On one of the last snowy days of the season in early March, Michael Trotsky is sitting in the offices of The Massachusetts Pension Reserves Investment Management Board (PRIM) in downtown Boston along with his colleague, Michael Bailey, reflecting on the last 12 months.
“We had a good year in private equity,” says Trotsky, who is executive director and chief investment officer at the $60 billion pension plan. “We’re very proud of this performance.”
The performance to which he refers comprises a 16.5 percent return from the pension’s private equity programme in 2015. A good year comes on the back of a good decade for PRIM. In December, the American Investment Council published a ranking of 155 US public pensions that placed the Massachusetts Pension Reserves Investment Trust (PRIT) first among its peers based on the performance of its private equity programme. PRIT Fund’s 10-year private equity return stood at 17.93 percent net of management fees and carry as of June 2014, compared with a median 10-year annualised return of 12.1 percent.
Trotsky and Bailey, who oversees the pension’s private equity programme, attribute their success in private equity to several factors: the programme’s long-term and consistent approach to the asset class, the distinctive way it conducts due diligence, and its ability to adapt to an increasingly competitive market by focusing on smaller managers.
PRIM began investing in private equity in the mid-1980s and has been consistent in the types of managers it backs.
Mass PRIT, which had $59.6 billion in net asset value as of 31 December 2015, has had a 10 percent allocation to private equity since Trotsky joined about five years ago. Over the years, it has built a robust and mature private equity portfolio including many of the top-tier, blue chip general partners in the buyout and venture capital world, such as The Blackstone Group, Charterhouse Capital Partners, Bain Capital, Apollo Global Management, CVC Capital Partners, TA Associates, Polaris Venture Partners and Union Square Ventures.
In compiling its programme, PRIM has made a virtue of patience, putting more emphasis on managers who have been disciplined in waiting for valuations to reach attractive levels before investing capital.
“What we’re worried about is that more and more money seems to be chasing private equity, so it’s more and more important to be with the top performers,” Trotsky says. “Many of our colleagues around the country are allocating more to private equity; that’s a change. It makes the bidding more competitive. Valuations are a little stretched so we think it is incumbent upon us to identify managers with discipline at this stage.”
This is particularly true in the distressed debt space, where timing of investments is fundamentally important, says Bailey. PRIM has a 4 percent target allocation to distressed debt, in addition to the 10 percent to private equity. It has been running behind on that 4 percent target for the past five years as the pension plan recognises the cyclicality of distressed debt investing and does not want to force its distressed debt managers to buy into an unattractive market. As financing conditions are deteriorating, at least in some sectors such as energy, dealflow is picking up.
“Distressed debt managers are poised for that point in the cycle when there really is a lot of fear of failure. The last three years have not been a great time; there hasn’t been a lot of default,” says Bailey.
PRIM had already committed capital to distressed debt funds in recent years but has a fair amount of unfunded commitments with GPs. As the cycle is turning, it plans to commit a little more this year to the strategy.
Another attribute of PRIM’s distinct private equity programme is the way it conducts due diligence. The pension runs a parallel process, identifying the managers it wants using in-house resources and using feedback from its private equity consultant, Hamilton Lane, to finalise manager selection.
“We identify the managers and the characteristics of the managers we’re looking for and conduct the due diligence process, in which our staff sources and conducts due diligence on managers and separately our investment consultant Hamilton Lane does their own analysis in parallel,” says Trotsky. “Only if the two meet together at the end and agree on a manager do we move forward. I have a philosophy: the day you outsource your thinking is the day you should go home.”
What is now internally called “the private equity model” of selecting managers has been so successful since the CIO joined that PRIM has decided to replicate it in its other asset classes, such as public markets.
Prior to Trotsky’s arrival at PRIM, the investment team used to send a request for proposal and passively wait for responses before picking the best equity managers. As it has become increasingly difficult to find public equity managers that outperform the market, the process has become outdated and inefficient.
With a desire to be more proactive, the pension plan modified its process with the private equity model in mind. It first identifies strong candidates based on a set of criteria developed internally. Once PRIM identifies managers whom it thinks fit its needs, it calls them to inform them of the upcoming RFP and encourages them to respond.
It then conducts due diligence in parallel with Callan Associates, its investment consultant for public equities, before making a final decision.
