California State Teachers’ Retirement System raises its long-term PE target to an aggressive 9%
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 state pension fund figured that it would take up to five years to get there.
Two years would have been a better guess. CalSTRS’ private equity holdings accounted for 9.5% of its roughly $165 million in assets as of the end of February, according to data distributed at its board meeting this month. 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.
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 boosted the pension fund’s allocation from 8.7% to 9.5 percent.
What happens next is the question that CalSTRS’ 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 have allocated an average of 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: The 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.
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.
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.”