General partners and limited partners spent 2004 in a dangerous game of fund-raising chicken, and at least one pension system finally realized that it has been driving a much smaller car.
The Ohio Public Employees Retirement System (OPERS) said in a Nov. 3 memo that it reduced its target allocation to venture capital investments, due to industry contraction and a corresponding oversupply of limited partner capital. The decision was made after consultation with advisor Pacific Corporate Group.
OPERS made its first venture capital fund investment in 1987, when it committed $10 million to a $74.5 million vehicle from Cleveland-based Primus Venture Capital. Over the next 13 years, OPERS invested in venture capital funds just seven more times, plus four buyout funds and three special situations funds. All of the vehicles-now known as the “legacy portfolio”-were based in Ohio and had produced a combined average IRR of 1.39% through the end of 2003, according to an annual report.
In 2002, however, OPERS decided to get serious about alternative investing. It allocated 4% of its $48 billion holdings to global private equity, of which one-fourth was dedicated to venture capital. The system immediately got to work, committing $175 million to a $6.45 billion buyout fund from New York-based Blackstone Group and $75 million to a $2.3 billion secondaries fund from London-based Coller Capital.
Tough Nut To Crack
Finding suitable venture capital funds, on the other hand, was more difficult. The Blackstone and Coller Capital funds were enormous, cash-hungry beasts, but venture capitalists simply weren’t in a mega-fund mood anymore. The bursting of the Internet bubble and subsequent fund size reductions had convinced almost everyone that the next round of fund-raising would be scaled back and extremely selective. New LPs would have a difficult time gaining entry-unless participating via a fund-of-funds-and new “public LPs” would be treated like lepers, due to potential transparency requirements.
Even though the overall size of OPERS grew to more than $59 billion by the end of 2003, it was still unable to crack the VC market. It had invested in another six buyout firms-committing a total of $425 million-but was without any VC firms in its non-legacy portfolio.
“We just didn’t have strong enough relationships with the so-called top-tier firms, which would have been where we wanted to invest,” explains Greg Uebele, OPERS’ assistant investment officer for private equity.
OPERS ultimately was able to make a troika of VC fund investments in 2004, but the target allocation clearly had become unrealistic. In order to hit its 25% target, OPERS would have needed to commit $1 billion to venture capital by 2009. Uebele and others simply didn’t see any responsible way to make that happen. Instead, they revised the VC target allocation to 15% of the overall private equity pot, which should work out to between $125 million and $200 million worth of VC commitments in 2005. The 4% private equity target will remain intact, with total net return expectations of 10.5 percent.
To fill the gap, Uebele expects a slight increase in leveraged buyout fund commitments, including some in the exploding mega-fund category (defined as $1 billion or more). OPERS has set a 15% net return target for mega-funds, although 10-year benchmarks for U.S. funds currently stand at 7.3%, according to Thomson Venture Economics (publisher of VCJ). Among the mega-funds that OPERS has already made commitments to are the aforementioned Blackstone and Coller Capital vehicles, plus newer ones from First Reserve Corp., Texas Pacific Group, Charterhouse Capital Partners and Permira.
Start of a Trend?
It is hard to argue against OPERS’ plan, given recent reductions in VC fund sizes and a corresponding expansion among buyout funds. The system possibly should lower its return expectations-particularly as mega-LBO firms keep artificially driving up purchase price multiples-but global diversification and stringent selectivity could help it beat industry benchmarks.
There is a problem, however, and it’s fairly serious for those concerned about LP overhang. In order for OPERS to meet its revised target allocations, it still must significantly increase its private equity exposure. OPERS had made just $1.77 billion in total private equity commitments through year-end 2003, including its legacy portfolio. That represented less than 3% of its $59 billion total, which means you can expect it to increase its investments going forward. This also goes for venture capital, as OPERS still isn’t close to its target, whether or not some of the expired legacy commitments are included.
And OPERS isn’t alone. About 43% of institutional investors plan to increase their private equity exposure in 2005, according to a recent study by Coller Capital. Some 9% expect to reduce current exposure levels, while everyone else will keep the status quo (i.e., too much LP money chasing too few GP opportunities). Respondents said that they were more interested in the buyout market than in the VC market, but there should be plenty of new money to be invested in middle-tier or lower-tier VC firms, once the top groups are filled.
The result is a continuing increase in LP overhang, albeit a slowed one. OPERS has taken a positive step by at least recognizing the problem, but an actual salve will not be applied until the results of the Coller Capital study are flipped, and a majority of LPs plan private equity exposure reductions.
In the meantime, returns hang in the balance.