Big U.S. pensions are pushing deeper into private equity, seeking exclusive deals alongside buyout firms and at sweeter terms.
Texas and California teachers are ramping up their allocations to co-investments, with more staff and new offices dedicated to buyouts. And Calpers, the largest U.S. pension, discussed this week whether to take a bolder step and do deals on its own.
Public pensions already pour billions into buyout funds of firms like KKR & Co. and Blackstone Group LP and have been rewarded with a median annual return of 11.9 percent. Co-investing, in which pensions buy direct stakes in companies alongside buyout funds while paying little or no fees, promises even bigger gains.
But it also requires building what amounts to an in-house buyout team to vet deals -- an expensive endeavor that some public pensions, which are overseen by cost-conscious boards, have been hesitant to take.
“To do it well and at scale, you almost have to be a professional investor because you can’t rely on public information or market rules,” said Ashby Monk, executive director of a finance research center at Stanford University. “You’re doing corporate due diligence, meeting fiduciary standards. That’s the hard part.”
Public pensions in Canada were among the first to jump into the strategy, investing in companies such as department stores and software producers either on their own or alongside private equity giants. As early as in the 1990s, the pensions began establishing deal teams, backed by their professional boards’ willingness to pay top dollar for talent in Toronto and New York.
Since then co-investing has spread in the U.S., with endowments and foundations as well as pensions angling for deals. And with buyout firms sitting on more than $1 trillion in dry powder awaiting asset prices to fall, there’s a lot of capital chasing a limited number of opportunities.
“There are so many LPs having the same idea at the same time, it’s making the competition harder,” Margot Wirth, director of private equity investing at California State Teachers’ Retirement System, told her board in Sacramento in January.
For Calstrs, which manages $224 billion in assets, the savings on fees makes the gamble worth it. Pensions typically pay a 2 percent management charge and 20 percent of gains when investing in a traditional buyout fund.
“Hundreds of millions of dollars in reduced fees and incentive payments can be realized by building a more sophisticated, higher capacity private equity co-investment program,” Wirth informed the board.
She proposed hiring 15 additional managers -- and opening a buyout office in a financial center like San Francisco -- to focus on co-investments. Calstrs could then double its annual commitment to the strategy, which has recently run between $500 million and $600 million.
Calstrs has already seen a bump from co-investments. The strategy returned 28.3 percent in the 12 months through March 2018 compared with 14.2 percent for its investments in private equity funds.
The pension board, composed of teacher representatives and state officials, will review a more detailed plan on the expansion of co-investing in May.
The Texas Teachers’ Retirement System has done direct deals for a decade, including co-investing, which accounts for about a quarter of its private equity portfolio, an allocation it aims to boost to 35 percent. Private equity is the pension fund’s top performer, returning 15.2 percent last year through June.
The Austin-based fund has proposed almost doubling staff to 270 people in five years as it pushes deeper into direct and co-investing, including adding to its 14-member private equity team. It is contemplating an Asia office to source deals after adding a London office in 2015.
Jerry Albright, chief investment officer, said last year the pension fund could save $1.4 billion in fees over five years from doing more in house.
The California Public Employees’ Retirement System, which oversees about $355 billion, may go beyond co-investing and cut deals on its own, putting it direct competition with giant buyout firms. The pension is considering, among several alternatives, opening a New York office and launching two proprietary funds that would invest $10 billion apiece in long-term operating companies and late-stage tech startups.
The proposals, which were discussed this week by the board, are designed to help achieve the pension plan’s 7 percent average annual return target and overcome its unfunded obligations to retirees. Calpers allocated $44.9 billion to private equity as of Dec. 31, including $17 billion that hasn’t been invested because of the lack of opportunities, according to a board presentation.
Some board members, including State Treasurer Fiona Ma, questioned whether a new buyout strategy would meet Calpers’s parameters for risk and transparency. But Ben Meng, who started in January as the pension’s CIO, said the board needs to explore all private equity options if it expects to meet its return target.
“No pain, no gain,” Meng told the board. “Private equity is the only asset class we expect to deliver more than 7 percent.”
As other public pensions, including those in New York City, look to do more with co-investing, they face the thorny issue of paying specialists high salaries. Private equity managers earn about $500,000 to $1 million, including bonuses, which is more than double the typical public pension payout, said David Fann, chief executive officer of Torreycove Capital Partners, which advises pensions.
Pensions will need that expertise to lower the risk of making big bets on companies that turn sour.
“A co-investment is obviously riskier than a fund investment because of single-company exposure,” said Elizabeth Weindruch, a managing director within the funds and co-investments arm of Barings Alternative Investments. “Though they’re positioning themselves for enhanced returns, they’re commensurately increasing risk.”
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