For decades, public pension funds have bankrolled the private equity industry, investing billions of dollars with large firms like Apollo Global Management and the Blackstone Group.
Now, frustrated by what it sees as expensive fees and lack of transparency at private equity firms, one state has decided on a do-it-yourself approach.
South Carolina’s pension fund is creating an independent firm to oversee the fund’s private equity holdings - doing what it would have paid a private equity firm to do. The effort is similar to the direct investment funds created by two of Canada’s biggest pension plans - the Ontario Teachers’ Pension Plan and the Canada Pension Plan Investment Board - but is believed to be the first of its kind in the United States.
“It’s high time that state pension funds are able to develop structures that have greater transparency and lower costs,” said Robert L. Borden, the chief investment officer of the South Carolina Retirement System Investment Commission, which oversees the management of the state’s $25-billion pension (U.S.) fund. Mr. Borden will run the firm under a plan approved last week.
Mr. Borden is particularly critical of funds of funds, which are firms that manage a portfolio of private equity funds. “There are layers of fees, your control rights are zero, and your costs are astronomical,” he said. “We’re trying to tackle that model.”
Although South Carolina has a relatively small $5-billion private equity portfolio, the initiative has raised eyebrows in the industry. State public pension funds account for about 35 per cent of private equity assets, according to data provider Preqin.
“This reflects how desperate state pension funds are,” said Colin C. Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth College in Hanover, N.H. “They’re looking to get big returns and put large chunks of money to work in private equity, but don’t want to pay the expensive fees.”
By reducing its reliance on outside money managers and investing directly in companies and real estate, the pension fund could eliminate about $2-billion in fees and other costs over the next decade, according to a study by consulting firm Booz & Co. The firm would charge the pension fund less than the lucrative fees - typically a 2 per cent management fee and 20 per cent of a fund’s profits - commanded by outside private equity firms.
Other state pension funds are starting to take more control over their private equity portfolios as they try to find ways to increase investment returns and cut costs. Earlier this year, the California Public Employees’ Retirement System announced plans to create portfolios with outside managers that would charge lower fees and offer more customized strategies. The Teacher Retirement System of Texas has expanded its program of co-investing in deals alongside outside private equity firms.
But creating an independent firm 100 per cent owned by a state pension fund is novel.
“By creating it, we can build value for ourselves rather than buy into someone else’s firm,” said the 47-year-old Mr. Borden.
South Carolina is also increasing its allocation to private equity, which has historically generated higher returns than such traditional investments as stocks and bonds. After a decade of sluggish performance that made it difficult to achieve the fund’s target investment returns, the state hopes that raising its private equity exposure will help it to meet those goals. Over time, the fund is looking to commit as much as $8.7-billion to the strategy, according to fund documents.
South Carolina’s roughly $5-billion allocated to private equity has investments in some of the most prominent buyout shops, including Apollo, Apax Partners and Clayton, Dubilier & Rice, according to the fund documents.
The enterprise still plans to collaborate with these outside private equity funds. It expects to allocate as much as 40 per cent of its assets to strategic partnerships and so-called co-investment opportunities in which the firm would piggyback on other funds’ deals. For instance, South Carolina already has a venture with Apollo, called Palmetto, in which it invests in European assets.
The South Carolina pension fund has approved $15-million in startup costs for the firm, which is set to begin next month.
Hiring personnel will be a major challenge for the firm, which will have its headquarters in Charleston and an office in New York. Initial plans call for hiring 30 professionals by next year and ultimately more than 60 people, according to the fund’s documents. Although its reduced fees will save South Carolina money, the firm’s lower revenue will make it hard to pay compensation on par with Wall Street.
Another potential issue: Private equity professionals may see the firm’s link to the state pension fund - along with its unproven track record - as less appealing or prestigious than working for an established firm.
Mr. Borden pointed to a number of factors in its favour. The dislocation on Wall Street has resulted in a greater supply of financiers looking for new opportunities. And the firm would not have to court investors in a difficult fundraising climate.
“Capital is scarce and talent is readily available,” Mr. Borden said. “We couldn’t have done this in 2007.”
There is no way Mr. Borden would have done this in 2007, and staffing such a venture will be difficult but not impossible. Capital is scarce and talent is readily available, but the question is for how long? Paul Hodkinson of Financial News reports, KKR dealmaker predicts mega-buyout return:
One of the top dealmakers at Kohlberg Kravis Roberts, the US private equity giant behind the biggest buyouts in Europe and the world, has said the mega-deals that characterised the industry’s boom years could return within as early as six months.
Michael Michelson, co-head of North America at KKR, was speaking on a panel at the Dow Jones Private Equity Analyst conference in New York yesterday and said improvements in the debt markets meant that it will soon be possible to do deals worth $10bn.
Michelson’s firm sealed both the $44bn buyout of US energy company TXU and the £11.2bn buyout of pharmaceuticals group Alliance Boots in 2007, the height of the debt-fuelled buyout boom, which remain the largest buyouts globally and in Europe respectively.
He said: “It is possible to raise $5bn to $7.5bn of debt for the right deal. Debt markets have rallied to a higher point than I would have predicted. It is possible we will see such deals being done over the next six months.”
However, Michelson added that while some large deals would “potentially makes sense”, the majority of deals would remain below the $10bn mark and others would require “a substantial equity component”.
The comments followed a report by Thomson Reuters last week on Blackstone Group executive Garrett Moran, who told attendees at the group’s investor day that a $10bn buyout would be possible in the current markets.
There has been no deal bigger than $10bn in the global private equity industry since 2007. Earlier this year a consortium including Blackstone Group attempted to buy US payment processing company Fidelity National Information Services for $15bn, although the bid fell through as fears over a sovereign debt crisis in the eurozone spread through the markets.
Kevin Conway, a managing partner at Clayton Dubliler & Rice also speaking at the Dow Jones conference, said an important issue in the return to large deals would be revolver facilities, and said “the sweet spot” were buyouts between $500m and $5bn.
The comments come amid a cautiously optimistic mood at the conference. In a straw poll, 77% of delegates said the economy was improving, compared to 23% who felt it was either in recession or headed back to recession.
Shawn Hessing, national sector leader of private equity at KPMG, said: “Private equity is just sleeping and it is waking up.”
Conway added: “I am fundamentally optimistic about the role private equity can play creating change.”
We'll see if private equity starts waking up in the next six months. If markets continue to grind higher, I think it's only a matter of time. As for US state pension funds adopting Canadian direct investing approach, they first have to attract and retain competent staff. And while that looks feasible right now, it might be next to impossible if private equity deals pick up significantly in the months ahead.