CalSTRS Looking to Beef Up Private Equity

Alicia McElhaney of Institutional Investor reports that CalSTRS is looking to cut public equity allocation in favor of private markets:
The California State Teachers’ Retirement System is moving money from public to private markets as a part of an updated asset allocation strategy.

CalSTRS plans to decrease its allocation to the public equities market by eight percentage points to invest more money in private equity, real estate, and what the retirement system calls “inflation-sensitive real assets.”

This move follows a decision by CalSTRS’s peer, the California Public Employees’ Retirement System, which increased its private equity commitments by $1.4 billion during fiscal year 2018-2019. CalPERS would need to commit another $10 billion per year to stay on track with its allocation target, plan documents showed.

While CalSTRS isn’t making such a drastic change, the move nonetheless marks a shift. The CalSTRS board’s plans to change its long-term allocation strategy were approved in November, but at January 30 meeting, board members discussed how to implement those changes.

CalSTRS plans to decrease its public equities allocation from 50 percent, which was the allocation on November 1, 2019, to 42 percent, according to the plan revision.

Doing so will allow the plan to increase its allocation to private equity from 9.4 percent to 13 percent. The retirement system will increase its allocation to real estate from 13.9 percent to 15 percent, the plan revision shows.

CalSTRS also plans to increase its allocation to inflation-sensitive real assets from 2.7 percent to 6 percent, an increase of 3.3 percentage points, the plan revision shows. This asset class includes global inflation-linked bonds and securities and infrastructure investments, according to the plan revision.

“CalSTRS has learned from experience that setting a rigid timeline is inefficient as investment opportunities ebb and flow and do not follow a calendar time frame,” the plan documents stated.

To solve for that, CalSTRS said it would make these changes in slow steps, at the recommendation of its consultant, Meketa Investment Strategies, the plan revision shows. For instance, it plans to gradually decrease its public equity allocation from 51 percent to 49 percent, then to 47 percent, and so on.

“If investment opportunities present themselves then staff will move quicker,” according to the plan revision. “However, if a steady allocation is more prudent, such as the allocation to private equity, where time diversification is critical, then an opportunity-based approach is more appropriate.”

A spokesperson for CalSTRS declined to comment on its allocation strategy.
I read CalSTRS's Investment Committee Item Number 4 which describes the proposed changes in detail.

Below, you will find CalSTRS proposed long-term asset allocation policy:

This represents the following changes to the current asset allocation:

Interestingly, CalSTRS plans on implementing these changes in steps, stating the following:
The next step in the process is to plot a course from the current asset allocation to the new long-term target. CalSTRS has learned from experience that setting a rigid timeline is inefficient as investment opportunities ebb and flow and do not follow a calendar time frame. Therefore, the implementation plan is expressed in “Steps” toward the long-term target. If investment opportunities present themselves then Staff will move quicker, as has been demonstrated in the past with the shift to a true global equity portfolio and the funding of the Risk Mitigating Strategies. However, if a steady allocation is more prudent, such as the allocation to Private Equity, where time diversification is critical, then an opportunity-based approach is more appropriate.

The Implementation Plan:

Staff and the Consultant will regularly monitor the asset allocation and will make recommendations to shift the Policy Targets at quarter end where appropriate. As the target allocations are adjusted, the Total Fund benchmark will also change for performance measurement purposes.
So what are my thoughts? I agree with CalSTRS, it's time to cut Public Equity exposure and invest more in Private Equity (primarily), Real Estate and Inflation Sensitive assets which include infrastructure investments and inflation-sensitive bonds.

Is CalSTRS calling a top in the stock market? No, it isn't but it's definitely paying attention to the stock market and the Fed and thinking now is as good a time as ever to start scaling back from public equities and go into private markets because when this liquidity-driven, central bank backstopped rally comes to an abrupt end, it won't be pretty.

In essence, CalSTRS is looking at what Canada's large pensions have done and it's aiming to implement a similar asset mix where the emphasis is squarely on private markets.

But taking the allocation in Private Equity from 9.4% to a long-term target of 13% sounds a lot easier than it actually is.

In my last comment, I discussed how private equity is falling short of expectations for many state plans that rely primarily on funds investments.

CalSTRS isn't immune to this trend. Recall, back in November, it reported a big drop in carried interest.

Fund returns are coming down and that's not the only problem. As state pension funds grow, they're finding it increasingly harder to maintain a sizeable allocation to private equity through funds.

The problem? Unlike Canada's large pensions, US state pensions don't have the internal resources to develop a large fund and co-investment program or do any purely direct investments internally.

Canada's large pensions have developed extensive co-investment programs to maintain or increase their PE allocation and reduce overall fee drag.

Now, one year ago, CalSTRS stated it wanted to double its co-investments over the next five years:
The investment staff of the California State Teachers’ Retirement System (CalSTRS) wants to double the number of co-investments in the system’s approximate $18 billion private equity program in the next two to five years, adding 15 new staffers and possibly opening an office in San Francisco to handle the additional investments.

The West Sacramento-based pension’s plan to build its private equity program is contained in agenda material for its January 30 investment committee meeting. The investment committee is being asked to approve CalSTRS’s strategic direction in efforts to expand the private equity program, the pension system’s best-producing asset class over the short and long term.

CalSTRS’s overall private equity returns for the one-year period ending March 31 (2019) totaled 15.5%, the largest return of any asset class.

CalSTRS currently has 8.1% of its overall portfolio devoted to private equity, but its long-term target is 13%.

CalSTRS investment officials see co-investments as a way to get to that target. Co-investments only account for a small part of the plan’s private equity portfolio, around 5%, said a September report from the Meketa Investment Group, which serves as a CalSTRS investment consultant.

