Most limited partners say they target new and emerging funds, but few actually have a plan in place to find these new managers. The California State Teachers’ Retirement System, has put together such a plan, tapping fund-of-funds firm INVESCO Private Capital to coordinate the initiative.
For the larger pension plans, investing in these next generation funds can be even more difficult when one considers that a typical commitment rarely equates to any more than just a drop in the bucket. Christopher Ailman, the chief investment officer at CalSTRS, said, “Some of these first-time funds might be less than $100 million in size, and it can be tough for us to manage a $10 million investment by ourselves.” This new initiative by the pension, will allow CalSTRS to do just that.
CalSTRS will start with an initial $100 million, and INVESCO will invest the money in new and next generation sponsors, defined by the pension plan as either Roman Numeral I or II funds, launched by leading entrepreneurs or existing private equity pros branching out into new partnerships.
“We wanted to take a look at some of the new funds being created,” Ailman told Buyouts. “We looked at the history of success, or even lack thereof, of first-time funds, and we realized we wanted to find the next Blackstones, Whitneys or TPGs that pop up.”
While INVESCO will have the say as to which funds receive commitments, there are some parameters CalSTRS has set. The first major guideline stipulates that at least 50% of the investments reflect the demographic diversity of California. “We have found that the face of private equity in America tends to be very pale and very male… Let’s face it, we’re in a diverse and global economy. Diversity breeds strength and we want to capitalize on that,” said Ailman.
The second constraint dictates that at least 50% of the investments come from firms that are based in California. “Nothing against Virginia or any other state, but I don’t want to find out that the Virginia State Pension Plan backed a VC firm based in San Diego and we missed out on it,” Ailman said. “This is important to make sure we have our finger on the pulse of that, and given the size of [the California economy] there are a lot of opportunities to focus on here.”
These two parameters, however, can overlap, which will allow INVESCO plenty of leeway to go beyond those boundaries for investments.
In selecting INVESCO to spearhead this initiative, CalSTRS cited the firm’s past experience in finding emerging managers. Katherine Cattanach, a general partner at INVESCO, confirmed, “We’ve been evaluating and investing in new and emerging managers since 1980. Slightly over 25% of our investments over that time have been in funds that would qualify as next generation funds.”
She adds that this new program, after less than a month in operation, has already developed a backlog of about 60 partnerships that want to be considered for an investment.
The investments will go toward both buyouts and venture capital, although neither CalSTRS nor INVESCO are placing any constraints as to how much goes where. Ailman did say CalSTRS’ existing private equity portfolio, which is roughly $6 billion in size and represents about 5% of the pension’s assets, is split up with 70% of the capital dedicated to buyouts, 25% venture and 5% in distressed debt. But he noted, “INVESCO will look at anything that comes around.”
CalSTRS is starting this program with a $100 million cap, but if it proves to be a success, the pension will put more capital into it. There are a number of benefits in backing next generation fund managers. For one, it gives limited partners an inside track into funds once they blow up. There were quite a few LPs that were left on the outside looking in when firm’s such as Providence Equity Partners and Hellman & Friedman raised funds last year. Targeting new sponsors, if the right firms are being targeted, can ensure this doesn’t happen.
Additionally, some cite there is evidence that new funds can provide more upside than existing managers when things do go right; not to mention that fund terms aren’t always as pricey. Ailman described, “We worked with McKinsey [& Co.] the summer before last and found that the return distribution for first time funds is wider than it is for established funds. The average return is very similar to that of established funds, but there’s a different risk pattern, and if you can latch on to some new funds there can be some very good returns as funds grow and develop.”