LP Profile: Private equity returns boost NJ pension; CIO search continues

Pension System: New Jersey Division of Investment

Assets Managed: $75.3 billion (Sept. 30, 2013)

Private Equity Assets Managed: $6 billion

PE Allocation Target: 10.5%

PE Allocation as of Sept 30: 7.8%

Chief Investment Officer (Interim): Christopher McDonough

Chairman of NJ Investment Council: Robert Grady

Participants in the retirement system: About 800,000 beneficiaries, about half retired and half still working

 

He praised Blackstone Group and the state’s role in helping the firm launch its tactical opportunities business as one of many bright spots in New Jersey’s private equity investments. The interview below is a combination of a phone conversation and emails between Grady and Buyouts, edited for length.

You’ve had a wide range of experience in the pension business. How does NJ fit into the wider context of public pension funds?

We’re one of the top dozen in the United States and top 20 in the world. Like many pension funds, you worry about the long-term health of the fund and the system, and I think we’ve done a good job in the last three years being attentive to improving that health. NJ has addressed managing assets well, and is working to address the long-term liability stream. On the asset side, we’ve diversified. We have a policy of only working with top-tier managers. In fact, we’ll only invest in top-quartile managers. We pursued a policy of keeping politics out of the board room. We have an exclusively fiduciary mission.

We’re trying to maximize returns for the beneficiaries while mitigating risk. We’ve done a good job managing the assets. In 2011, we got named the large fund of the year by a large publication, and we’re in the running to win a similar award this year – they’ll be making the announcement soon.

Another thing we’ve done on the asset side is we’ve worked hard to drive down fees. We’ve been creative with private equity funds by increasing our alignment of interests and driving down the overall fee load for the pension fund.

On the liability side, Gov. Chris Christie has passed a bill that reduced the long-term funding deficiency and liability stream by $120 billion over the coming years.

The state has also has been increasing its contribution to the pension system. This year, the legislature made a record contribution of $1.7 billion, the highest the state has ever made. That’s part of the deal that increases contributions over a period of seven years. We’re in the third and entering the fourth year of that deal. All in all, the pension fund is much healthier than it was three or four years ago.

NJ’s return was 18 percent in fiscal 2011 – its best performance in 13 years – excluding statutory mandated investments in police and fire mortgages. Was private equity a big factor in that?

In fiscal 2011, the return was 18 percent, fiscal 2012 was 2.6 percent, but that outperformed CalPERS, New York Common Fund, Florida Retirement System, the Harvard University and Stanford University endowments, and a number of other leading investors.  (Note that we are on a June fiscal year.)  For fiscal 2013, we were up 11.8 percent, even though we were conservatively positioned. So for fiscal years 2011, 2012 and 2013, the three-year annualized IRR of the fund was 10.6 percent. Interestingly, if you take the last six years, through both the 2008 crash and the rebound, New Jersey’s annualized return was at the top of the dozen large, similarly-sized public pension plans in the U.S.  That’s of course the whole point of our diversified asset allocation, to be able to withstand major downdrafts while still capturing significant upside in rising markets.

The world is full of risk. We continue to be highly diversified to find assets that are uncorrelated. Since our alternative program was started in private equity, real estate, hedge funds, and real assets, through the crash and the comeback in markets, private equity has been the top performer with 30 percent total return [including the financial crisis], hedge funds about 16 to 18 percent, and real estate with a single-digit return. Public equities have been a great performer in calendar years 2013 and 2012, but in 2011 not so much.

We are not as long the public equity markets as many other pension funds. We’re highly diversified, and not long traditional fixed income either…in fixed income, we underweighted Treasuries very significantly more than two years ago. We still had an allocation to investment-grade bonds, albeit shrinking, but we have had exposure to high-yield bonds, debt-related real estate funds and private equity funds, credit-oriented hedge funds, and other non-traditional fixed income categories

Tell us about the search for a chief investment officer [CIO].

Chris McDonough [acting CIO] is doing a terrific job and is a highly competent person. He was previously the chief investment officer for the City of Philadelphia pension plan. He knows what he’s doing and he’s doing a great job for us. That being said, we are running a full search and we are definitely in the market to hire at least one person. Chris is a candidate, and a strong one. One of the things that we’re seeking is a CIO. We’ve received over 100 resumes, many of them quite strong. We’ve interviewed over a dozen people in person. No decision has been made but the process is moving along nicely.

We are several bodies below the number of full-time employees [FTEs] we’re allowed to have under the state budget. There’s a chance we’ll hire more than just a CIO. Our ranks have been thinned with retirements, departures, family issues, illness, you name it. We may hire more than one person. We have about 70 people, 68 FTEs, I believe. We’re allowed to have 73.