The new January 30 plan said that over the last two calendar years, the CalSTRS private equity program has made new commitments of approximately $6 billion to $7 billion a year with co-investments representing approximately 8% to 9% of total new commitments.

The plan says private equity’s current team of 23 professionals, 18 who specialize in investments and five operational personnel, are at capacity for the current investment pace and that an additional 15 hires are needed to at least double co-investments.

CalSTRS paid more than $500 million in management and profit-sharing fees to its private equity general managers in calendar year 2017, the most recent data available. The CalSTRS plan says that “increasing co-invest represents the most immediate, largest, and greatest opportunity to reduce costs and increase investment returns.”

Under co-investments, CalSTRS and other pension plans are offered additional stakes in portfolio companies acquired by private equity firms, often at little or no additional fees. This is usually in addition to the pension plan’s investment as a limited partner in a co-mingled fund with a general partner.

Officials of the $214.9 billion CalSTRS see co-investments as a possible entry point to make direct investments in private equity at a later point without external managers.

CalSTRS’s approach contrasts with that of its larger Sacramento neighbor, the California Public Employees’ Retirement System (CalPERS), which is proposing to invest $20 billion in additional private equity funds through two direct-style investment vehicles. One vehicle, called Innovation, would take stakes in late-stage companies in the venture capital cycle. The other vehicle, known as Horizon, would take buy-and-hold stakes in established companies. CalPERS currently has around $28 billion invested in private equity.

The CalSTRS plan says the competition for high-quality co-investment professionals “makes it advisable to budget for a higher average salary for such professionals” than existing personnel. It does not state, however, what the new staffers should be paid.

The plan also says that private equity investment staff to be hired for the expanded co-investment program “would be significantly enhanced by being located in a major financial center.”

It says that while public asset classes are largely research-oriented, private asset classes are more relationship-oriented.

“In major financial centers, investment professionals have more opportunities to interact and form relationships with other investors, lenders, investment bankers, consultants, advisors, regulators, lawyers, and operating company executives,” the plan says. “Such an ecosystem is more efficient and is likely to result in a higher level of knowledge, competitiveness, and overall flow of opportunity.”

The plan says San Francisco is an “obvious choice to consider” for the co-investment expansion because there are many general partners located in the Bay Area, including KKR, TPG, and GI. It also said that other major institutional investors, including Singapore’s GIC sovereign wealth fund and the Queensland Investment Corp., have placed private equity professionals in the Bay Area.

CalSTRS is the second-largest US fund by assets, surpassed only by the $345.6 billion CalPERS, which is No. 1.
I'm not sure how that plan is going but hiring people who are able to analyze co-investments quickly and diligently requires paying them properly and that poses a problem for a large state plan like CalSTRS because the state Treasurer meddles in its compensation policy.

Still, in order for CalSTRS and CalPERS to maintain and increase their allocation to private equity, they absolutely need to develop a strong co-investment program. And to do this properly, they need to hire qualified staff and pay them properly to retain them.

This is especially critical fro CalSTRS which like CalPERS, fell short of its target when it reported its fiscal year results back in July:
CalSTRS just missed its target rate for annual investment returns, recording 6.8 percent for the fiscal year ending June 30, according to a Tuesday news release.

The rate fell short of the $237 billion fund’s annual target of 7 percent, according to the release.

“It was a roller coaster year and a very challenging environment in which to generate returns,” said California State Teachers’ Retirement System Chief Investment Officer Christopher J. Ailman. “Thanks to the in-house expertise of our investment team, we were able to come very close to our assumed rate of return despite the instability of the market.”

The California Public Employees’ Retirement System, which has about $370 billion in assets, recently reported annual returns of 6.7 percent, missing its 7 percent goal.

Returns for both funds suffered amid a stock market slump in late 2018 and then climbed steadily through the first half of this year.

Low returns can cause the pension fund over to increase the amount of money they collect from their other two primary sources of income — payments from employers and from public employees.

But CalSTRS’ longer-term averages are higher. Its three-year average was 9.7 percent, its 5-year average was 6.9 percent and its 10-year return was 10.1 percent, according to CalSTRS figures.

A $5.1 billion cash infusion to the fund from the state budget this year will help limit costs for employers and the state, according to the release.

The fund is about 64 percent funded, according to the release, meaning it has 64 percent of what it would need to pay all current and future obligations to retirees.

The fund has a plan to increase the funded status to 100 percent by 2046. Teachers’ contributions increased from 2014 through 2018, and they now contribute just over 10 percent of their pay toward their pensions. School districts contribute about 18 percent. Districts’ rate will increase to about 19 percent next year and then drop back down to 18.2 percent, according to CalSTRS projections.

Looking forward, Ailman cited President Donald Trump’s tweets along with trade wars, Iran aggression, consumer sentiment and Brexit as “key risks to monitor.”
You can read CalSTRS funding plan here.

Needless to say, unless we see a massive resurgence of inflation over the next decade and long-term US Treasury rates above 6%, I think it's optimistic to claim CalSTRS, CalPERS or any other state plan suffering a wide pension deficit will achieve a fully funded status in 2046.

Yes, that's years away, but what happens in the interim (like a massive financial crisis and prolonged bear market) can easily screw up optimistic projections.

The only way I see CalSTRS, CalPERS and other US state pension plans from achieving a fully funded status is by massively increasing contributions and adopting conditional inflation protection. They also need to get the governance right to manage more public and private assets internally.

Below, you can view CalSTRS's Investment Committee meeting from November 2019 (Part 1 of 3). Fast forward to minute 9 to see discussion on Private Equity and achieving long-term targets.