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PE's seismic shift

CalSTRS joins chorus favoring separate accounts over funds

030512 abelow
Starting: Houlihan Lokey’s Justin Abelow said the separate accounts move is gradual.

The $149 billion California State Teachers' Retirement System could be the latest institutional investor to stray from its love affair with private equity funds in favor of a more individualized approach.

CalSTRS' investment committee next month is scheduled to approve a new investment policy statement giving pension fund staff the ability to make private equity investments through separately managed accounts and to craft customized investments in the asset class to take advantage of specific opportunities as they arise. The new investment policy statement was proposed in a staff memo for the Feb. 2 investment committee meeting but was tabled until April.

The West Sacramento-based pension fund could conceivably make big investments through separate accounts. The proposed policy delegates to staff the ability to make these investments under certain circumstances and with each commitment no larger than 10% of the overall private equity portfolio as measured by total exposure. CalSTRS' private equity portfolio is valued at $21.4 billion.

The switch to customized investments from the old approach of investing in private equity managers' funds is a result of the 2008 economic meltdown. Investors believe their private equity managers let them down by piling on leverage and giving less-than-stellar returns for pre-crisis vintage years. Since then, institutional investors have been taking steps to gain more control. Most already have sifted through their voluminous lists of managers for the ones that survived with returns intact, and many now aim to invest larger sums in fewer, more individualized investment solutions.

These investment solutions have many names. A few investors — the Teacher Retirement System of Texas and the New Jersey Division of Investment — are calling them strategic partnerships. Many private equity managers use the term “managed accounts.” Others, like CalSTRS and the $140.3 billion New York State Common Retirement Fund, are merely calling them by a name familiar in other asset classes: separate accounts.

The trend is “not binary; it's graduated. Sometimes it is nothing more than a large limited partner has to have a side agreement with co-investment rights, breakup fees or opt outs from certain transactions,” explained Justin Abelow, New York-based managing director of consulting firm Houlihan Lokey. “It gets heavier and heavier until you get to separate accounts.”

Only a handful of private equity managers would have considered such an arrangement in the high-flying pre-crisis days, when even the largest investors could be told to “take it or leave it” on any given investment fund.

Those days are long gone.

Now, in exchange for breaks in fees and terms, private equity firms receive big chunks of capital at a time when even the most highly regarded firms are resigned to raising much smaller funds. These separate capital injections give the managers the ability to invest in the megadeals that they would not have been able to afford with smaller pools of capital. They also allow the firms to retain talent that would have been laid off if the firm had only raised a smaller commingled fund, industry insiders say.

Sizable investments

These investments can be sizable. The $109 billion Texas Teachers fund recently invested a whopping $3 billion each with Apollo Global Management LLC and Kohlberg Kravis Roberts & Co. KKR manages a $2 billion bank loan portfolio for the Oregon Investment Council Tigard, Ore., which manages the $56.9 billion Oregon Public Employees' Retirement Fund, Salem, confirmed James Sinks, spokesman. The New Jersey Division of Investment, which oversees $69.6 billion for the state's seven pension funds, invested up to $1.8 billion in three funds and four opportunistic separate accounts with Blackstone Group.

Not all separate account mandates have been of the jumbo variety. The $35.4 billion Maryland State Retirement and Pension System, Baltimore, has a $158 million credit separate account managed by KKR.

CalSTRS spokesman Ricardo Duran said officials there are not necessarily considering the strategic partnerships adopted by Texas Teachers and New Jersey.

CalSTRS expects separate accounts to provide more favorable partnership terms — such as early termination of the investment period, lower fees and increased transparency, the staff memo states. Currently, CalSTRS can invest through funds and co-investments. Some 94% of CalSTRS' private equity portfolio is in commingled funds, with the remaining 6% in co-investments, the report noted.

“Separate managed accounts will have more favorable partnership terms,” the staff memo states. “Almost always, management fees will be lower and sometimes carried interest will be lower, too.”

CalSTRS also expects that separate accounts might enable staff to create “customized investment strategies,” the memo states. In other words, CalSTRS staff would have the ability to direct a multistrategy asset manager as to how capital would be invested, in which strategies and when.

Not every investor can cut these deals.

“In order to get a `better deal,' a large limited partner typically needs to make large, long-term capital commitment to the general partner and the fund,” said Cindy Ma, New York-based managing director at Houlihan Lokey.

It is a trend that is building, however, and private equity managers welcome these new investments.

“We see more separate accounts are happening with a number of private equity firms,” Ms. Ma said.

Institutional investors recognize that they have negotiating leverage now, said Daniel Byrne, principal at the Roseland, N.J., office of consulting firm Rothstein Kass.

Not only can they get reduced management fees and reduced carried interest but they can customize their portfolio, opting out of investments that might be offered in the main fund, Mr. Byrne said.

Said Victor Quiroga, partner in the New York office of Triago: “Every day we see dozens of private equity firms raising ... smaller funds than before and spinoffs of bigger outfits focusing on strategies and sectors or regions,” instead of multistrategy approaches they once had offered. Triago is a placement agent and private equity funds advisory firm.

“What this means,” he said, “is that there are firms that have the deal flow to make very large deals, but do not or cannot raise very large funds. They have a gap. They know that their funds will not get larger soon.”

The managers' response has been to offer these separate accounts.

“It allows general partners to claim that they are in their "zone of comfort' investing in large deals but still be able to tell limited partners that they are not raising megafunds,” which some investors currently frown upon, Mr. Quiroga said.

This strategy has spilled over to firms that can still raise any size fund they wish, Mr. Quiroga said. For example, KKR executives see managed accounts and strategic partnerships as the next logical stage of building a broad capital base, he said.

“It's one more channel to building their capital base with limited partners that would not have gone into their normal funds anyhow.”