ASSET CLASS

An abundance of papers, purposefully organised in neat rows and layers, cover the surface of Réal Desrochers' desk.

Within minutes of sitting down at a small table in his Sacramento office, its round surface also becomes home to a stack of charts, graphs and reports as Desrochers talks animatedly about CalSTRS' private equity programme.

“You can spray and pray, which means you invest in everything that moves and hope that's going to work, or you can be very selective,” says Desrochers, director of alternative investments for the US' second-largest pension fund. “We're not going to spray and pray, we're going to take a bigger bet with a smaller number of people, and they'd better be good, they'd better be tier one.”

The bet he refers to is a hefty one. The $170 billion (€123 billion) pension allocated six percent of its capital to private equity last year; in the past five years it has been gradually climbing towards a nine percent target. Or, perhaps the word ‘ambition’ might be more appropriate. “We're not target chasers,” Desrochers points out. “We try to be good investors.”

By the end of May, CalSTRS had committed nearly $30 billion across 254 funds and 106 general partners. For the fiscal year ended in June, the pension's private equity portfolio – which includes buyout, special situations, distressed debt and venture capital allocations – returned 27.6 percent.

CalSTRS chooses GPs carefully, using a three-tier ranking system that Desrochers instituted when he arrived at the organisation 10 years ago, after having been head of international private equity for Canada's largest pension, La Caisse de dép^t et placement du Québec.

Desrochers walks out of his office briefly and returns with a huge three-ring binder – easily five inches thick – containing the scorecards of private equity fund managers. “This is volume one of three,” he says.

FIVE FACTORS
Every six months, CalSTRS' alternatives team scores fund managers based on five main factors: the fund's performance accounts for 30 percent of the score; alignment of interest, 25 percent; continuity and history of management team, 20 percent; investment strategy and pace, 15 percent; and strategic fit with CalSTRS' portfolio, 10 percent.

“I believe there are people that are very good, middle of the road or new, and people that have proved you don't want to be an investor with them,” Desrochers says. “We tend to re-up with the managers that are tier one, and over the last four or five years we've taken on maybe 10 to 15 new managers.”

The first-time funds in which CalSTRS invests tend to be led by people with whom the pension has previously worked, such as the Angelo Gordon and Blackstone spin-out Centerbridge Partners, or Shasta Ventures, founded by veterans from NEA, Battery Ventures and Trinity Ventures.

The funds in which CalSTRS would not invest, Desrochers says, are typically characterised by a lack of alignment of interest. Red flags go up if GPs commit little or no capital to their own funds, if carry is not shared appropriately among a team, and if vesting periods are too short.

In terms of how much CalSTRS would like a GP to commit to its fund, “there is no magic answer”, he says. “It's a changing world. There are people in America that are raising [multi-] billion dollar funds that just collect a billion dollars for themselves [in management fees] and they only put $200 million in their fund – what does that tell you?”

There is also no catch-all answer regarding the appropriate level of carry, but in order for a fund manager to retain its top talent, the profits must be shared fairly, he says. “It's not a communist regime, but if you go into a partnership and the top guy takes 70 percent of the carry, to me, that's a problem. It has to benefit the team.”

In addition to its normal commitments to private equity funds, CalSTRS has been co-investing with big buyout firms like The Blackstone Group and TPG for roughly seven years. Its $1 billion co-investment portfolio contains about 40 co-investments of up to $125 million each with partners they “know and like”, Desrochers says.

“The programme has served CalSTRS very well,” Desrochers says. “We always co-invest where we pay no fee, no carry. We look at who is presenting the co-investment: do they have a conflict, does it fit in the portfolio, what is the exposure, do we have the time, do we have the expertise, do we have an appetite?”

Of CalSTRS' 13 alternative investment professionals, three are dedicated to the pension's secondary and coinvestment programme. The team also includes a student from the University of California, Davis – one of several MBA students enrolled in the pension's internship programme.

Desrochers estimates that CalSTRS has recently passed on about a dozen co-investment opportunities. And the pension has halted co-investments with venture firms, he adds. “We realized it's not for us, there's too much risk,” he explains.

IRR IRRELEVANT
Whether it's a co-investment or a fund commitment, CalSTRS expects to double its money.

“Two times the money is what we want for a return – cash on cash, I don't talk about IRR,” Desrochers says. “I always say to the board, if you go the grocery store, what do they want, cash or IRR?”

He continues: “Everybody's talking IRR, [but] we know you can manage your IRR. If you're smart, if you've been in the business long enough, you know how to work your IRR.”

Though CalSTRS sits on nearly every advisory board for funds to which it commits, its staff spend half their time globetrotting to conduct due diligence, and meticulously report back findings and progress to the pension fund's bi-weekly investment committee review. Simply attending a fund manager's advisory board meeting is not sufficient research, Desrochers says.

At an advisory board meeting, “you smoke a big cigar and have a good glass of wine. This is not where you manage your portfolio,” Desrochers says.

He adds: “I'm not very generous when I say that, because the advisory board is a phenomenal way of meeting people and building networks in the industry and getting to know your colleagues, your peers. So you hear gossip – but hearing gossip doesn't make it reality.”

