Q&A: CalSTRS' Christopher Ailman

Q: How did CalSTRS' policies on environment, social and governance (ESG) issues come together?

A: We're one of the few US pension funds with a social policy dating back to the 1970s. If you break it down between E, S and G, our board decided to be ex-tobacco in 2000 - they removed it from the benchmarks, which effectively divested it. That was an S issue. We've focused on corporate governance since the 1980s and we didn't get into the environmental area until 2003, when we started making cleantech investments. So we had E, S and G but they were all separate. There were also our "21 Risk Factors," which have been around since the early 2000s when we were going into emerging markets equities. We officially adopted the UN PRI [Principles on Responsible Investment] in 2008 when all our existing policies were modernized and brought together. Now the board is starting to say we should refresh our approach. Next spring we will review everyone else's ESG policies and figure out where to go from there.

Q: How do you allocate resources to ESG internally?

In 2006-2008 I talked to a number of international funds and they had a sustainability or responsible investment officer. I didn't like that term. What is the rest of the team if this is your one responsible person? I also noticed that this person was often in a corner office or on a different floor. I decided that we had to be fully integrated. So we created the green team, which has a representative from every single one of our asset classes and they share information on what they are doing. We rotate membership of these teams and we plan on rotating the leadership too. The idea is it isn't just one person who is labeled the green person, but it is in all parts of our portfolio. It is the same with the governance and social teams.

Q: Is it fair to say that most US pension funds trail their European counterparts on ESG?

The UK's Environmental Agency Pension Fund (EAP Fund) is ahead of almost everybody. I would say we are more like APG - doing lots of things but not as comprehensively or aggressively as the EAP Fund or PGGM. We also talk a lot to Unilever, the Universities Superannuation Scheme [in the UK], and the Australians. If you look at North America, it's an upside down U. California focuses more on ESG, and then Oregon and Washington a little bit; the Canadians get it but aren't fully introducing it; and you've got some of the northeast states and New York. But then it stops - the whole middle of the country is missing. The state CIOs have meetings and four years ago I had to explain what ESG meant and they laughed. But last year they were all taking notes.

Q: What do you want to see from PE managers on ESG?

A: For me, ESG is a more comprehensive view of the risk and return opportunity. Private equity gets this. They might not have called it ESG until about two years ago, but they have been doing it for a long time. Ask them if they care about product liability lawsuits, labor union strife or pollution fines and the answer is yes. They look more deeply at risk than other people. Value managers in the public markets have also been doing this for a long time, and so have credit managers. The venture and growth investors pay less attention to it. That's because they want that growth and speed almost at any cost, even if it means taking short-term cuts in areas like labor, environment and governance. We say, "Thanks for the return over five years, but we need to repeat that over 10, 20 years. You need to think longer term."

Q: Are there specific criteria through which you can assess compliance?

A: The challenge you run into is that all managers - private equity and others - were very quick to sign up to the PRI. We send them all surveys and they say, "We incorporate ESG in our strategy," and that's the checkbox. I think 93% of our managers say they are compliant. We are working with the PRI to figure out what that really means. Right now every asset class does it somewhat differently and we are trying to identify standards that can be used to evaluate any manager. Almost all of our managers pay attention to ESG risk when doing financial analysis. But what does it mean to be a truly sustainable manager rather than one that only focuses on returns? It shouldn't be a separate investment process for ESG; it should be part of the investment analysis. In 2003 I was part of the interview panel for an emerging markets manager search in public equity. I'd stepped out to take a break and as I was walking back to the interview room I saw a marketing person say to his portfolio manager, "These are the 21 risk factors they care about, you need to tell them we do them." One of my staff asked about the risk factors and the manager said, "My marketing guy just handed these to me and, yeah, we can do all of them." They were thinking about it as a checklist, and they didn't get hired. We've learned that nuance between sales pitch slideshow and people who can execute.

Q: So, for private equity, do you expect an ESG officer to sit on the investment committee?

A: I would consider that industry-leading practice. I don't want to say best practice; that would be if ESG was integrated with everyone rather than just one person. One time we were doing a video conference with an infrastructure manager and they were telling us how wonderful they were. I asked them how big the team was and how senior they were within the organization. They said there were two of them and that they reported to the CEO. So then I asked, "Where do you sit - in the same building as the CEO or a block away?" I've learned this the hard way. In 2002 I was talking to a major US fund and the governance person admitted to me that they weren't allowed on the trading floor because the traders didn't like them. That's what I want to avoid - a special unit that sits somewhere else, checks the box, and isn't part of the process. You want someone who sits in the executive office and is required to vote in committee on every deal. The role has to be properly thought through because far too often I have seen big buyout firms with sustainability officers whose job is to take a deal that has already been done and pull out the positive stories and discount the negative stories. They don't think about it holistically.

Q: How easy is it to get comfortable with approaches to ESG in emerging markets?

A: Asia has been a real struggle for us. Direct investment in China only represents about 0.5% of our portfolio, although if you look at the portfolio based on where the corporate revenues are coming from China is number two. ESG is sometimes easier in Asia because family-owned enterprises think about sustainability; they don't want to take short cuts to get ahead because they are still going to own the company. But China is a range of experiences - there is more than enough money that is indiscriminate and couldn't care less about ESG. We've talked a lot to our board about China. We want to be more global in our equity portfolio, which means buying more emerging markets, but we have to come to terms with ESG there.

Q: ESG and fees are both hot-button topics in private equity. To what extent can you look at them in the same way - i.e. LPs pressuring GPs for more transparency?

A: Our hope is the fee transparency issue is something that just gets solved - an effort that has a conclusion, whereas ESG is going to be a discussion for the rest of our careers. The fee reporting issue has got a lot of press, but as we've peeled back the onion on our GPs, the situation is exactly what we thought. Can I give a number? Yes, it's 2% and then 20% of the profits. Do I know the dollar amount? No, because it's an aggregated payout over the life of the fund, you don't really know what the total carried interest is until the partnership finally closes some 14 years later. With these other fees, one of the things people have lost is the materiality. The fees are generally smaller, and since about 2003, most of them have been wrapped into the partnership and split with the GPs or credited back against the management fee to the LPs. We have always reported direct costs that we write a check for, but our board has asked us to go through and actually assimilate all of our indirect costs. We will do that by November, not just for private equity but also real estate and infrastructure. Has all this brought light to the issue of fees? Yes. I've long said 2/20 has been broken because larger funds like us negotiate very different terms. To that extent, it's a good thing.

Ailman will be making a keynote address at the AVCJ ESG Forum, which takes place in Singapore on September 5. For more information, please go to www.avcjesg.com.

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• Topics
• North America
• LPs
• Investments
• ESG
• California State Teachers’ Retirement System (CalSTRS)
• Asia