“At the end, this parallel process makes for a very productive conversation,” Trotsky says. “Our consultant may not have known about the manager. They may see risks that we don’t see, or vice versa. We have more intelligent conversations about manager selection.”
FOCUS ON THE SMALL
While its private equity portfolio may be mature, PRIM is constantly trying to adapt to the evolving landscape of the asset class. The private equity space has become more competitive and entry valuations have been elevated for several years.
By early 2015, buyout funds were paying more than 10 times EBITDA on average in the US, surpassing the elevated multiples of 2007 prior to the financial crisis, according to Bain & Company’s recent global private equity report. To make sure that returns remain robust, the pension plan has studied characteristics of strong performing private equity firms to find commonalities. One of the findings that has come out of the internal research is that smaller firms offer outperformance.
“For the past few years we’ve been focused on smaller private equity organisations, rather than mega buyouts or venture capital,” says Trotsky, explaining that Bailey and his team concluded from their own research that smaller GPs investing in smaller companies have the ability to buy at lower valuations, leaving more room for value creation through operational work.
“If we own both small and large GPs, we maintain balance in the portfolio,” he says. “If we only commit to one of the two, we may not have sufficient diversification.”
In order to assemble the manager line-up of its choosing, PRIM has had to be willing to pay the price to secure a spot with the best performing GPs. “We don’t like paying high fees more than anybody else does, but we’re happy to pay high fees for demonstrated skills,” says Trotsky.
That being said, PRIM has also been focusing on curbing fees and costs where appropriate, a common phenomenon among US public pension plans. Efforts to cut fees have fallen under a large programme called Project Save.
The most successful part of this project has revolved around hedge funds, where PRIM has been able to lower fees in the underlying funds and change the way it is investing, moving away from a hedge fund of funds model to a direct investing model. As a result it is saving more than $40 million a year.
A part of the private equity component of Project Save has focused on co-investments, in which fees and carried interest are typically either lower than the typical 2 percent and 20 percent, or not applicable at all. PRIM is not the only US public pension plan to use co-investments to lower fees, but its approach stands out.
Most LPs are taking an active role in the due diligence process when co-investing, hiring teams of analysts to assess the opportunities that land on their desk. The California Public Employees’ Retirement System, for example, hired Mahboob Hossain a little over a year ago to lead the pension plan’s four-person co-investment team.
PRIM, however, is taking a slightly more “fast-track” approach. When it set up its co-investment programme about a year ago, it looked carefully at its existing private equity managers and picked the ones with track records of successful co-investments.
When presented with a co-investment opportunity by the pre-qualified general partner, it typically approves it as long as it falls within the pre-approved parameters. “We don’t need any lengthy approval process,” says Trotsky. “We’re not second-guessing their analysis and it’s a very quick turnaround. That’s a competitive advantage in co-investments.”
In addition to reducing fees, the pension plan sees co-investments as an effective way to put more money to work with the best performing firms, especially at a time in private equity when the most sought-after GPs are raising funds in a matter of months and are typically oversubscribed.
“Sometimes we don’t receive as much as we’d like in fund allocations, so one way to get additional [exposure to] those firms is to co-invest,” Bailey says.
The pension can add capital with its best performing private equity managers at favourable fee structures. “We’re already investing in the transactions through the fund, so the capital we’re committing really has great risk-return characteristics. It’s a win-win because we can provide capital to managers, it deepens our relationship with them, and we put some assets on the balance sheet that we have a lot of conviction in already.”
Co-investments have also been a tool to address the denominator effect, which recently raised its head following the global stock market sell-off. The pension can scale back the capital allocated to co-investment if it needs to slow the pace of investment.
For the same reason, the pension has also recently slowed the pace of its primary fund commitments. PRIM committed $1.8 billion to private equity last year, and lowered the amount to $1.4 billion for 2016.
“Our outlook has not changed; we just have to compensate for the denominator effect,” says Trotsky. “Right now we’re running a little bit over-allocated in terms of private equity because of its relative strength.”
The actual allocation to private equity was 11.4 percent as of 31 December.
As the tide seems to be turning in the economy, Trotsky and Bailey recognise that exits are dwindling and cash distributions have actually already slowed down, but they believe that on the flip side, buying opportunities will likely increase, at least as long as credit market conditions remain benign.