So sue me

Denise Nappier hates to lose. And in her more than eight years as Connecticut State Treasurer and sole fiduciary of the state’s US$24.5bn pension fund, the Connecticut Retirement Plans and Trust Funds, she’s pitched a lot of battles. One scuffle that still brings up bitter memories for Nappier, even though it technically was a victory in her favor, was the much-publicized slugfest she had with Forstmann Little & Co. She took the New York buyout firm to court in 2002, accusing it of overexposing Connecticut’s pension money to two failing companies, XO Communications Inc. and McLeodUSA Inc, while trying in vain to resuscitate them. Nappier, known for promoting strong corporate governance in the companies her state invests in, sought the return of more than US$120m to cover the pension fund’s share of the losses. The two-year battle ended ambiguously in 2004. A jury found Forstmann Little guilty of breech of contract, but refused to award damages under the argument that, by honoring the firm’s capital calls, the pension fund acquiesced to the investments. Nappier, who believes the jury did not have a deep-enough understanding of private equity to make an informed decision, disagrees. “When we find it necessary to go after money we lost through investor malfeasance, we should then not be penalized because we answered the capital call,” Nappier, told a roomful of buyout professionals at the 19th annual Buyouts Symposium East conference. “We have to rely on the partnership with the GP, and we do so in good faith,” she added. Connecticut still managed to recoup US$15.5m from Forstmann Little in exchange for dropping its appeal.

Elected to her third term as state treasurer last year, Nappier has been battling to protect pension fund assets since the beginning of her tenure. Her predecessor ensured that. Nappier inherited in 1999 a state treasury tainted by the corrupt acts of former treasurer Paul Silvester, who later pled guilty to taking kickbacks from buyout firms and placement agents. Silvester’s transgressions included receiving more than US$100,000 in questionable campaign contributions in 1998 from buyout firm Triumph Capital, and directing an additional US$2m in Triumph Capital money to a girlfriend and another acquaintance. At the same time, Silvester gave Triumph Capital US$200m in state pension funds to invest.

Returns speak for themselves

When Nappier took office, the treasury put in place a self imposed, three-and-a-half year moratorium on new private equity commitments. During that time, it negotiated with general partners to reduce its private equity exposure from Silvester’s 20% allocation to 11%. Nappier ultimately recovered more than US$1bn in mismanaged or illegal private equity investments made by the former treasurer. “It is really unfortunate that my predecessor chose private equity investments as a vehicle for corrupt activities,” Nappier said. Connecticut reentered the private equity market in 2003, making its first investment in the US$6bn KKR Millennium Fund.

Despite a rough start with the industry, there’s a lot that Nappier does like about private equity—most of all, the returns. Since she assumed the treasurer’s office in 1999, the pension’s private equity performance has flourished, realizing a net IRR of 19.7% on post-vintage 1999 funds. And when vintage year 2005 and 2006 funds—which she said are still in their J-curves—are excluded, that number pops up to 23.5%, she said. On top of generating outsized returns, Nappier sees private equity as a vehicle through which she can help enact positive social, economic and environmental changes. “In our industry we call that the double bottom line,” she said. In particular Nappier commended buyout giant Kohlberg Kravis Roberts & Co., whose proposed buyout of TXU Corp. includes environmental concessions like doubling the Texas utility’s investments in alternative energy, and foregoing the construction of eight coal-fired power plants. New York turnaround firm KPS Capital Partners also got a nod from the treasurer as a firm that’s been able to outperform the market while also making a name for itself as a union-friendly partnership believed to have saved about 11,000 jobs through its deals.

Indeed, the numbers speak to Nappier’s confidence in the asset class. Connecticut’s state pension fund, which currently has about US$24.5bn in assets under management, has a target allocation to private equity of 11%. That’s almost double the exposure that the California Public Employees’ Retirement System (CalPERS) has with its 6% target allocation, and nearly three times that of the Ohio Public Employees Retirement System (OPERS), which has a 4% target allocation to private equity.

On average, Nappier signs off on between US$500m and US$600m in private equity commitments per year: 80% to buyouts, mezzanine and special situations funds; the remainder to venture. On the buyout front, most of the pension’s commitments are to mid-market and large-market funds. However, the pension is taking steps to access the smaller end of the market spectrum as well. Connecticut is currently below its target allocation with roughly US$1.4bn on the books and another US$1bn of committed capital that has yet to be called down.

