The Teachers’ Retirement System of the State of Illinois (TRS), founded in 1939, is a $35.4 billion pension system has been a consistent private equity investor and investment performer. Last year, it found itself in the news as a former member of its board of trustees was indicted for using his position to solicit kickbacks for politically connected friends. Two others involved pleaded guilty to lesser charges. TRS didn’t take the incident lying down. It publicly disclosed everything it knew about the former trustee and earlier this year filed a lawsuit against him and his two alleged co-conspirators. Despite the trouble, TRS managed to achieve its highest returns from private equity and bring its total assets under management to its highest level yet.
The pension system has 3.2% of its assets, more than $1 billion, invested in private equity. Fifty percent of its private equity allocation sits with buyout funds, 35% is allocated to venture funds, 10% in earmarked for distressed and mezzanine funds and 5% is allocated to “other” miscellaneous private equity opportunities.
Buyouts’ Matthew Sheahan spoke with Jon Bauman, TRS’s executive director since 2001, and his colleague, Stan Rupnik, who has served as TRS’s chief investment officer since 2004.
What are the biggest challenges facing Illinois TRS today?
Jon Bauman: We have a couple of unique challenges. An issue that relates to all of our investments is Illinois pension funds’ under-funded status. The Illinois pension funds are toward the bottom of the pack nationally in their funded status. That causes the role of the investment portfolio to take on even greater importance in maintaining the overall financial health of the fund. Private equity, albeit a small portion of the fund, has been the highest performing asset class. We hope to continue that track record by continuing to select and maintain high quality general partnerships. Other general challenges are matching funds in the market to our particular requirements in the portfolio, particularly in the venture space. Having the ability to access high quality partnerships over the next several years will be important to our success.
What aspects of being a private equity LP most concern you today?
Jon Bauman: A couple of things I would raise as issues include the ability of all the GPs to make good successful exits of the portfolio companies in a rising interest rate environment. And secondly, on an ongoing basis, that public funds will continue to be able to access the top performing funds.
Are you worried that good funds may turn you away due to fears over disclosure issues? Has the situation with the Ohio Workers Compensation Plan made things more difficult for your group to invest in private equity?
Jon Bauman: We have not had, to my knowledge, any fund turn us away over disclosures. You couldn’t rule that out, but I would hope that most GPs would understand that that was an aberration on the part of that fund and consultant, and realize that most of the seasoned public funds that invest in private equity would exercise more discretion in how we mange the release of information.
As it stands now, does your private equity allocation mesh with your appetite for private equity in general?
Stan Rupnik: We’re pretty consistent right now and have been since 2002. We will certainly look at our private equity allocation and make sure it’s appropriate going forward, but I don’t think we would change our allocations strictly based on what’s in the market.
How will LP allocations to private equity change in the future?
Stan Rupnik: There are two ways of looking at it. There are a lot of LPs that have brought their venture allocations down because there are not many opportunities right now or looking forward, expectations of venture returns will probably have to be reeled in a little bit. If you’re reallocating because your expectations are coming down that’s a more legitimate reason for doing it.
How are LPs looking to assess PE performance?
Jon Bauman: We use all of the traditional quantitative methods, but I believe that we also rely heavily on qualitative considerations. We rely heavily on our staff’s evaluation based on a site visit and an individual discussion with each of the investing principles of the firm. That way we can get as comfortable as we can with their investment philosophy and process. We can understand how they source deals and where they source them and what makes the firm special. A GP was telling me just recently that between our written questionnaire and on site visit that we spend more time than other LPs with the task of due diligence.
What kinds of buyout firms do you want to invest in? Do you have preference for stage, sector?
Stan Rupnik: We try to stay diversified across both the mega and small deal sizes. But also along those lines different folks do different things. There are financial engineers out there in the buyout world and there are operators and turnaround specialists. Both in terms of size and philosophy we try to keep a diversified mix in the portfolio.
Are buyout funds getting too large?
Stan Rupnik: Obviously, the trend is larger and larger and the buyout funds are infringing on the public space more and more so the question is how to react. You read the research that the correlation between the public and private markets is growing and it’s absolutely got to be a function of buyout funds getting so large.
Jon Bauman: Our concern as an LP has to be both for that and GPs investing against each other or having our money go from one GP to another in a series of club deals. We haven’t experienced that, but certainly if you watch the deals, a number of our fellow public funds have had that happen. Once you commit your money you can’t stop that. Particularly with these large fund sizes it’s something that the whole LP community has to be vigilant about.
What developments in the buyout industry are you watching closely?
Jon Bauman: We’ve looked at a number of sector funds versus more generalist type funds. We have funded a small handful of small sector funds, for example two funds that specialize in the financial services industry because that tends to be something that’s just not covered by other buyout firms. For the most part, investing on a sector basis is not something we do with regularity over time.
Stan Rupnik: We definitely see a lot more [specialized funds]. And they can make a good argument in their favor, but when that particular sector is out of style, you don’t have the safety and the risk control of a generalist fund to diversify your portfolio.
Jon Bauman: We don’t have any problem saying no’ to any given offering. We stay widely diversified and any sector fund like the two investments we made in financial services. We have invested opportunistically in the energy sector for example. [Our investment] would be based on our best judgment as to the portfolio waiting at the time and where a sector or specialty fund could address under-weights or fill in gaps in the portfolio.
How interested are you in investing in secondary funds?
Jon Bauman: Historically, we have not been a secondary investor. That’s not to say it won’t be something we’ll examine in the future. The reason we haven’t been an LP in secondary funds would be a combination of the fund being able to fill its private equity allocation without secondary investing, that there was probably a lack of staff capability in prior years to do the due diligence and that there weren’t a lot of secondary funds or offerings that under those constraints made sense for us to look at.
To what extent has the increased interest in private equity among other LPs hindered your ability to invest in preferred funds?
Stan Rupnik: Definitely quite a bit. You see funds come to market very quickly and leave very quickly. A lot of that is endowment effect, but it’s also a lot of public funds that have increased their allocation substantially. On the flipside, being a large fund we often have the benefit of getting the first look at the major funds that come to market. Maybe we’re doing the same damage farther down the food chain.
Jon Bauman: It’s a function of a relationship with a given GP that drives the bus more than anything else. I’m thinking of a couple of GP relationships we were the first-time investor in a given fund and were writing what we thought was a good sized check but we got reduced when the fund was over-allocated. I’m sure that some of our peers that were well tenured with those funds didn’t get reduced as much or had made larger allocations and got their full allocation. On the other hand, an over allocated fund that’s out there right now or one that just closed with a GP that we’ve got some tenure with that was substantially over allocated. We said we wanted our full allocation and we got it and I’m sure other folks were cut back. I agree that the increased interest has an effect, but it’s definitely situational and if an LP is building relationships with a concentrated number of GPs, that effect can be minimized.
How are your non-U.S.-based PE funds geographically dispersed?
Jon Bauman: We don’t have any. I would expect that that will be a border that we might cross over the next couple of years. It’s a function of the allocations always filled with domestic funds and the resources we had were not sufficient to properly diligence international funds. [We have] no bias against them, it’s just that we weren’t equipped to evaluate them.