CalSTRS Proposes Direct Private Equity Should First Target Co-investments

The more cautious approach to direct private equity investing at the second-largest US pension plan contrasts with a more aggressive approach by CalPERS, the biggest US plan.

Investment managers at the $220 billion California State Teachers’ Retirement System (CalSTRS), the second-largest retirement plan in the US, are embracing increased co-investments as a way to expand its private equity program and as an entry point into direct investing for the asset class.

A CalSTRS report that was presented to the investment committee on Nov. 7 contrasts how the West Sacramento-based teachers’ retirement system is going down a different road, at least initially, than its neighbor, the $361.1 billion California Public Employees’ Retirement System (CalPERS) in Sacramento.

The largest US retirement plan, CalPERS is proposing to invest $20 billion through two partnerships over the next decade in late-stage companies in the venture capital cycle as well as taking buy and hold stakes in established companies.

The CalSTRS report shows that system officials see co-investments, traditionally investments alongside private equity funds, as the best way to increase the size of its $18 billion private equity portfolio.

Co-investments only account for a small part of the private equity portfolio at the retirement plan, around 5%, said a September report from the Meketa Investment Group, which serves as a CalSTRS consultant.

The November CalSTRS report did not indicate how large co-investments could become, but investment staff say in the document they believe it’s the way for CalSTRS to encourage more direct private equity investments.

“For the medium term (the next three or four years), staff believes that increasing the Private Equity’s co-investing activities presents the greatest opportunity for improving performance (and reducing total fees and incentives paid to outside parties) through engaging in direct investing,” the CaSTRS report said.

In co-investing, pension plans like CalSTRS are offered additional stakes in portfolio companies acquired by private equity firms. This is in addition to their investment as a limited partner in a co-mingled fund with a general partner. However, the management of the additional investment is controlled by the general partner, not the institutional investor.

CalSTRS investment officials didn’t rule out taking a great role in direct investments in the future, but the report shows that investment staff of the pension is aiming to take a more cautious approach than CalPERS.

 “Staff also believes that increased co-investing provides the best means to prepare private equity to engage in more advanced forms of direct investing (e.g., co-leading deals, leading deals, etc.) in the future should that be desired,”  the report said.

CalPERS officials also say they want to build their co-investment program in their $27.6 billion private equity program but much of their attention is focused on setting up  two CalPERS-funded investment partnerships to invest in late-stage venture capital and buy and hold stakes in established companies.

Both pension plans have been dealing with the fact that they are unable to commit as much money as they want to new private equity funds after their existing funds end and capital is distributed back to the retirement plans.

Because private equity returns generally are beating the returns of other asset classes, the competition to be investors in private equity funds has become so heated that institutional investors can’t get all the commitments they want. CalSTRS’s overall private equity returns for the one-year period ending March 31 totaled 15.5%, the largest return of any asset class.

CalSTRS currently has 8.1% of its overall portfolio devoted to private equity, but its long-term target is 13%.

In the 12-month-period ending March 31, CalSTRS statistics show that funds ending their lifecycle distributed $5 billion, but CalSTRS was only able to commit $3.9 billion into new funds. CalSTRS made $390 million in co-investments in the six-month period ending June 30, compared to total commitments  of $1.9 billion in co-mingled private equity funds.

The CalSTRS report details the appeal of co-investments.

“Often there are no fees and carried interest charges,” it said. “This arrangement is highly appealing to many institutional investors because, in theory and often practice, it results in higher performance for their overall private equity program as the co-investment portion of their portfolio is invested in high-quality investments but with much reduced (or often completely eliminated) fees and incentive charges.”

CalSTRS data shows that the pension system has been investing in co-investment partnerships since 1996. Performance data for the co-investments has been mostly favorable compared to the system’s overall private equity portfolio.

For the one-year period ending March 31, co-investments saw a net investment return of 27.3% compared to the 14.2% return of CalPERS’s private equity funds. For the three-year period, co-investments returned 14.3% annualized compared to 10.4% for private equity funds, and for the five-year period, co-investments returned 13.7% annualized while private equity funds returned 12%. For the 10-year period, co-investments averaged a return of 6.6%, while private equity funds returned 8.1%.

CalSTRS Chief Investment Officer Chris Ailman said earlier in the year that he favored increasing co-investments, and the system has hired AlpInvest Partners as a co-investment adviser to look for additional co-investment opportunities beyond what private equity general partners were offering the pension system.

The CalSTRS Investment Committee was scheduled to offer direction to Ailman and private equity director Margot Wirth at the Nov. 9 meeting on whether it was in agreement with the plan to increase co-investments, but the matter was taken off the agenda because of time limitations. It is expected to be moved to another investment committee agenda at some point next year.

The issue is not considered controversial and investment committee members are expected to go with the report’s recommendations.

The CalPERS Investment Committee, meanwhile, is scheduled to give approval to its version of direct investing, forming two investment partnerships with a general partner and CalPERS as the sole limited partner, sometime in the next few months.


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