Alternative Investments Program Founded: 1988
Focus: Buyouts, venture capital, mezzanine, distressed debt, and equity expansion funds
Located: Sacramento, Calif.
Private Equity Assets Under Management: $15.7 billion
In the fall of 2006, the California State Teachers’ Retirement System raised its long-term private equity target to an aggressive 9 percent, 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 percent 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 percent of its money to buyouts, 9 percent to venture, 6 percent to equity expansion, 7 percent to distressed debt, and 1.1 percent to mezzanine. Its 9 percent target falls within a range that allows the pension to invest up to 11 percent in private equity, or as little as 5 percent. 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 CalSTRS’s allocation from 8.7 percent 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,” said Mike Moy, a managing director at Portland, Oregon-based Pension Consulting Alliance, the pension fund’s general consultant.
In all likelihood, CalSTRS will reach the high end of its private equity target allocation range—11 percent—sometime this year, even if the pension 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.
Spokeswoman Sherry Reser said that CalSTRS 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 percent 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 state teachers expect to receive.
A big bet on private equity—and an especially concentrated one—has so far paid off for CalSTRS. As of September 30, 2007, the pension fund’s Alternative Investment Program had generate one-year returns of 35.5 percent and three-year returns of 31.2 percent, outperforming the State Street Private Equity Fund index over the same periods by 4.6 percentage points, and 4.8 percentage points respectively. Its 10-year return as of last September was 18.8 percent.
Much of that performance can be attributed to five firms that represented 39 percent of the pension fund’s total exposure to buyouts as of September 30, 2007 and 26 percent of alternative investments overall. 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). CalSTRS has seen returns, since the inception of these relationships, of 21.6 percent, 25.1 percent , 27.6 percent, 29.3 percent, and 4.6 percent, respectively.
CalSTRS’s direct buyout investments have also performed well. As of September 30, 2007, the pension fund’s one-year return on its coinvestments was 39.4 percent. (It made two subsequent co-investments between September and December of last year. One was a $125 million investment in Texas Energy Future, a Dallas-based energy company purchased by TPG Capital, Goldman Sachs, and Kohlberg Kravis Roberts & Co.) Its 10-year return on coinvestments is 15.9 percent.
The pension fund’s fortunes have been so closely tied to buyout mega-funds that it moved quickly to publicly denounce a legislative proposal unveiled in February that might hamstring its ability to invest in them. The bill—which would bar state-run pension funds from backing buyout funds owned partially or wholly by sovereign wealth funds affiliated with countries that haven’t signed certain human rights treaties—could cost CalSTRS between $1.5 billion and $5.3 billion in lost investment revenue over five years, said the pension’s investment committee last month. Apollo Management and The Carlyle Group are just two firms that would by subject to the legislation. Last year, Apollo group sold a 9 percent ownership stake in its management company to the Abu Dhabi Investment Authority, while Carlyle Group sold 7.5 percent of itself to Abu Dhabi-based Mubadala Development Corp.
Whether CalSTRS’s exposure to mega-funds becomes anything other than a good thing remains to be seen. Many believe that fear over mega-funds is overblown, despite the credit-crunch-induced freeze affecting many deals. Still, there’s no denying that the U.S. market is stalled, and stalling big transactions. “To the extent that credit problems will impact buyouts, they will impact CalSTRS,” said Moy.
Of course, CalSTRS has other irons in the fire. The pension fund has been paying increasing attention to foreign markets, for example. As of September 30 of last year, 22 percent 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.
Like its peers, CalSTRS has also grown 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,” said Moy. “I think [all the public pensions] are more attuned to emerging markets.” Two of CalSTRS’s commitments to emerging market funds were made through Navis Capital Partners, which invests across Asia (CalSTRS committed $130 million to the two funds). The pension fund has also backed Newbridge Partners, a French buyout firm with Chinese interests. Its Newbridge Asia IV fund received a $150 million commitment from CalSTRS.
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 buyout, 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 the buyout funds Acon-Bastion Partners II LP and Palladium Equity Partners III.
Invesco is taking a hard look at “people who are qualified with underperforming or turnaround investments,” said Philip Shaw, an Invesco managing director. Shaw concedes that there’s “more competition than ever in the distressed space.” But, he added, because “default rates are still pretty low, I don’t think it’s too late.” Invesco is also keenly interested in growth capital, said Shaw, calling it “an attractive place to be, since bank lending will be hard.”
CalSTRS Alternative Investment Performance
As of September 30, 2007
Net IRR (%)
Investment Vehicle 1 year 3 year 5 year 10 year Since Inception
LP/fund investments 34.0% 30.6% 25.4% 18.8% 20.0%
Co-investments 39.4% 33.3% 30.2% 15.9% 15.3%