In the fall of 2006, the California State Teachers’ Retirement System (CalSTRS) raised its long-term private equity target to an aggressive 9%, up from 6 percent. The pension fund figured that it would take up to five years to get there.
Two years would have been a better guess. According to data distributed at its April 3 board meeting, CalSTRS’s private equity holdings accounted for 9.5% of its roughly $165 million in assets as of the end of February. CalSTRS defines private equity to include buyout, venture capital, mezzanine, distressed debt and equity expansion.
Within private equity, CalSTRS has allocated about 77% of its money to buyouts, 9% to venture, 6% to equity expansion, 7% to distressed debt, and 1.1% to mezzanine. Its 9% target falls within a range that allows the pension to invest up to 11%, or as little as 5%, in private equity. Practically speaking, however, it can go even higher or lower should it want.
Market volatility since last June in part accounts for why CalSTRS hit, then surpassed, its target so quickly. The pension fund’s stock portfolio has shed $5 billion in value since late December, falling from $67 billion to $62 billion. At the same time, CalSTRS’s private equity investments have risen in value from $15.1 billion to $15.7 billion. The double-whammy had a magnifying effect that boosted the pension fund’s allocation from 8.7% to 9.5 percent.
What happens next is the question that CalSTRS’s 13-person investing staff, along with its investment advisers and independent fiduciaries, are trying to figure out. That the public market has affected the overall asset size is “complicating the decision on how to react to target deviations,” says Mike Moy, a managing director at Portland, Oregon-based Pension Consulting Alliance, CalSTRS’ general consultant.
In all likelihood, CalSTRS will reach the high end of its private equity target allocation range—11%—sometime this year, even if it stops making new commitments. Of course, another big drop in the public equity markets would make that happen even faster. Moreover, as of September 2007, CalSTRS had $13.3 billion in unfunded commitments that general partners will eventually draw down, while distributions to CalSTRS have surely declined thanks to the slow IPO and M&A markets.
CalSTRS Spokeswoman Sherry Reser says the pension fund is “never going to turn down a good opportunity to invest.” At the same time, she acknowledges that, for the time being, the die has been cast. “We want to be nimble, but we still aren’t a private equity firm that can turn on a dime. Being policy-driven, we’re a little like a cruise ship. Once it starts in a direction, you can make a course correction but you’re pretty much heading in one direction for a while.”
CalSTRS’s course has been an aggressive one when compared with many of its public pension fund peers, which allocated an average of just 4.5% to alternative investments in 2006, according to the National Association of State Retirement Administrators.
But CalSTRS has good reason to be aggressive. It is facing a $19.6 billion unfunded actuarial liability, one that could hamper its ability to deliver retirement benefits that the roughly 800,000 current and former California teachers expect to receive.
A big bet on private equity—and an especially concentrated one—has paid off for CalSTRS so far. As of Sept. 30, 2007, its Alternative Investment Program had generated one-year returns of 35.5% and three-year returns of 31.2%, outperforming the State Street Private Equity Fund Index over the same periods by 4.6 percentage points and 4.8 percentage points, respectively. CalSTRS’ 10-year return as of last September was 18.8 percent.
Much of that performance can be attributed to five firms that represented 39% of the pension fund’s total exposure to buyouts and 26% of alternative investments overall, as of Sept. 30, 2007. They are five mega-firms: Blackstone Group (to which the pension fund has committed $2.6 billion across six funds), CVC Capital Partners ($1.6 billion across six funds), TPG Capital ($2 billion across five funds), Permira ($1.7 billion across three funds), and Providence Equity Partners ($1 billion across two funds). Those funds have returned 21.6%, 25.1%, 27.6%, 29.3%, and 4.6%, respectively to CalSTRS since it invested in each of them.
Of course, CalSTRS has other irons in the fire. The pension fund has been paying increasing attention to foreign markets, for example. As of Sept. 30, 22% of its alternative investments were international, and considering that CalSTRS’ international funds had generated twice the net IRR as its domestic funds, that percentage is likely to grow.
