LP interview: CalSTRS

At the AVCJ Forum in Hong Kong last November, delegates were invited to participate in a ping pong ball survey, indicating whether they agreed with certain predictions for the private equity industry by placing a ball in a bowl marked “yes” or a bowl marked “no.” One of the predictions was as follows: there will be more than two pan-Asian PE funds of at least $10 billion by 2025.  

“I reluctantly dropped the ball into the ‘yes’ bowl, but I wanted to write on it: ‘in protest,’” says Christopher Ailman, CIO of California State Teachers’ Retirement System (CalSTRS). “It is going to happen because there is too much capital in the world. I really hope we don’t invest in it.”

As the third-biggest pension plan in the US, CalSTRS is irrevocably drawn towards funds of size. As of November 2017, it had $221.7 billion in assets of which 7.6%, or $16.9 billion, was in private equity. The portfolio includes several large commitments to recent pan-Asian funds: $200 million for RRJ Capital, $155 million for MBK Partners, and $150 million apiece for Bain Capital, PAG Asia Capital, and SSG Capital Partners. FountainVest Partners also received $150 million for its third China vehicle. 

Further down the spectrum, CalSTRS invested $40 million in a Lilly Asia Ventures healthcare fund, most of which will be deployed in China, and $60 million to venture capital and top-up funds raised by Sino-US manager GGV Capital. Beyond that, however, it gets difficult. Ailman describes CalSTRS as a cruise ship that lacks the maneuverability of a speedboat-like endowment. 

“What we have done to access that small market is create fund-of-funds. Those have been useful, but the problem is FOF stands for fees on fees; while we are getting access, it comes at a cost that erodes a lot of the value we can get,” he adds. “We don’t want to be 40-50% of a fund so we automatically look at larger options, but especially in a region like Asia with its diversity – it’s huge but also very local – that can be an impediment.”

Addressing Asia

At present, CalSTRS has four fund-of-fund or separate account relationships that follow different strategies: venture capital and growth equity; next generation fund managers; middle market buyouts; and regional managers. The VC fund-of-funds is a product of necessity. Public institutions in California are subject to performance disclosure requirements that managers cannot countenance. The only way for CalSTRS to get exposure is by investing through someone else.

The next generation managers allocation, meanwhile, is intended to build relationships with GPs investing smaller early funds that might not otherwise get attention. While some large pension funds refuse to look at anything before Fund III, there is a willingness at CalSTRS to commit earlier. For example, it backed FountainVest’s debut fund of $950 million in 2008 and has since re-upped twice more as the GP raised $1.35 billion and then $2.1 billion. 

“We have so many of the established firms and we want to complement that by investing in some of the new talent. We always felt the generational shift. It’s been slow to develop in the US and Europe, but I think it is happening much faster in Asia,” Ailman says. “Asia feels a lot like US private equity felt in the early 1990s. We will continue to see a huge number of regional GPs develop.”

On joining CalSTRS from Washington State Investment Board in 2000, one of Ailman’s early objectives was to internationalize what was at the time a North America-centric portfolio across all asset classes. The challenge presented by Asia is its historical cyclicality. China will inevitably account for a larger portion of the overall portfolio going forward, but the question foreign pension funds must answer is how do they come with a sustainable investment strategy.

For PE specifically, mid-size firms in Asia are lacking in terms of back office resources and reporting capabilities. Ailman notes that improvements must be made in this area if GPs are to demonstrate an ability to execute in the long term. However, he is reluctant to say they should become institutionalized because of what this has come to mean for several US firms: listed asset managers with multiple strategies contesting auctions and delivering incrementally lower returns.

The notion of PE firms going public is not appetizing. “My concern is their wealth, especially the younger partners, is right there on the screen in front of them. They tell me it doesn’t change their perspective, but I think as a human being it has to: instead of wanting to invest long term you can constantly see what your net worth is.” 

Nevertheless, more GPs are likely to pursue IPOs, because either they need to facilitate the transfer of power to another generation of partners or they want to raise permanent capital. And CalSTRS continues to invest with these managers despite Ailman’s belief that any perceived gains are outweighed by the loss of focus arising from having too many people with interests in your business.

There are about 330 fund positions in the pension plan’s private equity portfolio across more than 100 GP relationships, but a portion of these are no longer considered core. Although there is a trend towards consolidation, there is not the same sense of urgency that emanates from other LPs. Neither is there a target for a particular number of relationships. 

California Public Employees’ Retirement System (CalPERS) has said it expects to have just 30 private equity managers by 2020, while Teacher Retirement System of Texas has led the way in forming strategic partnerships under which large allocations are made to particular GPs for multiple strategies. Ailman acknowledges there is a rationale behind these approaches, but he doesn’t necessarily endorse them.

“I would like a smaller number of GP relationships but if smaller and more concentrated means you just end up with the bigger firms, it creates a tension,” he says. “I don’t know if there is a right number but manager selection has been the key and I think persistence of returns in private equity is going to disappear, which means manager selection is going to be even more difficult and even more important.”

Value for money

There is also a certainty that the fee model has to change. As of year-end 2016, the net asset value of CalSTRS’ investments stood at $194.7 billion and it incurred $1.64 billion in costs. The total falls to $973 million when carried interest is stripped out, and private market strategies account for $792 million of that. PE was the single largest cost contributor in 2016: $206 million in management fees, $128 million in other costs, and $389 million in carried interest on a $16.5 billion portfolio.

Private equity has performed well, delivering a return net of fees better than all other asset classes on a 10-year basis and better than most others on a one-year and five-year basis. Global equity accounted for 54.4% of the portfolio compared to 8.5% for PE, but it generated only $147 million in costs. Does the performance differential justify the cost differential?

“I would argue the quality of the product, the service being provided, isn’t worth what we’re having to pay for it. Private equity returns are compressing and getting closer to public equity returns,” says Ailman. “I don’t have a problem paying carry, that’s an incentive fee. But we aren’t going to pay huge fees to cover operations. If you’re collecting fees on seven funds, pay your own expenses.”

There is no consensus as to what might replace the traditional 2% management fee and 20% carried interest. He suggests removing the management fee for larger players and paying them 25% of the profits above a hurdle rate. Some firms in the infrastructure, hedge funds and real estate space are already converting to a zero management fee approach, but not so much in private equity. This may be a function of the amount of capital available, with only spin-out managers willing to be flexible.

“There is an element of you get what you pay for,” Ailman adds. “If you look at the overall cost of investment management, regardless of asset class, it has to compress because the value added is not as substantial.”   

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• Topics
• LPs
• Fund-of-funds
• Fundraising
• California State Teachers’ Retirement System (CalSTRS)