CalSTRS' costs fall despite alts-rich portfolio

CalSTRS has been chipping away at the cost of running its $288.6 billion portfolio, even as its exposure to some of the priciest investments — private markets — and the size of the plan have both climbed.

What's its secret? Officials at the California State Teachers' Retirement System, West Sacramento, say that it's all about its collaborative model, which includes managing more assets in-house, including private markets through co-investments, joint ventures and direct investments in money managers, among other strategies.

The collaborative model has saved CalSTRS an estimated average of $195 million annually over the past four years, according to its latest collaborative model savings report.

Asset owners have been clamoring for co-investments alongside their fund investments for a few years now because they can reduce the overall fees paid, boosting returns. However, not all investors have the capacity to take advantage of co-investment opportunities or gain access to them, industry insiders said.

Among the challenges: having staff with the expertise to evaluate deals as well as streamlined processes, speeding up the time it takes to make a decision on an investment.

With returns of alternative investments, which many investors see as their top performing asset classes, also getting hit by current market conditions and rising interest rates this year, reducing costs is becoming even more essential for asset owners, industry executives said.

At CalSTRS, officials found that costs declined in 2021 despite an increase in the fund's net asset value and an increase in private markets exposure over the past five years.

Its investment costs also were lower than those of its peers. In 2021, CalSTRS' investment costs for its entire plan, excluding transaction costs and carried interest, amounted to 39.8 basis points, lower than the average of 48.8 basis points per dollar for its peer group of 40 U.S. public funds and 14 global peer funds and less than the U.S. public pension plan average cost of 59.3 basis points, a CEM Benchmarking Inc. analysis shows.

And pension plan officials expect to lower investments costs even more, whittling them down to 35 basis points in the next few years, said Scott Chan, deputy chief investment officer, at the investment committee's Nov. 3 meeting.

CalSTRS total portfolio costs include management fees and internal operating costs, and are generally correlated to the pension plan's net asset value, said Shifat Hasan, CalSTRS' head of investment performance and compliance, at the same investment committee meeting.

Even so, CalSTRS' total portfolio costs decreased relative to its net asset value by 4 basis points, the first time those costs dropped in more than five years, she said, crediting its collaborative model.

The plan's total portfolio costs declined even though CalSTRS' total plan assets grew by 29% in 2021, said Mike Dunigan, associate portfolio manager at the same meeting. "That is from the collaborative model," he said

As CalSTRS has increased its allocations to include more private market assets, pension fund officials have at the same time boosted its co-investments, which lowered fees, Mr. Dunigan said.

In 2021, the collaborative model reduced portfolio costs by 9% with most of the savings from an increase in co-investments in alternative investments.

CalSTRS had 188 co-investments last year amounting to a total of $11.9 billion, up from 135 co-investments totaling $6.8 billion in 2020.

CalSTRS had $68 billion in externally managed private assets in 2021, which cost the plan 163 basis points per dollar, compared with $40.7 billion in internally managed private assets including co-investments and joint ventures that cost 112 basis points per dollar.

Even so, private assets are much more expensive than public investments with CalSTRS' $44.6 billion in externally managed public assets costing 48 basis points per dollar vs. $184.9 billion in internally managed public assets at a cost of 3 basis points per dollar, the report said.

CalSTRS is not alone in its interest in co-investments, with the view that they will lower fees, among other reasons, consultants said.

In private equity, for instance, co-investments are generally done on a no management fee, no performance fee basis, whereas investments in a primary fund usually have fees that start at 2% management fees and 20% carried interest, said Andrew Brown, London-based head of private equity research at Willis Towers Watson PLC.

Investors use co-investments to blend down the fund's fees, he said. Co-investments also allow investors to get more exposure to a certain sector than the fund allows by selecting deals in the desired area as well as to participate in a deal in the manager's "sweet spot" in terms of sector and transaction size, Mr. Brown said.

At least in theory, investors paying lower fees should reap higher returns, he said. But there is a risk that the manager is not offering its best deals as co-investment opportunities, Mr. Brown said.

"Our take is that you need to have a high bar to co-invest because, at the end of the day, common sense would suggest that managers would not be giving away (their) best deals on a no fee basis," he said. Usually, managers offer co-investments in transactions that are larger than its typical deal and to take some risk off the table, Mr. Brown said.

Willis Towers Watson also co-invests but holds potential deals to a higher bar when deciding whether to make the investment, because the "single stock risk is quite high," he said.

At CalSTRS, its collaborative investment model is not based solely on co-investments.

As "net return investors" CalSTRS officials will use whatever investment structure would bring the most value, CalSTRS' Deputy CIO Mr. Chan said at the meeting. That includes joint ventures, ownership interests in firms, co-investments and separately managed accounts, he said.

CalSTRS is interested in maximizing value, Mr. Chan said. For example, when CalSTRS makes an equity investment in a private markets money manager, it shares in the revenues of that manager, he said. CalSTRS can maximize its investment by committing to the manager's fund and making co-investments alongside that fund, he added.

In April, for instance, CalSTRS committed $200 million to Principal Real Estate Investors to form or acquire a new real estate operating company.

CalSTRS' focus on cutting fees and its collaborative model has helped the pension plan in its goal to become a partner of choice, Mr. Chan said in a response to a committee member question.

When a money manager presents an co-investment opportunity to CalSTRS, for example, pension executives can react in a more streamlined and nimble manner, because of operational changes CalSTRS has made including hiring more experts for its private markets teams, Mr. Chan said.

"We've become a lot more responsive" to managers and there are only a handful of other asset owners that can respond as quickly, he said.

However, Mr. Chan said in response to another question, he doesn't think CalSTRS' push for lower fees will help drive down costs in the private markets industries.

"I'm not sure what the industry will do but I am clear what CalSTRS would do," he said.

CalSTRS will continue to negotiate to lower costs, Mr. Chan said.

"Will that bring down fees in the industry? Color me a little bit skeptical. I'm not sure that it will," Mr. Chan said.