It has been paying less attention—a lot less—to venture capital, around which CalSTRS first developed its alternative investments program in 1988. As of Sept. 30, its exposure was 7.6%, down from 10.5% one year earlier, and markedly below its 10% target for the class. The drop has been continuous, and precipitous. In March 2005, its exposure was 13.4 percent.
Among the venture funds to raise money from CalSTRS last year were two of the largest VC funds raised in 2007: JMI Equity’s JMI Equity Fund VI and Institutional Venture Partners’s IVP XII. JMI’s target was $500 million, but it ended up raising $600 million. Similarly IVP raised more than the $400 million it had originally planned to target, closing its latest fund with $650 million.
A complete list of CalSTRS’ 2007 commitments to venture funds was unavailable as of VCJ’s press time.
Since the program’s inception, venture capital has returned a net IRR to CalSTRS of 22.5%, second only to CalSTRS’ investments in European buyout funds, which have returned a net IRR of 26 percent.
So why has its exposure to VC declined? “The difficulty of gaining access, and making material commitments, to the top-performing venture capital firms has contributed to the decline in venture capital exposure, as CalSTRS has selectively committed capital to the segment,” Moy wrote in a presentation to the pension fund. “Access to top-tier venture capital firms has become particularly difficult for public institutions due to potential Freedom of Information Act requests.”
Like its peers, CalSTRS has grown much more interested in emerging markets. “In the public pension plan space, a lot of dialogue is dedicated to other regions of the world where there may be opportunities,” says Moy. “I think [all the public pensions] are more attuned to emerging markets.”
Two of CalSTRS’ commitments to emerging market funds were made through Navis Capital Partners, which invests across Asia. The pension fund has also backed Newbridge Partners, a French buyout firm with Chinese interests, committing $150 million to its Newbridge Asia IV fund.
We want to be nimble, but we still aren’t a private equity firm that can turn on a dime. Being policy-driven, we’re a little like a cruise ship.
And CalSTRS has been helping to fuel its reputation as a forward-thinking, socially conscious limited partner by focusing more on emerging manager teams, particularly those led by or that include minorities. In February, it gave New York adviser Invesco Private Capital $200 million to back venture capital and other private equity funds that reflect the demographic diversity of California itself, including ones that are led by or include women, African-Americans and Latinos.
The commitment comes on the heels of the $100 million CalSTRS committed to Invesco in 2005 to pursue a similar strategy. Invesco spread that capital across 15 general partners, including New Leaf Venture Partners, a health care focused venture fund based in New York, Syncom Management Co., a tech investor based in Silver Spring, Md., and Craton Equity Partners, a clean tech investor based in Westwood, Calif.
Invesco is taking a hard look at “people who are qualified with underperforming or turnaround investments,” says Philip Shaw, an Invesco managing director. Shaw concedes that there’s “more competition than ever in the distressed space.” But, he adds, because “default rates are still pretty low, I don’t think it’s too late.”
Invesco is also keenly interested in growth capital, says Shaw, calling it “an attractive place to be, since bank lending will be hard.”
California State Teachers’ Retirement System
Location: Sacramento, Calif.
Alternative Investments Program founded: 1988
Total assets: $164.6B
PE assets: $15.7B
PE allocations: Buyouts: 77%; VC: 9%; Equity Expansion: 6%; Distressed Debt: 7%; Mezzanine: 1.1%
Did you know? CalSTRS is the largest teachers’ retirement fund in the United States and the nation’s second largest public pension fund.
CalSTRS’ alternative investment performance
Net IRRs as of Sept. 30, 2007
Investment Vehicle 1 year 3 year 5 year 10 year Since inception
34.0% 30.6% 25.4% 18.8% 20.0%
Co-investments 39.4% 33.3% 30.2% 15.9% 15.3%