to general partners could drop by
$750 million. Calling the projected cost savings an “honest estimate,” Ailman
told the board that CalSTRS will need to make some “hard decisions” to carry
out the strategy, such as increasing compensation to attract and retain
individuals with investment banking skills. Michael Graham, global head
of private equity for Canadian pension plan OMERS, said the current
economic downturn may actually make it an ideal time for CalPERS, CalSTRS and
others seeking to build up their in-house deal teams. OMERS, as he recounted to
Markets Group, made the decision to move from making fund investments and
co-investing to simply doing deals directly during the midst of the Great
Financial Crisis. With many people out of work, OMERS was able to scale
rapidly. The fund’s private equity team, he said, had five people – including
himself – in 2007. Today, it has 150, including 110 investment professionals.
The GFC, he said, made it “much easier to hire” and those coming on board saw
the benefits in working for a firm with an “evergreen capital source” and
stayed. Graham concedes that if OMERS had tried to do what it did last year “it
would not have been as easy. The challenge is finding good people. But it may
become easier given the market turmoil and the [possibility] of a recession,”
he said.
Let’s Make a Deal
Aside from staffing,
another key issue for institutional investors wishing to do more co-investing
is getting into deals.
Many of the larger private market firms, said industry observers, have raised
such sizable funds in recent years that they are able to do transactions
without needing to go to their limited partners, or are doing so on a limited
basis.
Texas TRS, for instance, is at its 50% goal for principal investments in real
estate and 40% target for energy, natural resources and infrastructure, but is
nearly 10% below its 35% goal for private equity.
TRS’ Lange said the pension plan is “struggling with private equity” because of
the competition for deals.
Lange’s colleague, Randall, said a key issue for TRS is that the pension plan’s
market position is “declining.” The private equity sector, he said, is simply
growing at a faster rate than the pension plan. With retail investors starting
to become bigger players, Randall expects fund sizes to continue to grow while
TRS’ commitments will likely stay the same.
“There’s a lot more competition coming into co-investments, so we have to
figure out how to be competitive,” Randall told the TRS Investment Committee.
One step TRS is taking is shifting more of its investment activity toward
mid-market and small buyout firms and venture capital.
Such a strategy, say industry observers, may make sense as smaller private
equity firms often rely more heavily on co-investments from limited partners to
do deals.
HarbourVest’s Palmer said GPs – large and small – view co-investing as both a
way of taking down larger deals and a way of providing a service to LPs who
desire to co-invest.
“We see GPs across the size spectrum using co-invest as a tool to manage their
internal portfolio construction needs as well as a service to their limited
partners. It’s an important feature.”
Meketa’s Hartt concurred, saying that “I think GPs realize how valuable
co-investment is for some of their relationships and look to offer those
co-investments to solidify those relationships. That’s an important motivator to
offer co-invest capital.”
BC Partners, for example, has made it part of its DNA, having generated
more than €11
billion ($11.2 billion) of co-investment to more than 80 unique limited
partners.
BC brings its fund investors into its deals in two ways, said Alexis Maskell,
a BC partner and global head of investor relations. In some instances, he said,
BC will bring “sophisticated” LPs who are capable of co-underwriting/co-sponsoring
an investment into a deal early, and by doing so ensure they can “get
comfortable” with the transaction as well as BC’s thesis and value-creation
plan.
“It’s a collaborative process,” Maskell said.
The second way BC involves LPs is through syndication after a
deal is struck. BC will reach out to LPs, he said, who usually do not have the
bandwidth or a dedicated investment team to execute on a
co-underwrite basis. BC provides the needed information to have a deal
evaluated and approved. Maskell describes this process as a relationship tool
vs. a de-risking tool, a key reason why BC tries to provide co-investment
opportunities across its LP base, regardless of size.
Maskell said that deciding which LPs to contact for co-investment opportunities
and how much to allocate is driven by the firm’s “deep knowledge” of its LP
base and is more of an “art than a science.” The aim, of course, is to find LPs
who are interested, able to move quickly and are comfortable with the deal and
their role, he said.
“Above all, we want to give them first row access into the thematic investment
approach, sourcing and value-creation process,” Maskell said.
Institutional investors in recent years have benefitted from being co-investors
in transactions done by BC as well as other PE firms. It has, in a sense, said
Maskell been a “relatively risk-free exercise” as valuations have continued to go up. But now,
he points out, that is no longer the case. The industry is entering an
environment where the “paradigm has shifted.” As a result, LPs taking part
in co-investment deals will need to get comfortable with the “valuation
perimeters” and, of course, the risk that not every deal is going to be a home
run.
CalSTRS’ Ailman told his investment committee that getting access to
co-investment opportunities may be the biggest challenge. The system, he said,
will be battling to get into deals versus others who are active or are looking
to get active as co-investors, such as CalPERS, CPP Investments, GIC, Texas TRS
and Abu Dhabi Investment Authority.
“We have to be a good partner,” he said.
Hartt of Meketa said another way that LPs are becoming or may become more
active on the co-investment front is through GP-led secondary transactions.
Private equity firms, left with just a company or two in a fund, are
increasingly opting to raise smaller funds to lift that asset out of the fund.
More LPs are becoming comfortable with such transactions and are stepping up to
back the secondary transaction.
“That’s additional transaction flow for LPs,” he said.
Dealing Direct
One way of
course, is to avoid the stress of finding partners to do transactions with and do
deals directly – much like many of the Canadian pension plans and such
sovereign wealth funds as GIC and the Abu Dhabi Investment Authority are doing.
Ailman says he is aware of those plans’ efforts on the direct side but says
simply that “we do not have the right business model, in my view, to properly
and successfully execute direct investments at this time. So, we will stick to
our knitting.”
Musicco, speaking at Top1000funds.com’s Fiduciary Investors Symposium, said
that given CalPERS’ size, it has “ample opportunity to be leaning more into the
private markets space.” But the CalPERS CIO, whose background includes
overseeing private equity at the Ontario Teachers’ Pension Plan, said that
building the staff to do direct investing “takes a good decade” and the plan
would continue to rely on fund managers.
OMERS, in a sense, provides inspiration for public pension funds looking to
move away from investing in funds and co-investments and doing deals directly.
The fund’s private equity, infrastructure and real estate groups all operate essentially
as stand-alone firms.
“We’re able to mandate our own destiny,” said Graham.
The shift toward doing direct deals came out of the OMERS’ team looking at the
results and seeing that its efforts on the direct side were as good, if not
better, than what it was achieving through investing in funds. The private
equity team also realized that “it’s hard to be a direct investor, a fund
investor and a co-investor,” he said. The plan was thus made to simplify and
focus on deals.
And it has worked well. To illustrate the types of deals that OMERS can do,
Graham points to portfolio company Caliber Collision, which operates auto body
collision repair centers. OMERS Private Equity invested in the company in
November 2013, when it had 157 collision centers in five states. OMERS later
sold a minority stake in the business to Leonard Green & Partners. Together,
the firms helped build Caliber to more than 630 centers in 19 states before
selling it in December 2018 to another private equity firm, Hellman &
Friedman, who merged it with another collision repair company. OMERS, however,
retained a minority stake and today, Caliber, said Graham, has an EBITDA that is 10
times what it was when OMERS originally invested in it.
“We never paid fee or carry, we sold part of the business. We kept a minority
stake. That’s great color to bring to the OMERS’ board.”