Abundant due diligence coupled with discipline and diversification characterises the strategy behind CalSTRS' alternatives program, Desrochers says. “We're the three Ds,” he chuckles.

TAXING TIMES
Due diligence is set to continue increasing as the private equity landscape changes. Possible impacts will need to be studied with respect to proposed Federal bills that would increase taxes on carried interest and publicly traded partnerships. The management IPO trend in general also needs to be carefully examined, Desrochers says.

CalSTRS' chief investment officer Christopher Ailman has spoken out against the trend toward management IPOs, but the pension fund has yet to take an official position.

The concern Ailman has expressed “is that it distracts the GP from their normal business, and I think common sense says he is right,” Desrochers says. “It's not a corporate view, but he is our chief investment officer, so that's important.”

“On the contrary: to be on the Goldman exchange or to be public brings its own sets of governance,” he says, noting that, like them or not, management IPOs are likely to continue.

“I think this is a bigger market [today], it's going to grow, and you're going to have large-cap and mid-cap public [firms]. I think this is where it's going, no matter what,” he says.

Publicly floated private equity firms are nothing new Desrochers adds, citing European buyout shops like Candover and US investment banks with private equity arms, such as Goldman Sachs.

“People on this side of the Atlantic are talking as if they've discovered this great new thing, but it's nothing new,” he says.

Desrochers notes that another “natural progression of the industry” is for large LPs to purchase minority stakes in private equity firms, such as the 5.5 percent stake in Carlyle Group that CalSTRS' crosstown rival, the California Public Retirement System, purchased in 2001, or the Chinese government's recent acquisition of a 10 percent interest in The Blackstone Group.

As CalSTRS has been approached several times recently regarding such private placements, “we have changed policy to do just that”, Desrochers says.

BUY, SELL, MANAGE
Two other significant policy changes took place at CalSTRS' July investment board meeting: approval was granted for co-investing globally, and also for the sale of various assets in its portfolio.

“All of these big portfolios, to my knowledge, were built on the assumption that you buy. And now there's a clear phenomenon that you can buy and sell and manage your portfolio,” Desrochers says.

After nearly two decades of building up a diverse portfolio of alternative assets, he says, “the sum of the bottom line of this portfolio is greater than the individual parts. It would be natural to consider how we can monetize the sum of the parts.”

It's also a logical move considering Desrochers' observation that “around the world, people want to have better exposure to alternatives. They have provided better risk-adjusted returns, and also I think they are less volatile because they're non-market.”

There can be downsides to investing in private equity, he admits. “There are a lot of politics involved, that's the first thing that pops to mind,” Desrochers says. “And the politics are different for each market segment.”

Cons also include higher risk “because it has standard deviation of 30 to 35 percent if you take it as a whole.” Also he says: It's a new industry; and there's a lot of press. The compensation of people is extraordinary compared to other asset classes, so it attracts a lot of attention sometimes.”

But the most important upside can't be overlooked, he stresses. “If we didn't cap the allocation to alternative assets, the whole fund would be invested in there because of the returns,” Desrochers explains. “We've been very successful.”

Desrochers walks out of his office briefly and returns with a huge three-ring binder – easily five inches thick – containing the scorecards of private equity fund managers. “This is volume one of three,” he says.

FIVE FACTORS
Every six months, CalSTRS' alternatives team scores fund managers based on five main factors: the fund's performance accounts for 30 percent of the score; alignment of interest, 25 percent; continuity and history of management team, 20 percent; investment strategy and pace, 15 percent; and strategic fit with CalSTRS' portfolio, 10 percent.

“I believe there are people that are very good, middle of the road or new, and people that have proved you don't want to be an investor with them,” Desrochers says. “We tend to re-up with the managers that are tier one, and over the last four or five years we've taken on maybe 10 to 15 new managers.”

The first-time funds in which CalSTRS invests tend to be led by people with whom the pension has previously worked, such as the Angelo Gordon and Blackstone spin-out Centerbridge Partners, or Shasta Ventures, founded by veterans from NEA, Battery Ventures and Trinity Ventures.

The funds in which CalSTRS would not invest, Desrochers says, are typically characterised by a lack of alignment of interest. Red flags go up if GPs commit little or no capital to their own funds, if carry is not shared appropriately among a team, and if vesting periods are too short.

In terms of how much CalSTRS would like a GP to commit to its fund, “there is no magic answer”, he says. “It's a changing world. There are people in America that are raising [multi-] billion dollar funds that just collect a billion dollars for themselves [in management fees] and they only put $200 million in their fund – what does that tell you?”

There is also no catch-all answer regarding the appropriate level of carry, but in order for a fund manager to retain its top talent, the profits must be shared fairly, he says. “It's not a communist regime, but if you go into a partnership and the top guy takes 70 percent of the carry, to me, that's a problem. It has to benefit the team.”

