How Rhode Island plans to use secondaries to boost its PE exposure

PEI speaks with senior investment officer Jonathan Popielarski about the types of fund stakes the US pension wants to buy so it can hit its 11% target allocation.

Rhode Island State Investment Commission plans to ramp up its use of the secondaries market in a bid to increase its overall private equity exposure.

The $8.26 billion US pension will use the acquisition of LP fund commitments to build almost 20 percent of its private equity exposure, senior investment officer Jonathan Popielarski told Private Equity International. Rhode Island has a strategic target allocation of 11.25 percent by 2022.

“We are going through this big increase right now, and through secondaries we can backdate some of our investments to add diversification,” Popielarski said.

The pension system will take an opportunistic approach, investing in LP interests in both new and existing funds with its GPs as well as funds of GPs with which it does not have relationships.

Non-traditional buyers such as pension funds and sovereign wealth funds are becoming increasingly active on the secondaries market. Pensions accounted for 6 percent of buyers last year, the third biggest buyer type after secondaries funds and funds of funds, according to intermediary Setter Capital’s Volume Report FY 2018.

As Rhode Island does not co-invest alongside its managers – a strategy LPs often use to build stronger relationships with managers – it is hoping an increase in secondaries activity could do the same job.

“If we are invested [with] GPs in their Funds III and IV, there might be an opportunity to increase exposure in their Funds II and I, and it can make us interesting [partners] for new primary commitments,” Popielarski said.

If a market downturn leads to a public market selloff, some investors might find themselves over-allocated to private equity and need to sell for liquidity or mandate changes, he added.

“We actually have a bit of investment capacity that we can use to our advantage and maybe buy discounted secondaries of high-quality managers,” Popielarski said.

Popielarski added that the pension had recently developed its secondaries strategy process and does not know yet what sorts of dealflow opportunities will present themselves. There are no plans to sell funds stakes on the secondaries market, he said.

Secondaries is the latest method Rhode Island has adopted to expand its private equity portfolio. The pension, which has invested in private equity since 1989, undertook an asset allocation study in 2015 and as a result increased its target allocation to the asset class to 11.25 percent from 7 percent.

The pacing target for the $539 million private equity portfolio also accelerated from as much as $125 million per year to as much as $285 million; commitment sizes increased from a range of as much as $30 million to as much as $50 million.

“We want to ramp up our PE, but not all at once. We can’t necessarily time markets and don’t want to do a whole bunch right now, and then [find] it turns out to be a terrible vintage year,” Popielarski said.

Narrowing the focus

To meet the pacing target, Rhode Island is also focusing on making primary commitments to lower and mid-market funds as well as sector specialists.

“For most of PE history, relative to larger markets, there has been an arbitrage opportunity where you have been able to buy lower and get a higher price later. I feel like we are in an environment where this seems less likely,” Popielarski.

The lower mid-market may have more inefficiencies relative to larger markets, and transactions are less competitive and less intermediated, he added. Focusing on lower and mid-market funds of between $225 million and $300 million in size enables the pension system to take seats on GPs’ advisory boards, which comes with greater governance rights and better alignment.

Sector-focused funds the pension is eyeing include technology, healthcare, energy services and agri-business funds.

“On the deal origination front I find sector-focused funds are a lot more proactive and sometimes it is easier for them to deal with headwinds related to that industry,” Popielarski said.

Building GP relationships

While Rhode Island works closely with its investment consultant Cliffwater, which is helpful with operational and legal paperwork, the staff undertakes a significant amount of due diligence itself and works to build direct relationships with GPs, Popielarski added.

Rhode Island typically invests from Funds III or IV onward, when a team has been together for a while and has had some realisations in their portfolios. However, it establishes relationships with managers long before that.

“We might track our managers for two to three years, do phone-calls, pop into their office, and really try to understand their strategy and the kind of deals they do,” Popielarski said.

Rhode Island had committed $1.5 billion across 45 GPs and 78 active funds as of 30 September. Many of these are older commitments the staff is monitoring.

The pension system is concentrating on a core group of 25 managers. While re-ups and new commitments are roughly split 50:50, that ratio will change to 60:40 as re-ups gather a larger share, Popielarski said.

Rhode Island’s private equity portfolio returned 12.2 percent over 10 years and 9.6 percent since inception, as of 31 March, according to pension documents.