How Arizona PSPRS plans to overhaul its portfolio

Arizona Public Safety Personnel Retirement System’s private equity portfolio is in for significant changes.

The $10.3 billion pension system is combining private equity, real estate and real assets into a single alternative assets pool, expanding its co-investment portfolio and increasing its focus on Asia to get a more efficient yield out of its private investments, chief investment officer Mark Steed told Private Equity International.

Last year, its $1.36 billion private equity portfolio returned an annualised 10-year return of 11.36 percent, propelling the pension system to the fifth spot in the ranking of public pension funds in the American Investment Council’s latest public pension study.

Massachusetts Pension Reserves Investment Trust took the top spot in the ranking for the second consecutive year with 13.63 percent private equity returns.

Private equity generated the highest returns among all asset classes for public pension systems; public equity returned 8.5 percent, while fixed income and real estate returned 4.8 percent for 10-year median annualized returns in 2018. The study examined the data of 165 US public pension funds. The reporting dates for the data ranged from 31 December 2016 to 31 January 2019, with most dates as of 30 June 2018.

Public pension plans have been increasing their allocations to private equity. Almost 30 percent of the funds in the study had an allocation of more than 10 percent, up from 24.5 percent in 2017.

Arizona portfolio managers are rotated across every asset class so they can learn about each and gain an informed opinion; thus each would have met with every private equity manager over a period of two years. “We can hone each other’s ideas, we challenge and debate each other,” Steed said. “There are a lot of intangibles that yielded these results.”

Steed told PEI that there is “no one factor” responsible for the success of Arizona’s private equity programme, pointing to the pension’s governance structure, flexible mandate, the internal team and its investment consultants StepStone Group and Albourne.

Arizona PSPRS’ new private markets portfolio will include buyouts, venture capital, opportunistic real estate and some operating companies in the oil and gas space. The pension system is re-assessing all its GP relationships.

“They have to compete for capital now,” Steed said. “We can get a more efficient yield out of our private market investments in this way.”

Arizona PSPRS will look to create four or five core relationships in each sub-asset class in the next few months. It will look for strategic relationships that include better fees and alignment, including fiduciary duties across multiple funds and investments, Steed said.

The team will review who is considered a core manager, and whether fund investments with non-core managers should be offered for sale through the secondaries market or allowed to run off.

Steed described the process of trimming the portfolio as a “cold, clinical review” of who the pension system considers is adding value and is a good partner.

“We have had these relationships, but we have to be as dispassionate as possible. I tell everyone here, ‘You can’t name the lobsters, because if you name them you can’t cook the lobsters.’ We are maniacal about not having these biases about managers.”

In part, the desire to reform the partnership model stems from the pension system’s belief that “decade-long growth across nearly all strategies and markets typically produces the type of wealth and hubris that creates conflicts of interest and economic misalignment between parties”, according to pension documents.

Increased co-investment programme

Arizona is expanding its co-investment programme from 10 percent of its private markets portfolio to 20 percent.

“We are scaling up our programme so that it becomes big enough to move the needle,” Steed said.

Arizona PSPRS began its co-investment programme in 2008 and reserves co-investment allocations when making primary fund commitments. Since the allocation is pre-approved, the pension system does not have to wait for board meetings for approval; this gives it flexibility to make quick decisions.

The pension system has allocated $1.8 billion to co-investments across private market strategies, of which $599 million had been committed as of 31 March. Private equity accounted for $256 million spread across 16 co-investments with an average commitment of $16 million; the other 18 investments accounted for $341 million and were spread across other private markets asset classes as of 31 March, according to pension documents.

Arizona PSPRS’ co-investments generated a net internal rate of return of 12.2 percent and a total multiple of 1.53x since inception in 2006, as of 31 March. Over the same period, the net IRR and net multiple of the private markets portfolio was 9.95 percent and 1.3x, respectively, documents show.

Another strategic focus for Arizona is to expand its Asia portfolio, as the pension system expects its non-US private equity strategies to generate the best returns, according to pension documents.

“Asia has helped protect our performance,” Steed said, adding that China was definitely a target, but the pension system is looking at other markets too.