Who's Paying What.

From aiCIO's February issue: Tim Walsh, Blackstone, and the fee revolution. Leanna Orr reports.

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Stephen Schwarzman met with the head of the World Bank on Wednesday; Thursday morning, he’s speaking to a mostly empty meeting hall in Trenton, New Jersey, trying to make the audience like him. “Contrary to what you might read in the press, private equity creates jobs,” Schwarzman says to the 30 or so union members and state employees scattered in front of him. “Blackstone paid $74 million in taxes to New Jersey last year, and we see some really interesting opportunities for us here.” During his presentation, he rattles off Blackstone’s commitments to New Jersey—26 portfolio companies, three headquarters, and thousands of employees—but his investments are not what brought him to Trenton. Schwarzman is there for his investors. “Blackstone is the world’s largest manager of alternative investments,” he says by way introduction, “and the New Jersey Division of Investment is one of our most important clients.” 

Important, sure, but also one of the lowest paying. New Jersey’s $73.7 billion state pension fund is—thanks to a cocktail of strategy, bold leadership, luck, and innovation—getting more for its asset management money than almost any other public pension fund in America. 

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Schwarzman spent half an hour or so at the podium, giving his take on the state and future of the global economy, and describing Blackstone’s place in it. “Europe has got a variety of structural flaws, although it doesn’t look like a Eurozone collapse will be the case,” he said. “Still, it’s tough to get loans, which means opportunity for people like us who have money from nice people like you.” A lot of money, to be precise: In 2011 alone, the New Jersey Division of Investment (NJDOI) committed $2.4 billion to the private equity firm Schwarzman founded, bringing the total investment well north of $3 billion. As he spoke to the audience—some in their matching purple union T-shirts, and others who looked like they shared a Madison Avenue tailor with him—Schwarzman couldn’t help but give a sense of his own place in the world financial market, as well. “I was with somebody yesterday who is the head of the World Bank,” he mentioned casually, as the source of a certain chart. 

After the presentation, he stayed on to answer questions from the State Investment Council, looking much less aware of the time than his well-dressed staffer, who began pacing in the back. The topic of fees came up, as it does predictably at council meetings, according to the chairman. 

“There has been a trend to pressure on fees,” Schwarzman acknowledged. “I think there has also been a re-looking across the pension fund industry and asset management as to who exactly is getting money to manage. It’s good to save money on fees, but if you give money to the wrong people, you will destroy those savings many times over. On some of our products there’s fee pressure, on others there isn’t. Markets have been unfavorable, so it’s rare I go into meetings and see any happy people. Institutional investors who have underperformed their needs—just because markets haven’t worked—are looking for ways to economize. It’s not unexpected.” Schwarzman shakes his head at investors who drop Blackstone over fees, and switch to bargain managers with “you’ve got to be kidding me” performance records. “And we say, ‘good luck!’” 

NJDOI is fixated on fees, but hardly about to jump ship for a cheaper fare. As Schwarzman semi-joked while going over the Blackstone-NJDOI deal, “You all have negotiated too good a deal with us.” 


New Jersey’s state pension fund has been an investor in Blackstone since 2005, the first year it had an alternatives program. In fact, an allocation to Blackstone V was one of the first five investments NJDOI made in the alternatives space. One of the staff members who was instrumental in that initial deal with Blackstone, also brought the relationship to its apotheosis in 2011: their $1.8 billion strategic relationship. Christine Pastore, former co-head of alternative investments at NJDOI, says the real turning point for the fund was, in fact, a year earlier, with a regime change. 

In an unlikely twist of fate, NJDOI owes its second wind to a politician. The previous director retired after a decade in senior positions, and newly minted Governor Chris Christie took the departure as an opportunity for an overhaul. According to people familiar with the situation, the director’s legacy included a clutch of very questionable investments—some of which are still being flushed out of the portfolio. 

Christie handpicked prominent finance types to do a full-scale review of the fund’s portfolio and operations. One of them—former Carlyle partner and current managing director of Cheyenne Capital Robert Grady—became the investment council’s chairman. He led a search to fill the directorship, recruiting Tim Walsh from the Indiana State Teacher Retirement Fund to lead pension system.

People involved with the fund tend to treat 2010 as Year Zero for NJDOI. (Next year, look for the albino tiger of the pension world all over NJDOI reports: the four-year return.) This makes sense: the fund overhauled its leadership, governance, strategy, and goals over a short period of just a few months. Walsh and Grady agreed early to focus on minimizing the costs of achieving solid returns, but that process didn’t start with contracts. It started with policy. 

