CalSTRS Sees a Big Drop in Carried Interest

Alicia McElhaney of Institutional Investor reports on why CalSTRS paid less to invest in 2018:
The overall cost of investing for the California State Teachers’ Retirement System has fallen, but not because investment managers have decreased their fees.

This is according to CalSTRS’s annual investment cost report, which was released ahead of the retirement system’s monthly meeting on November 6. The report showed that the total cost of managing the retirement system’s portfolio decreased by six percent year-over-year.

The reason? Two words: carried interest. As the performance of investments that charge carried interest — a type of performance fee — fell year-over-year, so too did the cost of investing for CalSTRS.

According to the report, the overall costs of investing for CalSTRS were lower in 2018 because carried interest paid by the pension fell by 36 percent in absolute dollars from the previous year. CalSTRS paid nearly $1.72 billion in investment costs in 2018, the report said. This is compared with $1.83 billion the previous year.

“The reduction in carried interest indicates a slowdown in realized profits from private investments made over the last several years,” the report said.

But according to the report, which included details on fees charged between 2015 and 2018, CalSTRS’s total portfolio costs when excluding carried interest increased 14 percent from the previous year. The increase, the report said, is the result of net asset value growth, new investment strategies, and asset allocation changes.

The plan’s net assets increased three percent in 2018, which contributed to the increase, the report said. What’s more is that new investment strategies, including a shift within the global equity asset class from a home-country bias to a global structure, accounted for a five percent increase in costs because of higher fees charged by the new strategies, the report showed. The remaining increase of six percent resulted from a continued effort on the part of CalSTRS to increase its allocation to private assets, it said.

What’s more, the cost of investing for the retirement system was lower than its peers. According to an analysis of 48 U.S. public funds and 15 global peer funds with five or more consecutive years of data, CalSTRS paid, on average, at least five basis points fewer than its peers in total investment costs between 2015 and 2018.

As of September, the retirement system had an estimated $238.3 billion in assets under management, its chief investment officer report for November showed. It returned 6.8 percent for the fiscal year ending on June 30. A spokesperson for CalSTRS did not respond to an email seeking comment.
Take the time to skim through CalSTRS's 2018 Annual Investment Cost Report here and the presentation here. The slide below is the critical one showing total portfolio costs and carried interest (click on image):

And below, you can see the investment costs in dollars (click on image):

As you can see, there was a 36% drop in carried interest in 2018 which is why total investment costs dropped 6% in 2018.

The plan's assets grew approximately 3% in 2018, driving up costs in absolute dollar terms. In terms of the attribution of where costs increased, see the chart below:

In terms of total external versus internal and private versus public market costs, the slides below give you a nice breakdown:

Not surprisingly, the externally managed private funds make up a bigger cost percentage of NAV (1.76% vs 0.36%).

The report states: “The reduction in carried interest indicates a slowdown in realized profits from private investments made over the last several years.”

That isn't good, it means private market fund managers are having harder time delivering the alpha they used to deliver.

I recently discussed how there are bubbles everywhere, including private equity where performance is deteriorating, secondaries are no longer selling at a discount and volatility is often underestimated even if the alpha is there over the long run.

I also discussed how private equity titans are looking to cash out, although not because they think it's the top of the market as most of them are plowing the bulk of the money they receive from funds right back in their business.

Still, the reduction in carried interest at CalSTRS is alarming and in my opinion, it's a harbinger of things to come for CalSTRS, CalPERS and most other US pensions which primarily rely on their fund investments in private markets to generate their required target rate-of-return.

In Canada, our large pensions have mature, developed private equity co-investment programs where they can scale into the asset class and pay no fees. In fact, in most Canadian pensions, the co-investment portfolio is much larger than the fund investment portfolio which is how they are able to maintain their 12-15% allocation to private equity.

To do this properly, Canada's large pensions hired an experienced team of private market professionals and compensates them appropriately so they can quickly analyze co-investment opportunities as they arise.

In the US, it's hard to ramp up co-investments because most pensions are incapable of attracting and retaining a qualified staff to this activity on the scale that is needed.

This is why US CIOs like Chris Ailman at CalSTRS and Ben Meng at CalPERS are worried and need to think outside the box when it comes to private equity. Both these CIOs are extremely smart, part of the 2019 Power 100 List, but they face structural issues when it comes to fully developing their private equity programs and making sure they remain competitive and deliver the requisite returns over the long run.

