Funding Issues Challenge Kentucky’s Investment Head

With the $13.8 billion pension fund he oversees far from fully funded, and a board undecided about whether alternative investments are part of the problem or the solution, CIO Adam Tosh finds himself scaling back his ambitious plan for the private equity program at Kentucky Retirement Systems.

The commonwealth of Kentucky’s pension liabilities add up to $36 billion, but pension assets stand at only $13.8 billion. The imbalance stems from the state not contributing to the retirement system in 12 out of the past 18 years, said Tosh. He added that the money that is supposed to go to the pension plan gets diverted into other projects, and thus cannot be invested, compounded and grown. Tosh said this type of scenario is occurring all over the country but that “Kentucky is worse off than other states.”

Tosh believes ramping up the alternative investment program, which has a 12 percent target allocation, could be part of the answer, but the board isn’t necessarily sold on the idea. “We have some board members who are indicating we should be ramping up our alternatives because they think it will help meet their liabilities and our actuarial hurdle going forward. Others are saying the exact opposite,” Tosh said, because they feel that, although the targeted returns for alternatives look attractive, the risk is that much greater. Tosh said he’s awaiting guidance from his investment committee on how much to commit to the asset class over the next 12 months, and hopes to get some resolution by the end of August. “It’s kind of frustrating, but I can’t give you a number because it would be a shot in the dark,” he said.

With the program somewhat in limbo, Tosh said he has had to scale back the size of private equity commitments the state makes, get more selective about what types of vehicles it pledges to, and seek out more liquidity-friendly and income-producing investment strategies. For example, the firm has begun evaluating master limited partnerships, which involve things like oil pipelines and energy storage facilities, “so we collect the tolls on the transference of oil or jet fuel,” explained Tosh. One such recent pledge of $25 million went to a separate account managed by Tortoise Capital Advisors, which invests in energy infrastructure companies that transport, distribute or market natural gas, coal, crude oil and refined petroleum products. The firm’s strategy emphasizes current cash distributions.

Short History

Kentucky has been committing to private equity since 2003 via an alternatives portfolio that stands at a current allocation of 11.6 percent, close to its 12 percent target.

The state’s alternatives bucket contains private equity, private debt, timberland, oil and gas partnerships, commodities, real estate and private placements, spread among 40 managers. Within private equity, the LP’s breakdown among subsectors is roughly 60 percent buyouts; 20 percent venture capital; 10 percent international; and 10 percent debt. Returns for the alternative portfolio for the five-year period that ended Dec. 31, 2009, stood at 3.61 percent, which beats its benchmark return of 3.12 percent.

The pension fund pledged a total of $345 million to private equity in 2008, and, with its target allocation looming, slowed its pace a bit in 2009, with total commitments of roughly $300 million. For the time being, the state is likely to make commitments of $25 million to $50 million when backing mid-market funds, which Tosh defines as those ranging in size from $1 billion to $3 billion. In recent years the pension fund has emphasized the build-out of its international portfolio, as well as the development of an emerging-managers portfolio.

On the international front, the state’s portfolio includes a $40 million pledge to Arcano Capital, a Spanish fund-of-funds manager that invests in European and Latin American mid-market funds. When looking at investing in Latin America, Tosh felt it was crucial to choose a manager that didn’t just have a couple of people who could speak the language, but rather that had people who knew the culture, who understood the Napoleonic code, on which much Latin American law is based, and who knew key players and families. “If you’re not fluent with the culture and laws, you’re going to miss some of the nuances that could ultimately cost you money,” he said. Tosh also wanted to build partnerships in Latin America so “we could invest slowly over time as opposed to ‘here’s a lot of cash and we hope that it does well and we’re out of here.’”

The state has also accessed non-U.S. markets by committing to Horsley Bridge Partners International Fund V, a fund of funds earmarked for small buyout and venture capital funds in Europe and Asia; and Keyhaven Capital Fund III, a Europe-focused mid-market buyout fund.

Kentucky established its emerging manager program in late 2007 to access the smaller end of the private equity market and to act as a conduit into its core fund via a total of $125 million committed to San Francisco-based Bay Hills Capital. “We’ve done two funds with them,” said Tosh. “And we’re pretty pleased with it.” An initial pledge of $75 million was made to Bay Hills Capital in late 2007, with a follow-on commitment of $50 million in 2009.

General partners who got slugs from the original $75 million Bay Hills Capital mandate include Marlin Equity Partners, which takes controlling interests in businesses experiencing different levels of operational, financial or market-driven changes; Accel-KKR, which takes majority stakes in mid-market technology companies; and Callisto Capital, which makes control investments and takes minority interests in private and public companies.

“We were doing a lot of small buyouts when everyone else was looking at large and mega-buyouts,” said Tosh. He defines small buyout funds as those under $500 million. To identify such shops, the investor not only works with Bay Hills Capital and alternative investment consultant Strategic Investment Solutions, but also generates some prospects internally from a director of alternative investments and two other staffers.

Tosh prefers that his staff and their consultants initially perform separate due diligence processes on the same GP, “so that I’m getting different opinions on the same things from different angles. It doesn’t do me any good if I get group-think.” Tosh also noted the importance of onsite visits to GPs. “We’re not going to get the kind of info we need…from having one GP and a marketer come into our office and sit in front of our polished conference table and tell us their story in an hour,” he said. It’s critical to spend the time to do due diligence on the team, its process, what the underlying investment opportunity is, and its sustainability or non-sustainability and to try to understand “how they are ultimately going to make money from that – or more importantly, how they could lose money from that investment,” said Tosh.

One example of a small buyout firm that earned Kentucky’s confidence is Greenwich, Conn.-based Mill Road Capital, which has earmarked its $250 million fund for minority positions in small-cap public companies across a broad array of industries and as well as some outright acquisitions. The firm typically holds an investment for two to three years, a strategy that garnered a $30 million pledge from Kentucky in 2008.

Despite Kentucky’s severe underfunding, “we’re going to have the ability to invest, but our checks won’t be as big as they used to be,” said Tosh. “We have to understand what the impact would be on our cash flows, but it doesn’t mean that we would just walk away from [making appropriate commitments]. We still need to maintain [the private equity portfolio],” which can take time. “It’s an interesting challenge that only gets more interesting,” Tosh said.