Texas: PE needs to get cheaper

As return expectations come down, fees need to adjust accordingly, says Christopher Schelling, director of private equity at the Texas Municipal Retirement System.

Private equity fund managers must reset their margin expectations as increasing dry powder and competition begin to take their toll on returns, according to Christopher Schelling, director of private equity at the Texas Municipal Retirement System.

In an interview with Private Equity International, Schelling said one of the biggest challenges currently faced by private equity as an asset class was the spread between gross and net returns.

“As the spreads between bid and ask in a given market decline, the commissions and other explicit transaction costs tend to come down as well,” he said.

“The market is getting more efficient, so it needs to get less expensive, which means managers have to reset their margin allocations, like it or not. They can do it rationally and collegially, or I wouldn't be surprised if it's done for them.”

More money committed to private equity is fuelling competition for deals. According to PEI data, H1 fundraising in 2017 reached $264 billion, exceeding capital raised by funds holding a final close in any first half of the year since the financial crisis. Of the 369 funds closed in H1, 55 percent closed above target, a proportion that has increased year-on-year from 23 percent in 2010.

“Everything is being banked to some degree, and that just reduces the inefficiency, which is where excess returns come from,” Schelling said. “So, return expectations, particularly the spread to public, need to come down.”

Texas is still a relatively new private equity investor, having made its first commitment just 18 months ago. It has a target allocation of 5 percent, and its current exposure to the asset class is 0.75 percent.

As such, benchmarking its private equity portfolio performance is “a big challenge”, Schelling said.

“Currently, we have a benchmark that is more of a cost of capital than a true benchmark – it's the Russell 3,000 plus 300 basis points,” he said.

“Our board has decided to forego a benchmark over the first five years – the heart of the J-curve – because returns will not be the most valid indicator of the success of the programme.”

When analysing potential commitments to managers, Schelling said “staff compare each manager to a strategy and vintage-specific peer benchmark to evaluate manager level performance across multiple metrics”.

Texas Municipal Retirement System has assets under management of $26 billion as at 31 March 2017.