Will it be possible to get legislation passed to set up the office of investment differently with a Democratic legislature and a Republican governor?Currently the cap is at $200,000, based on compensation levels from about 20 years ago. I guess the top end fund managers at large private equity funds make about $1 million if they hit their performance benchmarks.

I think the fact is that both the head of private equity, Christine Pastore, and our prior director of the Division of Investment, Tim Walsh, have left in the past couple of years as a result of compensation issues. It’s put a focus on this issue. I believe it will be possible to make a change here, and the governor and the treasurer are in agreement that one is needed. It’ll take legislation. I think it will be possible to get agreement on a bi-partisan basis to amend our compensation levels. We’ll never compete with Wall Street. But we should be able to compete with other states. 

Another possibility is to restructure the whole thing. Some states have spun out their investment organizations – that’s a more far-reaching plan. I don’t think we’ve decided yet whether we would go that far – but clearly we need to have some amendment in the compensation structure to be able to retain people. I think our board agrees with that on a bipartisan basis. We have unions on our board, public employees, private individuals appointed by the governor – some are from the investment business and there is uniform agreement that we need to be able to retain the best people.

Blackstone just closed a $4 billion fundraising for its tactical opportunities business – didn’t this fund line start with NJ?

We put them in [that] business. We’ve been very happy with our investment there. We did a strategic investment with Blackstone Group —  a fairly large amount of money over multiple years to Blackstone, across multiple funds, geographies, and strategies. One of the biggest  pieces of that $1.5 billion strategic partnership was for this new business of Blackstone Tactical Opportunities. We were able to negotiate very favorable terms: 0 percent management fee on committed capital, a 1 percent management fee on drawn capital and 15 points of carried interest, not 20. And we had strong governance rights with respect to decisions on individual investments. It was very good for New Jersey and it provided fee savings, but for Blackstone it has also been a very good partnership, opening up a major new category of business for them. For New Jersey, with our very small private equity staff and limits on travel, it gives us access to Blackstone’s “feet on the street” and deal flow all around the world. It’s been a great relationship, also with investments in GSO, GSO Energy, Blackstone Energy and Blackstone Capital Partners VI, in addition to the investment in Tactical Ops. We also invested separately in Blackstone Real Estate Partners VII. What’s great is that across all of those categories, we have very substantially positive IRRs to date. I think it’s fair to say that NJ, at least, is very happy with the relationship so far. And we hope Blackstone is happy too.

If I’m a private equity firm who wants to draw investment dollars from NJ, what should I do? How does the state handle newer, younger private equity funds?

We look at all funds. We do want to see a top-quartile ranking. It may be partners who broke away from a firm with top-quartile performance and formed their own firm. They should get in touch with the private equity staff at the Division of Investment, headed by Chris McDonough, and in private equity we use a consultant, Strategic Investment Solutions in San Francisco. We’re looking at many dozens of private equity firms every year. Our goal is to pick the best performance, strategy and team. We’re trying to diversify, and we want multiple styles and regions – Asia, Europe, U.S., larger funds, growth equity, distressed, and so on. We want to have a diverse portfolio.

We continue to make new commitments. In fiscal 2013 we had about $1.3 billion dollars in distributions – and only about $950 million of capital calls. So even though we’re making new commitments to private equity, our actual dollar allocation to private equity went down by more than $300 million. We are targeting a private equity allocation of about 8 percent over the coming year. We constantly review that.

We’ve been happy with our [private equity] program. If you look at what happened, private equity did its job during the crash – because private equity firms had what I call “temporal flexibility”, that is, when the crash came, they weren’t forced to sell. Many firms — Blackstone Group, Thomas H. Lee – they bought debt of companies they invested in, they averaged their price down, they renegotiated, refinanced or in some cases outright canceled massive amounts of debt, which all accrued to the benefit of equity holders. So they performed quite well during the crash. Last year we had an allocation of a little over 7 percent, this year it is just over 8 percent The average, large public pension fund allocation is about 11 percent, so we are not the most aggressive in this regard. We constantly re-evaluate our asset allocation with the goal of having a diversified portfolio. So right now, there’s no specific plan to increase it. On any given day we’re re-evaluating our asset allocation. It could go up, or down.

You were appointed to the New Jersey State Board of Investment in May 2010 and became chairman in September of that year. Do you hope to continue with another term?

My service is up to the governor, and technically I believe my first term is up this year or when someone is appointed to replace me. But if the governor asks, I will be happy to serve.

(This story has been updated to include a more recent figure for the value of the pension system.)