LP interview: PennSERS

Pennsylvania State Employees’ Retirement System (PennSERS) got a first taste of Hahn & Company in 2011 when Asia Alternatives backed the Korean manager’s $750 million debut fund. Hahn & Co. has since grown substantially, closing a second fund and a sidecar at $1.9 billion in 2015. It is currently looking to raise $2.9 billion, once again across two vehicles. 

Asia Alternatives remains an investor in Hahn & Co. and PennSERS remains a client of Asia Alternatives. However, the pension system decided to invest in Hahn & Co’s latter two funds on its own as well, committing $50 million to each vehicle plus a further $25 million for the sidecar alongside Fund III.

“Ultimately, that’s how I would like to see fund-of-funds work. We prefer partnering with GPs directly and exploring unique relationships and Asia Alts complements that with specialized regional knowledge of the market that we currently cannot devote a ton of resources,” says Bryan Lewis, CIO of PennSERS. “We received exposure to Hahn & Co. initially through Asia Alternatives and because of their performance and their rising capacity we now have a direct relationship there. Practically speaking, when we establish direct relationship like that it helps us negotiate lower fees.”

The pension system is still invested in Hahn & Co. through Asia Alternatives and regularly communicates with the fund-of-funds to prevent portfolio overlap. It committed to China-focused Primavera following a similar process, but Lewis doesn’t expect this graduation from indirect to direct exposure to become a standard approach for PennSERS in Asia.

“I think there will always be a place for fund-of-funds among public pension plans. We want Asia Alternatives to help us mitigate the risk of partnering with managers too early on. They can identify spin-outs and smaller teams, but we will continue to write $75-100 million checks and we wouldn’t feel comfortable making that size commitment with a manager early in their fund life,” he says. “In addition, because of our public disclosure requirements, it would be difficult to access some of these managers.”

Altering allocations

The pension system had $29.3 billion in assets as of year-end 2017, which included allocations of 13.9% to private equity, 7.5% to real estate, and 7.2% to multi-strategy. All are several percentage points below the long-term strategic target. 

The real estate portfolio is a well-established collection of direct and fund investments, most of it private. But multi-strategy is a more recent construct. Formed after PennSERS cut back allocations to hedge funds, it is split equally between private credit, opportunistic equity, and opportunistic fixed income. Lewis didn’t want niche strategies buried in corners of larger portfolios, such as private credit within private equity, long-short equities within public equities, and emerging market debt hedging within core fixed income.

Asia Alternatives aside, PennSERS’ Asian private equity exposure is an eclectic mix. Global firms such as Bain Capital and TPG Capital are represented alongside homegrown regional players ranging from RRJ Capital to Excelsior Capital, special situations investors like Avenue Capital and ADV Partners, and a cluster of country managers, including Baring Private Equity Partners India, CID Group, and Lightspeed India Partners. This breadth could be symptomatic of a global program that ballooned out of control.

Go back 15 years and the pension system’s asset allocation was not unlike that of a US college endowment, with more than 25% in private equity. “In the early 2000s, when our plan was 110-120% funded [it has now around 60% funded], the investment staff allocated $3-4 billion in capital to GPs but across a lot of $10-35 million commitments. There were as many as 25 new partnerships in any one year,” Lewis explains. 

Along with a reduction in the percentage allocation to the asset class, steps have been taken to trim the number of partnerships in the portfolio. PennSERS was invested in 330 products operated by 151 managers at the end of 2017, but only about 167 are considered core for now. The rest are being discontinued. 

“The strategy in reducing legacy relationships is focused around being proactive in communicating with GPs. In a lot of cases, fund managers have difficulty winding down and liquidating funds completely. If GPs are in the later stage of their fund life – perhaps there is only one asset left – the key principals aren’t there, and the contacts aren’t readily available to talk about restructuring,” says Lewis. PennSERS has assigned administration of its LP rights for these non-core relationships to Fairview Capital.

