New private equity firms are targeted

Public pension fund officials are launching emerging private equity manager programs to reserve space in what they hope will be the stellar, sought-after funds of the future.

Among those starting such separate programs are the California State Teachers' Retirement System, Ohio Public Employees Retirement System and Los Angeles City Employees' Retirement System. Others, such as the Teacher Retirement System of Texas, are looking into investing with emerging managers through funds of funds.

Few corporate pension executives are making special allocations for emerging private equity managers, but many are dealing with the highly competitive buyout and venture capital markets by investing in smaller managers that focus on smaller deals.

Emerging managers are generally new private equity firms, both venture capital and buyout, that are making the rounds with their first funds. A number of the new venture capital firms are focused either on a certain region or a business sector.

Going with an emerging manager is a risky strategy. To ease the risks, most investors are sticking with firms formed by general partners that split off from established, name-brand firms or can show proven investment experience.

"There are a lot of generational issues with our general partners (of existing private equity firms), meaning they're getting older and going to step away from the business," said Kirsten Macintyre, a spokeswoman for Sacramento-based CalSTRS. The pension fund has $116.2 billion in assets, of which 4.7% is allocated to private equity.

"We want to be able to take a look at some of the interesting managers that may split off from those more senior firms … or new ones that are being created today," Ms. Macintyre said.

CalSTRS officials are in contract negotiations with INVESCO Private Capital, New York, which would manage an emerging private equity manager program for the system. Officials there hope to launch the program within the next 60 days, she said.

"They will get $100 million to start, and they'll scour the U.S. for those new bright stars to invest in, totally at their discretion," Ms. Macintyre said. "Their challenge is finding needles in a haystack … finding and taking chances on these new and next-generation managers that don't have a long and impressive history behind them."

Emerging manager programs are taking off, said Clinton Harris, founder of Grove Street Advisors LLC, Wellesley, Mass., which runs a $2.9 billion program for the $164.3 billion California Public Employees' Retirement System, Sacramento. That program invests smaller commitments in smaller buyout and venture capital partnerships.

"We'll take some credit for that," he said. "If you wait until a fund has already proven itself, it is too late, and you won't get much money in."

Fund officials who include new private equity managers think they will enhance portfolio returns by identifying the next generation of top-tier managers, said Bradley Atkins, chief executive officer of Franklin Park Advisors LLC, Conshohocken, Pa., a private equity advisory firm.

"They believe their (private equity) portfolio is overallocated and not diversified," Mr. Atkins said. As the private equity firms grew, they invested more money in bigger deals, and fairly soon, many of the firms migrated to the same space, he said. "They are finding their portfolio overallocated to competitive segments."

One reason pension funds are moving into these smaller and emerging private equity funds is that "some of these mandates are disguised as economically targeted, in-state programs," said Thomas Lynch, head of the private equity consulting business at Wilshire Associates Inc., Santa Monica, Calif. State and regional private equity firms are generally smaller than the national and international players.

The $59 billion Ohio Employees' fund, Columbus, is reviewing an Ohio/regional private equity investment program. The $44 billion Washington State Investment Board, Olympia, and the $44 billion Oregon Public Employees Retirement Fund, Salem, have regional private equity investment programs, according to a report by Pacific Corporate Group LLC, Ohio's private equity consultant. Oregon officials have set aside $100 million targeting national and in-state venture capital funds that will invest in Oregon startup companies, according to the report.

"In the venture capital world, you have to be very cautious how you approach it…because it is very risky. There are a lot of emerging groups entering the market," Mr. Lynch said. "But it's the phase in the cycle where you see good emerging names."

In fact, he compares it to the late 1980s when Polaris Venture Partners, Spectrum Equity Investors and Weston Presidio Capital were formed.

"The top-tier firms are going through organizational changes. Some of the second-generation partners are going off and forming new firms," Mr. Lynch said.

But it is a difficult time for private equity firms to make money, he said. "It's a more competitive market this cycle. Venture capital and private equity (buyout) have to be better."

A number of buyout funds were raised in the last four to five years, noted Ben Procter, partner in Watermill Ventures, a Waltham, Mass.-based midmarket buyout firm.

"First-time funds are always hard," Mr. Procter said. "There are some investors interested in first-time funds because there is more inefficiency…. If you go in one and are one of the lead investors in the first-time fund, you have a lot to say about the terms."

One corporate fund that does seek out emerging private equity managers is that of New York Life Insurance Co., New York.

New York Life's $2.4 billion pension fund has been investing in private equity for two years, said John E. Schumacher, president and chief executive officer of New York Life Capital Partners. NYLCAP oversees the pension fund's private equity investments.

Mr. Schumacher declined to give the fund's allocation to private equity, but said it was the typical pension plan allocation, which is about 5%. He said the majority of NYL's new private equity commitments have been with new or emerging managers, but he wouldn't give a dollar amount.

"By investing in new emerging managers we avoided the megafund craze," Mr. Schumacher said.

While the investments are riskier, there are greater opportunities for higher returns, he said. "These funds are smaller. We are not competing against big (pension) funds that have minimum investments to make and can't get it," Mr. Schumacher said.

He noted that the pension fund invested in the first fund of every one of its top tier of 14 private equity managers.