“The first thing I did as chairman,” Grady recounts, “is propose a resolution to the board in three categories: private equity, hedge funds, and real estate. I said, ‘As a policy of the New Jersey pension fund, we will only invest in top-quartile managers.’” The council passed his resolution unanimously. “You have this trailing history in many states—New York, California, and others—of pay-to-play or people who knew board members getting allocations…that were not top performers. I wanted to protect the staff from political influence, from that kind of special pleading. If someone came in, and even if it was a state senator’s brother, and said, ‘Hey, I’m a great private equity manager,’ I wanted to give them the ability to say, ‘Sorry, our policy is that we only invest in top quartile. So when you can show me you’re top quartile, we can have a discussion.’ And by the way, when any manager comes to our door, that question is always, always asked of the consultant and of the staff, and we say, ‘Show me the records. Show me the data. Show me the Preqin. Prove that they’re top quartile.’” 

“Top quartile” has become the unofficial mantra of (post-2009) NJDOI. When Walsh came in at number 25 on aiCIO’s Power 100 list, his staff reportedly took pleasure in congratulating him on barely making it over his own quality threshold. At least with asset managers, there seem to be virtually no exceptions to Grady’s proposal. (No word on Walsh’s fate if he slips at all in next year’s ranking.) For one thing, the policy filters out three-quarters of the overstocked asset manager pool, including those most eager to schedule a pitch meeting. Staff hours do not factor into the data table (see sidebar), which only looks at external management expenses, but in-house efficiencies do help keep NJDOI’s overall costs low. In its report for the 2012 annual meeting, the fund claims its total annual costs, from office supplies to checks for Schwarzman, amount to 0.285% of its assets, or 28.5 basis points. Similarly sized public funds average about 47.7 basis points overall, according to the RV Kuhns data. Grady’s years of experience as a general partner in private equity and now venture capital must have given him confidence to step into the chairmanship of a major institution, and propose to ban dealings with three-quarters of asset managers. 

NJDOI has still managed to negotiate what it calls “preferential terms” on 25 out of the 58 alternatives investments made in the post-2009 era. Minutes after meeting Grady for the first time, he trotted out this statistic and I asked the obvious question: How? “Two things,” he replied. “Number one, there is a little bit of an element where size should matter. And we are a big investor in some of these funds. It probably makes sense at this point in the industry’s maturity that big investors should be able to forge that special relationship.” Walsh intercepted with number two: “It’s not as easy raising money as it was in ’05, ’06, ’07.” 


Just as the US economic recovery has been a boost for personal finances across the board—arguably disproportionally so for the wealthy—asset management fees have dropped overall since 2008, but especially for the largest funds. Mercer’s latest fee survey found “general downward pressure” on private equity fees, but that investors with leverage have been typically driving negotiations. Because, as Walsh said, it’s not as easy raising money as it once was. The report calls this “a rationalization” of supply/demand dynamics, while one of Mercer’s partners—Brian Birnbaum—characterized it closer to a reality check. “Coming out of the financial crisis, hedge funds were still down north of 20%,” he explains. “I think investors had bought these strategies thinking they would perform better in periods of crisis, and their experience has been something different. Investors are always willing to pay higher fees for protection, but there’s an increasing realization that hedge funds may not be the solution.”

Mercer’s data shows a sustained decline from the pre-crash “2-and-20” management-performance fee standard for hedge funds. The median is now 1.5 and 20, but in fact, far fewer funds pay the median. Rather than a simple rate cut, Mercer reports that hedge fund managers are offering fee incentives in exchange for longer lock-ups and larger investments. Every year, Mercer has found more institutional investors are taking managers up on their offers. If there is any leeway, the data indicates that management fees are the place to look for it. Whether GPs prefer to discount here or are responding to client demand, every person interviewed for this story expressed the same position: Performance fees are fine rewards for alpha, and management fees piss me/my board/my members off. (Tim Walsh put it succinctly: “Nobody is questioning what Colin Kaepernick was getting paid with the 49ers. Their fans wanted them to win.”) This increase in flexibility, if not drop in rack rate, testifies to a changed dynamic between asset owners and asset managers. 

Bob Grady is one to know. It can be easy to buy into the notion of institutional investors as sleeping giants, with vast untapped market power in the form of “secret capital.” I floated this idea to Grady: that the “general downward pressure” on fees that Mercer reported could be the front edge of a much more powerful push. He was thoughtful for a second. “The pendulum tends to swing back and forth in the LP-GP relationship, and I think since the crash the pendulum has been a little more on the LP side,” Grady said, and then chose his words carefully. (Indeed, forecasting power dynamics must be tricky when you play for both sides.) “Given the difficulties that arose for some firms after the crash—the difficulties of investing money and the difficulties of raising money—more people understand the constraints LPs are under. One salutary effect of the recession and slow economy of ’09 is that people are just a little more respectful of the LPs. But I don’t see LPs extracting more and more right now; there’s kind of a general balance.” 