Fewer but deeper

The approach for future commitments will be characterized by fewer but deeper relationships with GPs, but with a recognition that PennSERS is not as significant a player in private equity as it once was. The pension system doesn’t have the capacity to write $1 billion checks like some of its domestic peers. That said, it still wants to be a meaningful partner with an advisory board seat.

“We look for size, scale and a strong relationship where we have access to management and can customize our mandate,” says Lewis. “We make fund commitments of $75-100 million and our pacing target is $650-700 million a year. We could allocate $400-500 million to a single manager across multiple products and vintages. When we decide on future partnerships, a key component is the ability to pace into their funds over several years rather than make one large commitment immediately.”

He cites TPG as the kind of relationship PennSERS wants to have. The pension system is a longstanding investor in TPG and has backed additional strategies as they come online. It might not be the largest investor by dollar value, but it is well integrated with the firm’s team, from individual managers to senior leaders. 

Strategic partnerships are also a way to reduce fees, which is an ongoing goal for PennSERS. It paid out $135 million to managers in 2017 – private equity and real estate accounted for the bulk of this – compared to $189 million in 2011 and claims to have cut investment expenses by more than $100 million since 2010. Co-investment is helpful in this respect as well and PennSERS has been innovative in its use of resources and time to become more active. 

With a team of three covering private equity globally, the pension system doesn’t feel able to handle co-investments directly. Even if it wanted to, governance protocols prevent swift action. The solution is to tack co-investment sidecars onto fund commitments – this happened with Asia Alternatives – with zero management fee and little if any carry so the overall economics are blended down.

“Part of our co-investment strategy has been to rely on our underwriting of managers and to allow them to utilize us as a partner that can provide certainty of capital. We trust them to be fair and prudent from an allocation perspective.  We have a veto right for deals that might be sensitive to Pennsylvania, but in the majority of the decisions we are hands off,” says Lewis.

Streamlined decision-making is not only an issue regarding co-investment. Lewis would like the board of trustees to delegate more responsibility to the investment staff, particularly on re-ups. The argument is that if nothing has materially changed, there is no need for a full board approval process. Delays have become a more pressing concern given the increasing prevalence of expedited first and final closes among top-tier managers.

The right balance?

Such reform efforts are complicated by the presence of a state treasurer who is an outspoken critic of private equity. Last year, Joseph Torsella claimed that PennSERS could have saved $1.6 billion in fees if it had opted for index-tracking strategies rather than placing money with more expensive investment managers whose funds performed poorly. The larger Pennsylvania Public School Employees’ Retirement System (PSERS) was accused of wasting $3.9 billion.

The state treasury said last September that Torsella had authorized the transition of more than $2.4 billion in public equity holdings and $2.9 billion in fixed income holdings to low-cost index strategies, while initiating a review of state’s approach to alternatives. In addition, changes have been made to fee disclosure policy, obligating PennSERS and PSERS to report carried interest paid to GPs as well as management fees. 

Lewis is not opposed to increased transparency, but he is wary of full disclosure for the sake of it. Should information sharing move beyond fees and reach into more sensitive data such as underlying portfolio holdings in the public domain could undermine the pension system’s ability to participate in certain asset classes, especially in private equity.

On a one, three and five-year basis, PennSERS’ global public equities portfolio has outperformed private equity, but the situation turns on its head for longer time horizons. The 10-year net return on private equity is 7.5% versus 4.3% for public equities – exceeding the minimum 300 basis point premium required by the pension system.

“Private equity has been the highest returning asset area over 30 years in our portfolio. Particularly with buyouts, as long as we are doing better than the median we can outperform public markets over a 15-30-year period,” Lewis adds. “In some cases, we are more of a term taker than a term maker, but that’s the market. For the funds we are investing in, it is still worth the effort and the overall risk-return trade than not being in this space.”   

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• Topics
• North America
• LPs
• Fund-of-funds
• USA
• Asia
• Pennsylvania State Employees’ Retirement System (PennSERS)
• Asia Alternatives Management