LP Radar: Kentucky Retirement cuts out middle man

When the Kentucky Retirement System (KRS) shared the results of a consultant’s report with its trustee board in early September, it revealed it had paid 75 percent more in fees to its fund managers in the last fiscal year than 12 months earlier.

The timing was somewhat unfortunate for KRS, whose slogan is “building a better future for Kentuckians”, reflecting its significance as the administrator to 348,000 beneficiaries and $15.6 billion in assets across five pension funds.

A month earlier, a group of public school teachers had filed a class action lawsuit against another state pension group – the Kentucky Teachers’ Retirement System (KTRS) – and three of North America’s largest private equity fund managers, Blackstone, The Carlyle Group and KKR, in connection with KTRS’s alleged increase in exposure to eight commitments the system made totalling $595 million. The suit charged the system with failing to adequately address its “dire” funded status, illegally raising teachers’ contributions and improperly investing in private equity funds.

KRS began investing in illiquids 13 years ago. Its target allocation to alternatives stands at 13.1 percent, with private equity making up 10 percent of that allocation. It had carried $3.2 billion of commitments to 73 private equity funds through 30 December 2014 (it had $2.5 billion in drawn down capital through mid-year), according to data from the system.

The pension plan’s exposure to the asset class is through a range of strategies, including buyout, secondaries, funds of funds, venture capital and growth capital partnerships. It achieves global exposure through funds that invest in North America, Europe, Latin America, Central and Eastern Europe, and Asia, according to PEI Research & Analytics.

Like many other pension fund managers it is focused on making larger commitments to fewer managers. These include the 2013-vintage $4.1 billion New Mountain Partners IV to which it committed $50 million, and a $55 million allocation to the 2013-vintage $1 billion HIG Capital Partners V. It also has a stake in the 2012-vintage $1.5 billion Riverside Capital Appreciation Fund VI.

Its private equity investments generated a 22.7 percent return through its fiscal year 2014, according to KRS’s last annual report.

While KRS recorded $62.4 million in fees for the asset class in 2014, its expenses for fiscal 2015 jumped to $108.3 million, raising questions about why the fee increase was so pronounced.

Speaking to Private Equity International, KRS chief investment officer David Peden said that the system’s allocation may decline below its target 10 per cent allocation this year, and that the jump in expenses was the result of different accounting methods deployed over the last two fiscal years.

Prior to this fiscal year, KRS had used an equity method of accounting but in 2015 the staff relied on an accounting method termed “proportional consolidation” that added a partially-owned company’s revenues, expenses, assets and liabilities to the owner’s income and balance sheets.

“A lot of the numbers in [the CEM report] are fees, sure, but in some cases opportunity costs are included, and many are adjusted in order to capture an apples-to-apples comparison to our peer group,” he said.

The system’s investment costs were reported to be 9.2 percent above similar-sized pension systems. Peden, though, discounted the comparisons saying they did not make sense given their “different liabilities and asset allocations”.

Peden also attributed the higher costs to the system’s focus on using funds of funds in its approach to private capital investing, instead of making direct investments, and also noted that two of its pensions are poorly funded and not well suited to the asset class’s illiquid nature.

As a result, he told PEI that its direct investment programme is being developed. “It’s an ongoing effort but, by the time we get to the end of 2016, we should have greatly reduced reliance upon funds of funds.”

KRS has followed LP industry trends with an initiative to make more direct co-investments. It has also aimed to become more transparent over the past year after questions arose about what it was paying investment managers to which it allocates capital.

The system also replaced Altius Associates with fellow private equity consultant Pension Consulting Alliance in February 2014.

Meanwhile, the investment team is seeking a professional to oversee its private equity assets, which are managed by director of private equity Brent Aldridge. At the same time the retirement system’s executive director William Thielen, who was appointed to the position in 2011, is expected to retire from KRS at the end of 2015, according to press reports. 

According to figures from PEI Research & Analytics, KRS committed $100 million to DB Secondary Opportunities Fund III, $60 million to BDCM Opportunity Fund IV and $40 million to Ares Special Situations Fund IV in 2014.