If there is balance at the moment between asset owners and managers, there must be a number of holdovers still paying 2-and-20 to counteract NJDOI and a few others. The data that follows suggests there is. It’s rare for public funds to publish the fees they agree to, not just the expenses incurred, as those that do typically have something to show off. Still, when balance sheets show high ratios of manager payouts to the assets under management—excepting serious alpha situations—all signs point to inequitable fee structures. As Birnbaum has concluded by consulting for numerous pension funds, “some investors are very aggressive in negotiating, and some are just prices takers.” 

The lead dealmakers at NJDOI, however, are neither. Strategic relationships save the fund about $60 million per year, Walsh estimates, and have involved surprisingly little negotiation. Since the mission of the arrangements is alignment of interests, too much to negotiate over could even signal a faulty structure. The critical step happens well before terms even come up: maintaining a positive and long-term relationship with an asset manager. Fair or not, Pastore says public pension fund staff may need to prove themselves to get there. “There are sophisticated public pension plans, and ones that are less sophisticated. To be perceived as sophisticated in the GP community means that staff does its own work and negotiates the contracts directly. Those who are in the weeds, working late, attending meetings, and building relationships are typically perceived positively. LP’s have to build creditability. New Jersey was likely seen as a sophisticated investor in alternatives—specifically private equity—because of their ability to do things outside the box.” 

One of those things they did was make the initial approach to Blackstone about setting up new terms and doubling down on NJDOI’s investment. With Walsh’s encouragement, Pastore went to the firm’s New York office and floated the idea. From there, a mountain of due diligence and much strategizing followed. One of the core ideas of the partnership was to take advantage of investment opportunities NJDOI and Blackstone knew were slipping through the gaps of their individual mandates. A certain asset, clearly mispriced, might be too liquid or small for the firm’s private equity division, or require quicker action than a public pension is capable of.

Thus, the joint Tactical Opportunities Fund was formed—a separate account bankrolled by up to $1 billion of NJDOI assets, and eventually staffed with reassigned Blackstone employees. “Blackstone was very focused on the mandate once New Jersey became more serious about working with them,” Pastore recounts. “The idea was a new one for both Blackstone and New Jersey, and as a potential early adopter, New Jersey was able to negotiate very favorable terms for the deal.” The private equity firm agreed to contribute 3% of the fund’s assets to align interests, as well as take no fees on committed capital. Investment staff at the New Jersey fund also had governance rights over the portfolio, with the ability to veto an investment or slow down allocations, as well as the freedom to pitch opportunities. The Tac-Ops idea worked—and continues to work—because neither party could feasibly capture those opportunities alone. Blackrock, despite its size, staffing, and reach, was looking for opportunistic capital, Grady says. “You don’t have the ability to move quickly and take advantage of real dislocation in a typical mandate as in, ‘We’re going to invest in private energy companies,’ or ‘We’re going to invest in control-only buyouts of industrial corporations.’ Tac-Ops is like, ‘What about other stuff?’” 

New Jersey taxpayers spent 28 cents in management costs for every $100 Walsh, Grady, and their team invested in the 2012 fiscal year, according to a draft of the NJDOI’s unpublished annual report. The total bill came to $224.2 million. But like so many investment expense tallies in other public plan reports, that figure doesn’t tell the whole story. Bob Grady flew to and from Wyoming at least a dozen times over that period, and paid for it himself, as with all his other expenses. One council member estimated that two thirds of the council, which includes a Colliers executive (in charge of real estate, naturally) and other top business people, do not take reimbursements from the state. Tim Walsh is the highest paid person in the division, making $185,000. Unlike a private equity titan’s income, that’s not taxed as capital gains. NJDOI has some of the lowest investment costs in the industry in part because the people setting up partnerships, finding legislators to pass reforms, and conducting due diligence are experts doing so for free, or nearly so. But as Stephen Schwarzman proved by showing up in Trenton to speak at the NJDOI meeting, people don’t mind a pay cut if the other incentives are in line. 

The one question that Robert Grady seemed unprepared to answer was why he does this job. “Public service,” he replied after a few moments. “I got some luck at Carlyle and Robertson Stephens, and want to give something back.” He chose well. As NJDOI optimizes fee efficacy, Grady has optimized his own public service. There are whispers, too, that he may aspire to a more official position as a public servant, and it’s immediately believable. He has a politician’s tendency to speak in numbered lists—“Frankly, what we’re trying to do is bring fresh thinking to the public plan world. Number one: by being aggressive, and lowering the burden of fees on our members by using our size. And number two: by trying to be flexible and innovative.” 

Long after Schwarzman had been shuttled off, back to Manhattan, in his private towncar, Grady adjourned the second and final council meeting of the day. He made the rounds, despite the long day. Finally, both he and Walsh could leave the hall. Walsh went back to the office, and Grady, to see the Governor.  —Leanna Orr