CalSTRS Going the Texas Teachers' Route?

Gregory Roth of Reuters reports, California pension eyes commitments to PE firms:

The $145 billion California State Teachers' Retirement System, the nation's second-largest pension fund, is actively considering making large separate-account commitments to private equity firms, a senior investment official at the fund told Reuters Buyouts Magazine.

The development comes on the heels of similar commitments made by the Texas Teachers' Retirement System and the New Jersey Division of Investment. "We're definitely looking at separate managed accounts," said Pascal Villiger, a private equity portfolio manager at CalSTRS. "It's definitely something that I think all large institutions are seriously looking at."

Late last year, two giant commitments shook the private equity world. The first, by Texas Teachers', involved committing $3 billion each to separate accounts managed by private equity shops Apollo Global Management and Kohlberg Kravis Roberts & Co.

A few weeks later, New Jersey pledged $1.5 billion to The Blackstone Group for three separate accounts covering a variety of investment strategies. This was in addition to $1 billion that New Jersey had already pledged to Blackstone Group in 2011 for its regular slate of private equity and real estate funds.

Separate accounts are different from typical private equity funds in that the investments are not commingled with money from other investors. Rather, they consist of customized investments for just one investor. Their advent represents a sea change in the way public pension funds, the largest sources of private equity money, use their huge size to drive down fees and negotiate better terms.

The trend toward separate accounts is also likely to help accelerate the ongoing transformations of the largest private equity firms into generalist asset managers equipped to offer their clients a wider scope of investments beyond private equity. Blackstone Group, for instance, now manages $137 billion in fee-earning assets, yet only 27 percent of its assets ($37 billion) are invested in private equity. The rest is invested in real estate, hedge funds and credit offerings.

Even though large separate accounts are relatively new in private equity, CalSTRS's Villiger said there were already a variety of flavors. "At one extreme, it's just basically co-investments alongside a commingled fund with reduced economics. At the other extreme, in terms of Texas Teachers', it's a very highly customized solution."

CalSTRS's move to consider large separate accounts was strongly hinted at in late January, when the pension publicly posted proposed changes to its investment policy that would allow such investments. The pension's board was scheduled to discuss the policy changes at its February board meeting.

In making its case, the proposal highlighted the advantages of separate managed accounts, among them "discounted fees and preferred terms," adding that "almost always, management fees will be lower and sometimes carried interest will be lower, too."

Under the proposed policy, each separate account would be limited to 10 percent of CalSTRS's private equity portfolio. But since CalSTRS has $21.3 billion in private equity holdings, it is feasible that separate account commitments could amount to as much as $2 billion each.

To be sure, separate managed accounts would probably represent just a fraction of CalSTRS's overall private equity program. Villiger said that with 14.7 percent of its overall portfolio in private equity, CalSTRS was already over its 12 percent target allocation. That said, he predicted that CalSTRS would probably spend between $2.5 billion and $4 billion on private equity each year.

"A sustainable pace is probably a number closer to $4 billion," he said.

Kelly DePonte, a fund marketer at Probitas Partners, said the recent moves by big pension funds to consider separate accounts represent much more than a desire to save on fees. "It's also a wish for more control," he said, "so that there is more of a conversation between the GP and LP about each individual investment."

Separate accounts make a lot of sense for large U.S. public pension funds. Not only do they get to lower fees, they can have more control over their investments and obtain significant knowledge leverage with their GPs.

I think you will see an increase in these type of separate account arrangements in the alternatives space because large investors are increasingly conscious of fees and trimming their GP relationships. You'll see this not just in private equity but in real estate and hedge funds too.

In Canada, such arrangements are rare because our large public pension funds prefer investing direct in private equity, co-investing only when it makes sense for them. Ive discussed these trends here and here. Below, some CNBC interviews with Steve Leblanc of Texas Teachers' and Jim Leech of Ontario Teachers' discussing their private equity strategy.