FEATURE: Public Pensions Fight Through LBO Market –

In the past, public pension funds griped about a lack of investment opportunities in the exploding field of buyout funds. But in today’s market, where mega-funds are a dime a dozen, investment opportunities abound.

Public pensions as large as the California Public Employees’ Retirement System (CalPERS), which manages approximately $155.91 billion, and as small as the Milwaukee County Employees’ Retirement System, which manages approximately $1.64 billion, have managed to get their foot in the door with buyout firms such as Welsh, Carson, Anderson & Stowe, Apollo Advisors, Code, Hennessy & Simmons, and Vestar Capital Partners, according to the Directory of Limited Partners 2000, a sister product of BUYOUTS.

Yet, while many public pensions have managed to plunge into leveraged buyout funds, others are still being left in the dust. And as insiders see it, those who have not yet managed an entrance may need to look elsewhere for alternative asset allocations.

The Silver Lining

Back in 1996, BUYOUTS reported the woes of the public pension investor, who then faced the catch-22 of having too much money for small funds and too few relationships with big funds. Large public pensions, which often need to invest several hundred million dollars in order to meet allocation requirements and that were not already invested in a buyout fund were forced to invest in funds-of-funds for access to smaller funds. Pensions were faced with the prospect of either paying higher fees for a diverse portfolio or having a portfolio heavily weighted toward large funds (Sept. 30, 1996, p. 1). The concern was that small funds were the big funds of the future, according to Boston placement agent Richard Troy of Troy Investment Associates. Without access to those funds, the large funds would also be out of reach.

The situation today remains less than ideal for public pensions, but the horizon is a bit brighter. According to placement agents, general partners and public pensions alike, those pensions that wanted to invest four years ago should be in the game by now. But those that hemmed and hawed may have missed the boat entirely.

While large pension funds still need to unload large blocks of capital that may not be compatible with small funds, the good news is that there are more opportunities to invest in a buyout fund straight away. The rise of the mega-fund has allowed buyout firms to open the limited partner pool to new investors. One GP at a Chicago-based buyout firm says that when his firm launched its new fund with a target increase of $1.1 billion from its previous fund, “we had to go out and bring in some new folks.”

With mega-fund launches in the first quarter of this year like Thomas H. Lee Equity Fund V LP, with a $5 billion target, and Apollo Investment Fund V, with a target of $4.5 billion, buyout funds will need the large investments of public pensions, says a managing director at a Connecticut-based placement agent. According to BUYOUTS, nine funds with targets over the $1 billion mark were launched last year and in the first quarter of 2000, and over 20 closed. “Another $2 billion isn’t coming from high net worth individuals or endowments,” the source says. “They are coming from your large public pension plans . . . the way [these mega-funds will] get to the critical mass they want to get at is by getting larger bite size from larger investors. And to me, those are your state pension plans and a handful of corporate plans as well.”

So, while public pensions may have had fewer opportunities in top tier funds up to now, that will likely not be the case by the end of this year, he said.

“We’ve seen a number of funds with very strong track records and good organizations that are increasing their fund size,” says Scott Henderson, executive director of Massachusetts’ Pension Reserves Investment Management Board (PRIM). “That opens up opportunities for us because fund managers are looking to take money from new investors. So we’ve been able to find some very good quality opportunities in the last couple years.”

All Others Need Not Apply

“For any investors who are trying to come into private equity today or have been trying to get in for the last several years, there’s no doubt that access, particularly to the funds with some of the longest histories and best track records, is pretty limited,” says David Donnini, a principal at GTCR, Golder Rauner LLC. “It’s not just the public guys. It’s anyone who’s new to the game.”

Successful public pension funds in the New Economy version of alternative assets investing are made up of three things: established relationships, consistent investments, and efficient management strategies.

“If you are a new public pension fund trying to invest in alternative investments for the first time, you shouldn’t do it. The likelihood that you can begin a program and get access to top quality performers is remote,” says PRIM’s Henderson. “But if you’ve got a program that’s been up and running for a while, you want to make sure you proceed as a loyal, reliable source of capital so that people can count on you from fund to fund to fund.”

Building Blocks

As all limited partners know, investing is about relationships. Private equity funds of all types look to existing LPs first during pre-marketing of the fund and then tap newcomers for the balance of the fund.

“When a company like us goes out and raises our next fund we’ll tap our existing partners and if we can raise the amount of money we are looking for in that fund from our existing partners, there’s really no reason to go outside of that group,” says the director of a New York-based buyout firm that receives approximately one-third of its funding from public pensions. “Our existing partners have first priority in terms of getting an allocation of the fund, and that may mean it’s very difficult to bring in new partners. I think this probably is similar to what has happened at many of the other firms.” In the firm’s current fund, approximately 85% of the fund was subscribed by existing limited partners.