I recently discussed how CalPERS is ramping up its in-house private equity which is now headed by Greg Ruiz, a former private equity fund manager. He's in charge of ramping up Pillars III and IV.

I believe Chris Ailman and his PE team at CalSTRS are taking a closer look at BlackRock's Canucks -- Mark Wiseman and André Bourbonnais -- who are shaking up private equity with their long-term private capital team, known as LTPC.

In my opinion, it would make a lot of sense for many large US pensions to take a closer look at BlackRock's private equity model and really understand the advantages it offers over traditional PE models.

Importantly, not only can you save on fees over the long run, you can also generate the requisite long-term returns by eliminating all the churning that typically goes on in PE Land as funds keep selling investments to each other as they focus on raising assets for their next fund.

Like I said, when you see a big drop in CalSTRS's carried interest fees, it's time to start worrying because it's not only going on there, that's for sure.

By the way, I've focused mostly on private equity but a recent study from the University of Chicago Booth School of Business highlights how pensions are paying billions in 'unnecessary' real estate fees:
Investors would be better off adding leverage to their core real estate portfolios than paying billions of dollars in fees each year for alternative assets in the sector, a new study has found.

Underfunded public pensions have shifted to riskier assets in hopes of high returns, but their reach for yield in non-core real estate funds is not paying off, according to real estate professor Joseph Pagliari of the University of Chicago Booth School of Business and Mitchell Bollinger, an industry advisor, investor, and analyst.

Investors could have collectively saved an average $7.5 billion a year in “unnecessary investment-management fees” from 2000 through 2017 by adding more leverage to less risky, core assets rather than investing in non-core funds, the researchers found. Bollinger and Pagliari published their findings in the Journal of Portfolio Management last month.

Many chief investment officers at public pensions are “swinging for the fences,” seeking to repair their funding shortfalls with outsized returns from alternative investments such as non-core real estate, Pagliari said Friday in a phone interview. “If you adjust for fees and risk, then on average, investors have overpaid by approximately 300 basis points per year for their non-core real estate funds.”

Core real estate funds typically hold fully-leased buildings that are considered investment-grade, according to Pagliari. Non-core funds in private real estate, including value-added and opportunistic, are riskier and involve more leverage.

He and Bollinger found that value-added funds underperformed levered core funds by 3.26 percentage points annually, while the opportunistic funds lagged by 2.85 percentage points.

“Consider the implications,” Pagliari and Bollinger wrote in their paper. “Investors could have increased the leverage on their core portfolios from approximately 22 percent to somewhere between 55 percent and 65 percent, and they would have outperformed the net returns of the value-added and opportunistic funds by approximately 300 bps per year while incurring the same level of volatility.”

Value-added funds charge investors about three times more in fees than core real estate funds, according to their research. Opportunistic funds are even more expensive, raking in about four times more in fees than core real-estate funds.

Joseph Azelby, head of real estate and private markets at UBS Group’s asset management unit, noted at a media briefing in June that pensions have been shifting a portion of their core real estate holdings to properties under development or renovation. He flagged these riskier bets as a potential concern because pension managers had similarly stretched for yield in the runup to the 2008 financial crisis.

During the phone interview, Bollinger said it’s not easy to change the behavior of pensions despite “overwhelming” data showing it would make “economic sense” to add leverage to core funds instead of paying for riskier, private real estate. Having approached risk-taking in the sector in the same way for years, pension fund managers may be reluctant to venture outside their “comfort zone,” he suggested.

Pagliari also finds it puzzling that investors wouldn’t want more leverage on core assets and less on riskier properties that aren’t fully leased or require development.

“That’s a bit of a mystery,” he said by phone. “It’s backwards.”
I've already discussed how investors are taking on riskier real estate bets and this new study confirms what I've long suspected, namely, value added and opportunistic real estate funds aren't better than core real estate once you adjust for fees and risk but I doubt anyone in Pension Land is taking notice.

Below, the CalSTRS Investment Committee meetings from the September board meeting. Take the time to watch these clips, they are packed with detailed information.CalSTRS CIO, Chris Ailman, talks in the third clip below, well worth listening to his insights.