Texas ties the knot

The Teacher Retirement System of Texas now has a permanent allocation to KKR and Apollo. It’s the kind of super-long-term marriage of which the private capital market should expect to see more, and which will alter the landscape of the asset class.

Last month, Texas Teachers revealed an agreement that will see Kohlberg Kravis Roberts and Apollo Global Management each take charge of roughly $3 billion in private market allocations. The mandates are discretionary, flexible with regard to underlying investment strategy, and “recyclable,” meaning that cash distributions produced by the investment activities can be put back into new deals without KKR and Apollo needing to go through the typical follow-on fundraising rigmarole.

These partnerships crystalise a number of trends, among them – investors wanting fewer, deeper GP relationships; investors continuing to be ga-ga about private market opportunities; and many of them having the luxury/challenge of extremely long-term investment objectives.

As a KKR statement made clear, the deal with Texas Teachers is “subject to the negotiation of definitive documentation”. Indeed, even more interesting than the broad contours of these arrangements will be their to-be-determined details and impact on the market.

Anyone with a stake in the private capital markets should be interested in the following questions to rise from the Texas deal:

Fees – a fund-formation lawyer I know says that as soon as the Texas deal was announced, he began fielding calls from contacts and reporters who all had the same question: What are the terms and conditions? The partnership with KKR is described as a “customised, incentive-based arrangement”. Certainly some form of carried interest will be applied to the fund commitments, but how about direct investments? A Pensions & Investments article reports that the arrangement with KKR will pay incentive fees based on “aggregate performance” rather than on a fund-by-fund basis.

As for management fees, it could be argued that the evergreen nature of the capital requires an entirely new formula. The public market shareholders of KKR and Apollo should be particularly interested in these details, as fee collection has been billed as a major selling point of these franchises. If fundamentally lower fee arrangements are being locked into evergreen relationships, the value of KKR and Apollo shares are different – not necessarily diminished, but different.

Deal selection – Texas describes a benefit of the partnership with KKR as giving the pension access to “the best ideas of KKR”. The press release alludes to a system of “idea sharing between the staff at Texas Teachers” and KKR, notwithstanding the discretionary mandate. This raises a few questions, among them – will KKR be allocating Texas capital to funds and direct opportunities based entirely on the needs of Texas? How will these objectives be weighed against the objectives of other KKR clients as well as the goals of KKR itself? If, for example, the broader Texas Teachers portfolio is overweight in natural gas assets, but a KKR “best idea” is a massive bet on a natural gas platform, does Texas capital get excluded? Is it even KKR’s job to worry about what else is in Texas’ portfolio?

Likewise, with each investment opportunity around the world requiring a finite amount of equity, how will KKR and Apollo apportion the equity among their funds and the increasing population of co-investors and “customised-account” partners with which they have relationships?

Consolidation – Not every large investor will adopt an approach like Texas Teachers, but many of them will move toward private-market programs that favor broad relationships with firms that invest in every geography, sector and strategy around the world. This trend naturally favours the largest firms with the most diversified platforms. It may encourage an otherwise rarely seen phenomenon – private equity firms merging with each other. For the most part, a large, diversified private equity franchise has no interest in acquiring a smaller, specialised firm, and vice versa. But if a massive investor wants global diversity through a handful of GP names, this may be enough of an impetus for larger firms to fulfil investor needs by stamping their brands on managers active in specialised strategies. If the fundraising market remains as brutal as many expect, running into the arms of a mega-firm will become a more attractive alternative for talented but struggling franchises.