The South Dakota Investment Council (SDIC) has long been a staunch proponent of large cap corporate buyout funds that command the interest of many of the biggest retirement systems in North America.
As the likes of the California Public Employees’ Retirement System have moved to pare back their limited partner relationships and focus on large buyout funds, the SDIC has consistently relied on an asset allocation strategy that chooses mega fund partnerships run by some of the world’s best-known buyout names: Blackstone, Cinven, Carlyle Group, CVC, KKR and Silver Lake.
Established in 1971 by the state legislature of South Dakota, SDIC now manages $11.5 billion in assets for the state’s 79,000 public pension members. Overseen by Matthew Clark, state investment manager, and Jim Means, chairman, it has an 11.6 percent allocation to private equity. Officials from SDIC were unavailable for comment as Private Equity International went to press.
What is unusual about the pension manager is that the bulk of its financial sponsor investments are focused almost entirely on large cap US and European buyout fund managers, including a pair of natural resource-focused funds managed by Riverstone Holdings and Carlyle Group. It also relies on internal management rather than external consultants to make allocation decisions.
While some LPs have sought to diversify their portfolios in areas like small cap, middle market and emerging markets, South Dakota’s exposure to new opportunities remains minimal.
Other larger pension systems have also launched emerging manager programmes aimed at newly formed and relatively small firms, with CalPERS among those rewarded by their ambition.
Without this diversity an LP can be left with an extremely concentrated and “constricted” investment portfolio, as one veteran fundraising professional told PEI.
“When you have a limited staff you can buy [big] brand names, but buying a brand name doesn’t ensure that you’re not going to have problems,” the executive said.
One such firm in SDIC’s portfolio is London’s Doughty Hanson, which is in wind-down mode and earlier this year abandoned fundraising efforts for its Fund VI.
Of the others, Blackstone commands the largest share of commitments by far with 2.8 percent, or $298.8 million, of SDIC’s assets allocated to the New York GP’s private equity partnerships. Committed investments in the firm’s buyout funds include $100 million in BCP VII, revealed in the minutes of SDIC’s April meeting, as well as earlier stakes in BCP V in 2004 and BCP VI in 2011. A further $50 million was committed to Blackstone Energy Partners II last year.
Among the next tier of fund managers are Silver Lake, to which it has committed 1.4 percent, or $149.2 million, and Cinven (1.1 percent; $117 million).
The problem with relying on large caps is that it eliminates the chance to enjoy returns from other market segments.
According to research by Oliver Gottschalg of Peracs, the private equity research group, and Ralf Gleisberg, of Akina, the advisory firm, large cap fund portfolios have underperformed those built from their small and mid-sized counterparts.
Published in May, the study of 771 mature European and North American primary buyout funds through the vintage years of 1998 to 2007 indicated that a portfolio balanced by small/mid-cap exposure was at less risk than one concentrated in a single market segment.
Large cap funds also offer a lower return dispersion than their smaller equivalents, as shown by the analysis that found the expected large cap average returns totalled 1.66x, compared with average small/mid-cap strategy returns, which yielded 1.72x. It is also telling that some large GP fund managers have gone downstream in their search for midmarket buyouts and better returns in recent years.
To be fair, SDIC has diversified its investments to Blackstone by making a strong commitment to the firm’s real estate funds with 12.1 percent, or $1.2 billion, put down. It has also invested in real estate funds run by Lone Star and Starwood Capital, among others.
SDIC’s members have unquestionably benefited from a commitment to private equity that dates back more than 20 years – PE partnerships saw an annualised internal rate of return, net of fees, of 9 percent between November 1995 and June 2014.
But, it remains to be seen whether the weighty concentration in big buyout funds will continue generating the same performance. By continuing to maintain its focus on the mega firm, the solid, long-term performance South Dakota has enjoyed may start to decline.