In addition to its normal commitments to private equity funds, CalSTRS has been co-investing with big buyout firms like The Blackstone Group and TPG for roughly seven years. Its $1 billion co-investment portfolio contains about 40 co-investments of up to $125 million each with partners they “know and like”, Desrochers says.

“The programme has served CalSTRS very well,” Desrochers says. “We always co-invest where we pay no fee, no carry. We look at who is presenting the co-investment: do they have a conflict, does it fit in the portfolio, what is the exposure, do we have the time, do we have the expertise, do we have an appetite?” Of CalSTRS' 13 alternative investment professionals, three are dedicated to the pension's secondary and co-investment programme. The team also includes a student from the University of California, Davis – one of several MBA students enrolled in the pension's internship programme.

Desrochers estimates that CalSTRS has recently passed on about a dozen co-investment opportunities. And the pension has halted co-investments with venture firms, he adds. “We realized it's not for us, there's too much risk,” he explains.

IRR IRRELEVANT
Whether it's a co-investment or a fund commitment, CalSTRS expects to double its money.

“Two times the money is what we want for a return – cash on cash, I don't talk about IRR,” Desrochers says. “I always say to the board, if you go the grocery store, what do they want, cash or IRR?”

He continues: “Everybody's talking IRR, [but] we know you can manage your IRR. If you're smart, if you've been in the business long enough, you know how to work your IRR.”

Though CalSTRS sits on nearly every advisory board for funds to which it commits, its staff spend half their time globetrotting to conduct due diligence, and meticulously report back findings and progress to the pension fund's bi-weekly investment committee review.

Simply attending a fund manager's advisory board meeting is not sufficient research, Desrochers says.

At an advisory board meeting, “you smoke a big cigar and have a good glass of wine. This is not where you manage your portfolio,” Desrochers says.

He adds: “I'm not very generous when I say that, because the advisory board is a phenomenal way of meeting people and building networks in the industry and getting to know your colleagues, your peers. So you hear gossip – but hearing gossip doesn't make it reality.”

Abundant due diligence coupled with discipline and diversification characterises the strategy behind CalSTRS' alternatives program, Desrochers says. “We're the three Ds,” he chuckles.

TAXING TIMES
Due diligence is set to continue increasing as the private equity landscape changes. Possible impacts will need to be studied with respect to proposed Federal bills that would increase taxes on carried interest and publicly traded partnerships. The management IPO trend in general also needs to be carefully examined, Desrochers says.

CalSTRS' chief investment officer Christopher Ailman has spoken out against the trend toward management IPOs, but the pension fund has yet to take an official position.

The concern Ailman has expressed “is that it distracts the GP from their normal business, and I think common sense says he is right,” Desrochers says. “It's not a corporate view, but he is our chief investment officer, so that's important.”

The evolution is, however, natural for a relatively young industry, and the trend toward public floats may not be all bad, Desrochers adds.

“On the contrary: to be on the Goldman exchange or to be public brings its own sets of governance,” he says, noting that, like them or not, management IPOs are likely to continue.

“I think this is a bigger market [today], it's going to grow, and you're going to have large-cap and mid-cap public [firms]. I think this is where it's going, no matter what,” he says.

Publicly floated private equity firms are nothing new Desrochers adds, citing European buyout shops like Candover and US investment

banks with private equity arms, such as Goldman Sachs.

“People on this side of the Atlantic are talking as if they've discovered this great new thing, but it's nothing new,” he says.

Desrochers notes that another “natural progression of the industry” is for large LPs to purchase minority stakes in private equity firms, such as the 5.5 percent stake in Carlyle Group that CalSTRS' crosstown rival, the California Public Retirement System, purchased in 2001, or the Chinese government's recent acquisition of a 10 percent interest in The Blackstone Group.

As CalSTRS has been approached several times recently regarding such private placements, “we have changed policy to do just that”, Desrochers says.

BUY, SELL, MANAGE
Two other significant policy changes took place at CalSTRS' July investment board meeting: approval was granted for co-investing globally, and also for the sale of various assets in its portfolio.

“All of these big portfolios, to my knowledge, were built on the assumption that you buy. And now there's a clear phenomenon that you can buy and sell and manage your portfolio,” Desrochers says.

After nearly two decades of building up a diverse portfolio of alternative assets, he says, “the sum of the bottom line of this portfolio is greater than the individual parts. It would be natural to consider how we can monetize the sum of the parts.”

It's also a logical move considering Desrochers' observation that “around the world, people want to have better exposure to alternatives. They have provided better risk-adjusted returns, and also I think they are less volatile because they're non-market.”

There can be downsides to investing in private equity, he admits. “There are a lot of politics involved, that's the first thing that pops to mind,” Desrochers says. “And the politics are different for each market segment.”

Cons also include higher risk “because it has standard deviation of 30 to 35 percent if you take it as a whole.” Also he says: It's a new industry; and there's a lot of press. The compensation of people is extraordinary compared to other asset classes, so it attracts a lot of attention sometimes.”

But the most important upside can't be overlooked, he stresses. “If we didn't cap the allocation to alternative assets, the whole fund would be invested in there because of the returns,” Desrochers explains. “We've been very successful.”