Many public pensions have found the best way to optimize their investment reach was to hire a placement agent. “I think working with gatekeepers is probably as good a strategy as any,” Donnini says. “Some of those gatekeepers have long-term preferred positions with good firms and . . . they can sometimes work new clients into those opportunities.

However, some fund managers cited a danger of public pensions working with a consultant, which is that pension funds can sometimes rely too heavily on the agent. One placement agent advised that public pensions keep on top of the markets they are interested in and be very specific about what they are seeking.

The LP Sidestep

Another way public pensions build relationships with firms, while maximizing their investment opportunities is by sidestepping buyout funds to invest in more focused funds, such as a mezzanine fund or a fund with a regional focus, thereby gaining access to the firm’s other funds, sources say.

At GTCR, the mezzanine fund was the only opportunity for new LPs to enter into recent fund raising. “We actually haven’t really had much opportunity to add LPs for our equity funds, although when we put the mezzanine fund together we did talk to some new LPs and try to expand the base a little bit to folks who had a strong interest in mezzanine. And as part of that we did bring in some pretty significant state pension funds – Washington and Kansas come to mind. I’m sure there were at least one or two more,” says Donnini.

But by far, those funds that are in the best position to invest are those that have been working the private equity world for many years. “Accessing real top-tier buyout funds . . . hasn’t been an issue for us,” says Henderson. “I guess that’s because we’ve been investing in the asset class for 15 years . . . We’ve been a long time investor with Tom Lee, for example, so when he raises a new fund, since we’ve been loyal to him in the past, it’s real easy for us to get the allocations that we want.” PRIM also has investments with Blackstone Capital Partners, Boston Ventures Management Inc., Kohlberg Kravis Roberts and Forstmann Little & Co., according to the Directory of Limited Partners 2000.

A Firm’s Best Friend

Fund managers agree that the most important criteria for a new public pension investor, or any LP for that matter, are consistent investments and loyalty. The unfortunate part of this equation is that it excludes many of the smaller public pension funds that are unable to offer large investments to numerous funds.

“[GTCR’s] ideal LP has a long-term perspective, will play consistently across multiple funds, will participate with all the funds we’re working with – mezzanine as well as equity – and at a reasonable size,” says Donnini.

Therefore, without a sufficient size fund, diversified investments of meaningful size are simply not possible. And the possibility for investment in top-tier funds is limited. Additionally, a good LP recognizes that private equity is a long-term asset class, says Donnini.

Keeping It Together

The good news is that general partners, overall, have found public pensions to be a welcome addition to their investment pool. Some of GTCR’s biggest limited partners are public pension funds and Donnini says that they are also “some of our best limiteds.” In actuality, the aforementioned obstacles are the same ones that face any new investor in private equity. However, by several sources’ accounts the inefficiency in pension fund management also prevents investments in buyout funds. While a weak staff and bureaucracy weren’t necessarily considered a reason to exclude a public pension from a fund, a strong staff and expediency are certainly preferred, sources say.

“My sense is that [public pension funds] have been more difficult to bring into a fund because of the requirements – very long forms and things of that sort. And so to a degree they are less attractive,” says a director at a New York firm.

“Our best public pension LPs are the ones that have high quality staffs and really empower those staffs to make decisions and speak with a fair amount of authority for their institutions, and thus end up being a little bit more like some of the less institutional LPs,” Donnini says. A long-established staff provides the relationships, speed and decision-making power that make the investment process successful.

When there is one investor that requires long, detailed forms and another that can get through the process with less bureaucracy, when it’s time to close the fund, the group with the belabored process, typically a public plan, may be the one that is left behind, the New York source says.

Even with a placement agent it can be difficult to cut through the red tape, says the president of a New York firm. Some pension funds have consultants that are overzealous in their due diligence, and it can take an endless period of time. If this happens, private equity firms would tend not to go to them, he adds.

The Consolation Prize

For those funds that don’t already have established relationships with a family of funds, the best alternative is probably “not to do it all, ” says Henderson. “If you are insistent upon doing it, maybe a fund-of-funds approach [would be the best option], but that tends to be expensive,” he adds.

The president at a New York private equity firm highly recommends fund-of-funds, like HarbourVest Partners LLC, a Boston-based fund-of-funds, because they give public pensions an opportunity to diversify their portfolio while offering smaller investments. “Funds-of-funds wind up being a superb vehicle because they can invest $25 million or $30 million or $50 million in a partnership and that could represent maybe 10 or 15 investors in their fund.”

That may be a good option for smaller pension funds. However, for larger public pensions, the extra expense is not necessary to get exposure, says Henderson. “From our perspective it really isn’t worth investing in this asset class unless you can access the top performers. If you just do the average you might as well put your money in the public securities or public equities markets,” he says.