Texas Teachers’ PE chief on focus on DPI, shift to smaller market funds

As the year comes to a close and 2024 opens up, the fundraising market continues to be a story of haves and have-nots – LP capital is flowing to top performers, while every other firm is struggling to raise. This is reflected in the fundraising numbers showing records amounts raised for the buyout strategy going to far fewer funds than in the past.

Will fundraising open up in the new year and what factors could lead to a smoother track to final close? Have term negotiations changed? And how important has DPI become when LPs evaluate a potential new commitment? To get answers, we sat down with Scott Ramsower, head of private equity funds at Teacher Retirement System of Texas.

What is your outlook for fundraising into 2024?

For us, we expect our supply of capital to be relatively flat in 2024 vs where we were in 2023 – and 2023 was down from prior years. We expect this to be generally the same for other LPs in the broader market as well. So, we don’t expect much change to the fundraising environment in 2024 and, as a result, we expect the terms pendulum to stay in the LPs court.

We are pushing on transparency, governance and alignment of interest terms – and we believe the broader LP community should be as well. Given that we don’t think the fundraising pace is going to pick up dramatically in 2024, then we will continue to take our time to ensure we’re backing the right partners while getting appropriate terms – and we’ll weigh our options if that’s what is required.

From the GPs perspective, we’re seeing that they are definitely thinking through a variety of options to attract LP capital – things such as first-closing discounts, seeded portfolios, etc. We expect that to continue in 2024 as well.

Of course, certain GPs have always been able to raise faster and those will still exist. TRS will be prepared to support those GPs as well.

The system has been focusing on smaller PE funds. What is driving that shift?

When I joined in 2010, we had six people and a smaller amount of NAV within the private equity portfolio. Fast forward to today, we have about $33 billion of NAV and the team has grown to 26. So, the team and the NAV have grown a lot.

We’re still putting $3 billion to $4 billion to work as we always have year in, year out. It’s just a lot easier to put that amount of capital to work with 26 people than it is with six people. In the early days, scale was our friend – we needed to put large amounts of capital out the door with fewer resources and, as a result, we had very large minimum bite sizes. Therefore, by and large, we were focused on the larger end of the market.

We also pay close attention to our benchmark, which has a lot of exposure to the lower end of the market. Since we now have more resources, we are able to focus on the lower end of the market so that we can move more in line with our benchmark going forward.

Fundamentally, we like the potential risk/return available down market. The manager dispersion is wider and thus implies some greater risk, but we also see that as alpha potential if we can execute well. That, as well as the greater exit optionality that exists down market, are reasons that we think the smaller end of the market is attractive.

As we’re going down market and committing to smaller funds, we still have decently large check sizes that we need to put to work, and gaining access at that size can be hard to do with a high-quality manager that has solid LP support. However, in today’s market some LPs may just be out of money or have less money, they may have non-GP specific reasons they’re not re-upping, or they’re re-upping but they’re coming in at a smaller amount. So, GPs have a hole in their fundraising that needs to be filled – that is where we’re seeing opportunities to step in as a new LP at a relatively large size and we’re trying to take advantage of it. It’s purely coincidental that our timing down market happens to be at a time in which we can express our leverage, but that is working in our favor.

Why are LPs so focused on DPI in today’s market?

If a manager has a low DPI (ie, they haven’t given us capital back) it means two things. First, the less DPI a fund has the more unrealized value that fund has, so therefore we have to do more work analyzing the quality of that portfolio. In addition, the more leap of faith we have to take that the track record is as the GP says it is, because it’s more dependent on unrealized values. And these unrealized values are obviously being called into question in today’s volatile market vs actual cash in our pockets.

The second thing is that it is likely that the GP is going to have to hold those investments even longer than originally expected as the environment has just gotten harder for exits. This is going to elongate our money in the system and lower IRRs.

So we’re looking at managers saying, ‘because you didn’t take chips off the table when you could, we now have to spend more time doing work to form a view on the unrealized portfolio and, likely IRRs are going to degrade from here because you didn’t lock in any of that gain sooner.’ It also means the overall system has more NAV than expected, so as a result, us and others are going to have to tap the brakes in terms of deployment pacing for a couple of years.

All of this is resulting in re-ups taking a lot longer than they did before because we’re having to answer more questions around the quality of the existing portfolio. Also, it’s likely that it’s going to take a while for us to get back to peak deployment because we’re going to have to slow down for the next few years.

How do you view NAV loans?

At a high level, so far this has been more noise than substance. We’re hearing more and more about it from our GPs, but we’re not seeing a ton of it. It’s kind of in the category of, there’s a whole lot of chatter about it, but it hasn’t been executed upon a ton in our portfolio at least.

But, when we do see it, we’re seeing it used for two main use cases. One is to create distributions for LPs and one is to support or add portfolio companies.

For that first bucket – creating distributions for us – we’re against it. First, they are cross-collateralizing the equities in our portfolios, which we’re not a fan of. Second, as we sit today, rates are pretty high, so to send us capital back at 10-plus percent, the best case, we re-invest that back into private equity and hopefully we can earn more than 10 percent. But the more realistic case is that it goes back into the trust pool where our cost of capital is 7 percent. Also, if we wanted to do it, we could do it cheaper than the GP could, just given our collateral base. So, overall it’s a pretty inefficient use of our capital.

If they’re doing this to create distributions for us – it’s the same as continuation vehicles – they should know how we view these distributions. When we show our GPs track records, we’re showing actual DPI, but we’re also showing DPI ex-CVs and ex-NAV loans.

So they’re doing it to give us money back, which is theoretically good, right? We’re overallocated, we need money back, so that’s creative. However, they’re not getting credit for it in our track record analysis, as all DPI is not created equal in our opinion. We call these use cases ‘synthetic DPI’ and we carve it out when we assess their performance.

So, we’re telling GPs – this is awfully costly and if you’re doing it, you’re not necessarily getting full credit in your track record.