Getting Active

Nappier is well known for her shareholder activism, taking companies like Home Depot and Sun Microsystems to task for issues related to executive pay. In the case of Sun Microsystems, Nappier led a proposal that ended last November with 44% of the company’s shares voting to ask Sun’s board to enact an annual shareholder vote on executive compensation. The goal is to give shareholders the power to vote on pay packages recommended for top corporate executives. Does she see a need for better corporate governance among buyout shops? Her speech at Buyouts Symposium East left little doubt. “It would be reasonable to suppose that private equity could be the next landscape for governance reform,” Nappier said, “particularly because so much of the money in your deals comes from public pension funds.” Indeed, Nappier’s affinity for private equity’s returns has not blinded her from what she sees as potential conflicts of interest in her role as the protector of Connecticut taxpayers’ money. She said that while buyout firms themselves can operate with minimal public exposure, “public pension funds invest in a fish bowl. We have to answer not only for the returns of our investments, but also for the unintended consequences.”

She called attention to the reputation buyout firms have for taking over public companies and initiating large-scale layoffs to cut costs. Those can be difficult to justify, she said, when general partners are raking in millions of dollars in management and ancillary fees, some of which come directly from the company’s balance sheet. Nappier acknowledged that, in some cases, these job cuts are necessary to cut fat and get a company back on track. But she said that firms that take public pension money should strongly consider public interests. “We should be mindful of where the money really comes from,” Nappier said. “In my case, the taxpayer of the State of Connecticut may have something to say if my investment in a private equity firm lands them in the unemployment line.” While praising carried interest for directly tying compensation to company performance, Nappier also worries that as buyout fund sizes grow well beyond their former bounds, the traditional 1.5% to 2% management fees are beginning to look more and more like “profit centers.”

Nappier also advocates for stronger rights when it comes to limited partner agreements, and to date has only backed funds that honor “no-fault divorce” clauses. Such clauses give limited partners the power to remove the general partner of a fund and either terminate the partnership or appoint a new general partner if there is strong disagreement over the way the fund is being managed. No-fault divorce clauses are especially important in situations where “GPs are throwing good money at a bad deal in an attempt to prop up a company that will eventually go bankrupt,” Nappier said.

How hard is Nappier’s going to fight for change in private equity? She describes her approach to dispute resolution as measured, preferring to talk through differences rather than litigate them. And that’s likely how she’ll tackle the issues where she’d like to see change. “In the rare instance when my fiduciary duty causes me to seek a judicial remedy, I find it very unfortunate that matters could not be resolved in my conference room as opposed to the court room,” she said. And you can almost count on there being conference-room battles in the months ahead. When it comes to corporate governance in private equity, Nappier said, “I am at the juncture of past indifference, and moderate activism.”

The next phase

So what is next for the pension plan? It is looking to diversify its portfolio by backing asset managers that tend to fly under the radars of most large institutional investors, including Connecticut-based firms, women and minority-owned firms, and emerging managers with less than US$2bn in assets. The idea is to find tomorrow’s private equity superstars before they are overrun with limited partner demand. The state plans to back managers pursuing a variety of private equity strategies, including buyout, mezzanine, special situations and venture capital. The program, structured as a fund of funds with US$120m to US$150m to commit, represents the second phase of the Connecticut Horizon Fund set up by the US$24.5bn state pension fund. The first phase—investing in up-and-coming liquid asset managers—was initiated last year, and the state has already put almost half a billion dollars to work. “It’s not a traditional fund of funds—it’s one that provides an infrastructure to these smaller funds so that they can find success,” Connecticut State Treasurer Denise Nappier said. “But their returns have got to be just as good as they are for the mainstream private equity firms, and to the extent that they are not, they will be terminated.”

Last year, as part of its first phase, the Connecticut Horizon Fund program put a total of US$435m to work with four fund-of-funds managers, money that was ultimately earmarked for domestic equities, international equities and fixed income portfolios. Those investments “are already meeting or exceeding the performance of our more traditional liquid investments,” Nappier said. WWe believe if we limit ourselves, we are going to miss out on the best opportunities out there,” Nappier added. “So we are strongly committed to opening our doors where we believe we can get superior returns.”