LA County forms separate account to address ‘lack of agility’

The Los Angeles County Employees Retirement Association plans to remedy a “lack of agility” in its investment process with a $300 million re-up to a fund-of-funds separate account with Pathway Capital Management.

LACERA approved the commitment at its September 9 meeting. The Pathway account, known as the Gateway Private Equity Fund-B, will deploy the commitment to small buyouts, venture capital, special situations and international strategies within its private equity portfolio, according to a pension memo made available through a public records request. The $47.7 billion retirement association committed $300 million to its first Gateway account in 2008.

LACERA is underweight in many of those strategies because of a “lack of agility” in the pension’s investment process, according to a private equity staff memo. Strong LP demand for smaller fund managers compresses general partners’ fundraising timelines — sometimes to as short as two months — and LACERA can’t complete due diligence and close on a new commitment as quickly as endowments and other LPs.

Difficulties accessing smaller general partners are compounded by LACERA’s inability to write small checks. As a large public pension, LACERA makes most commitments between $50 million and $200 million, sizes that effectively exclude managers raising less than $750 million from consideration, according to the memo.

This resulted in a significant number of “lost” commitments over the years, staff wrote, including opportunities LACERA did not pursue because of timing or because its commitment size would have been less than $50 million.

As a result, the bulk of Los Angeles County’s private equity exposure is in mid-market and large buyout funds, which accounted for approximately 70 percent of its portfolio as of mid-2014, according to LACERA investment reports.

The new Gateway account will alleviate some of these issues by putting the ball in Pathway’s hands. The firm will have sole approval or veto power over what funds receive commitments through the Gateway account, according to the memo. Commitment sizes will typically be smaller, averaging around $30 million per fund. The $300 million account will likely be deployed across five to 15 funds.

Prioritizing VC

Pathway may invest as much as half of the new $300 million account in venture capital funds, according to the staff memo, a marked increase from the $73.4 million it allocated to VC strategies from LACERA’s first Gateway fund.

LACERA staff has struggled to make direct commitments to venture capital firms, securing just four fund commitments over the last 14 years, according to the memo. The problem became particularly acute as LACERA’s venture capital returns soared to 2.9x between 2002-2012, higher than any other private equity sub-sector in its portfolio.

A lot of the exposure LACERA developed during the period can be attributed to Pathway, which made eight venture capital fund commitments through the pension’s first separate account. Those commitments netted a combined 27 percent internal rate of return through March 31, according to a firm presentation obtained through a records request.

“Gateway’s venture capital portfolio, consisting of eight funds, is off to a strong start,” staff wrote, noting many of those commitments are still quite young.

New relationship

Los Angeles County staff negotiated a handful of changes to the terms of its newly expanded separate account.

Most notably, although Pathway still holds discretionary authority over what funds comprise the new Gateway portfolio, LACERA staff will now have the option to sit on the LP advisory boards of funds held through the account. This will strengthen the pension’s direct relationship with smaller managers, according to the staff memo.

In addition to obtaining direct access to fund managers, LACERA also convinced Pathway to only charge its management fee against invested capital, rather than committed capital as it had with the previous Gateway fund.

Pathway will not take carried interest on the fund.

LACERA held an 8.7 percent allocation to private equity as of December 31, according to its website. The pension set an 11 percent target for the asset class.

Action Item: See LACERA’s investment portfolio here: http://bit.ly/1QGa8ac