Trying to remain an active venture capital investor, the Los Angeles County Employees Retirement Association (LACERA) recently made a domestic fund-of-funds investment and last year revamped its private equity portfolio to include overseas partnerships. Part of the shift in LACERA’s program is the result of an ongoing problem pension investors have while trying to forge new relationships with top-tier venture firms, says David Locke, LACERA’s investment officer for alternative investments.
The large amount of capital flowing into the industry has left the $25.9 billion pension shut out from a number of high-profile venture vehicles, and many existing partnerships have set limits on the amount of capital that L.P.s can invest, Mr. Locke says, declining to provide specific details.
“The demand for top-tier groups is elastic and has increased significantly over the last few years,” he says. “But the supply for experienced groups is inelastic because experience takes time.”
In response to this trend, LACERA’s four-member investment team recently decided to back a fund-of-funds for the first time. The pension in March made a recommendation to the LACERA Board of Investments to approve $20 million for INVESCO Private Capital Inc., a venture capital funds-of-funds manager. The decision to back INVESCO was made for strategic reasons because of its relationship with specific general partners, Mr. Locke explains. If all goes well, the pension will consider backing other as yet unidentified funds-of funds, says Chris Wagner, the pension’s senior investment analyst.
Revamping Private Equity
An overhaul of LACERA’s private equity investments began last year when Mr. Locke recommended that 10% of the alternatives allocation be carved out for international funds. Prior to formalizing overseas investments, LACERA in 1998 backed one international vehicle, CVC European Equity Partners L.P., with $25 million.
LACERA this past year has already invested 7% of its international allocation in information technology, retail, bio-medical and manufacturing funds in Western Europe. The pension backed two funds-of-funds – investing $25 million in HarbourVest International Private Equity Partners III L.P. and $50 million in Brinson International Partners Fund – and also put $50 million in CVC European Equity Partners II L.P. and $30 million in Apex Europe IV. Unlike the reasons behind LACERA’s decision to back domestic funds-of-funds, the pension invests in international funds-of-funds because of the inherent difficulties in conducting due diligence from a distance and the lack of knowledge about foreign markets, Mr. Locke says. The plan is to build its international investments slowly, adding two or three new partnerships a year, he adds.
LACERA devotes 6%, or $1.5 billion, of its total pension to private equity investments, of which 3% already is committed. The pension has been trying to work its way to 6%, but its distributions return at a faster rate than new investments can be made, Mr. Locke adds. Some $360 million is available to invest in 10 to 14 partnerships each year. At press time, LACERA had invested 45%, or $162 million, of its 1999 available capital pool in domestic and international private equity partnerships.
In the Beginning
The pension began opportunistic private equity investments in 1986 with venture capital, buyouts and special situations, Mr. Locke says. LACERA’s board formally established a 5% private equity target in 1990 and increased it to 6% in 1995. Its first discretionary adviser, Chancellor Capital Management, was hired in 1990 and made direct investments on behalf of the pension. LACERA discontinued direct investments when it switched to Hamilton Lane Advisors in 1997.
Under Chancellor, LACERA diversified its portfolio by making smaller commitments to a wider range of venture capital funds that varied by geography, stage and industry. Hamilton Lane has continued that tradition but has crafted a more “sophisticated” strategy by emphasizing a balance between venture capital and buyouts, as well as seed- to late-stage deals, Mr. Locke says. The pension’s investment board has not approved investments in oil and gas exploration or production, timber, farming, commodities or hostile takeovers.
Strict Rules for First-Timers
LACERA also readjusted its private equity investment strategy to emphasize later-stage venture capital investments, to impose strict criteria for first-time funds and to consolidate its roster of buyout partnerships. Additional fine-tuning of its investment strategy includes placing more attention on distressed and turnaround investments rather than buyout mega- funds, Mr. Locke says. LACERA is concerned with the higher risk and more intense due diligence connected with first-time funds, but the pension is willing to invest in partnerships that have solid track records in their area of expertise. The pension, for example, invested $10 million in Prospect Venture Partners L.P in 1997 because managing partners Alex Barkus and David Schnell had more than a decade of combined experience as former partners at Kleiner Perkins Caufield & Byers, Mr. Locke says.
LACERA’s first foray into venture capital began in 1986 with a $50 million investment in Warburg, Pincus Capital Co. L.P. The pension’s staff made seven opportunistic investments, committing as much as $150 million in the buyout fund GKH Investments L.P. in 1988, until the board hired Chancellor two years later. Chancellor expanded the pension’s portfolio by adding a number of venture capital partnerships, including an $11.3 million investment in Oak Investment Partners V and $25 million in Summit Ventures III.
Following several key staff changes at Chancellor, LACERA’s board searched for a new adviser and chose Hamilton Lane, which also serves as a non-discretionary adviser for the pension’s international investments.
Overall, Mr. Locke says LACERA is satisfied with its private equity returns. The fund, which previously used the Nasdaq Index as a benchmark to gauge performance, changed to the Russell 3000 Index in the mid-1990s because it more accurately reflected the pension’s private equity portfolio. The LACERA board in 1997 officially set the pension’s private equity IRR target at 500 points above the Russell 3000 for a 10-year period. The pension currently is 200 points above the Russell Index, and its current IRR since inception is 17.5%, while the Russell 3000 is 15.7% on a dollar-weighted basis using LACERA’s cash flows. Mr. Locke says the pension’s total $1.9 billion in commitments to date – some $1.2 billion of which was committed in the last two years – could explain the depressed effect on the fund’s potential IRR. LACERA has a total of $1.1 billion of its investments drawn down and has received $1 billion in distributions from its partnerships, Mr. Locke adds.
LACERA’s investment staff consists of Messrs. Locke and Wagner, Chief Investment Officer Kenneth Shaffer and Investment Analyst Shelly Tilaye.