Teacher Retirement System of Texas expects to increase its private equity co-investments allocation to 35 percent and double the investment team to 30 professionals to support its growth in the next three to five years.
The $153.1 billion Texas TRS made its first private equity co-investment in December 2009. Almost a decade later, co-investments account for $4.5 billion, or 23.2 percent, of its $19.6 billion private equity portfolio, and are spread across 20 different managers.
“We got a really good start date in terms of market tailwind,” Neil Randall, managing director, private equity told Private Equity International.
TRS’s co-investment success is largely based on organisational support and resources backing the strategy, according to Steve LeBlanc of CapRidge Partners. LeBlanc was part of TRS and led its investment efforts in private equity and real estate from 2008 to 2012 when he left to set up his private real estate firm; TRS is a limited partner and co-invests alongside CapRidge funds.
For one, Texas TRS views co-investments as a strategy to deepen relationships with its premier list of GPs, LeBlanc said.
“We aim to be substantial LPs in funds we commit to so we can ‘earn a spot’ on their co-investments, although we do seek to differentiate ourselves beyond just fund commitment size,” Randall added.
The TRS team constantly refers to the three tenets on which its co-investment model is based.
“Are we being a good partner to the GP? Do we have the organisational processes to move quickly? Are we transparent and predictable to work with?” Randall said.
In addition, TRS has dedicated investment professionals for co-investments, based primarily in Austin, Texas with some in London. It has also steadily built in-house expertise to gain a more nuanced understanding of its GPs.
For instance, Tamara Polewik, a director in the pension’s private equity co-investment programme, was a general partner for several years, and worked at FdG Associates and JH Whitney before joining TRS in 2016. Her GP experience brings valuable insights to the system’s process, Randall said.
It is important for an LP to put themselves in the GP’s shoes, Polewik told us.
“You have to understand that a deal does not look perfect on Day 1; understand how the GP is drinking from the fire hose for the deal and be open minded about the due diligence and underwriting process,” Polewik said.
Texas TRS is not looking to disintermediate the GP through its co-investment programme, according to The Carlyle Group‘s Mark Christopher, a managing director in the investor relations team. The pension has co-invested alongside his firm.
Carlyle tries to give LPs between four and eight weeks to assess co-investment opportunities and appreciates TRS’s speed and certainty of execution in the compressed timeframes.
“A quick, detailed no is the second-best answer in this business, and TRS is decisive and quick,” Christopher said.
The team has deep sector knowledge, is thorough in its diligence and provides a detailed explanation on why it declines co-investment opportunities.
“These relationships are marathons, not short distance relationships, so transparency is valued,” Christopher said.
At the top of the funnel, the Texas TRS team views more than a hundred deals per year, some of which are early calls that may fall through. The team commits to roughly 20 deals in a year.
It bundles the performance of its co-investments into the total private equity portfolio, which generated the highest returns among all asset classes over one year (18.6 percent) and five years (11.6 percent) as on 31 July.
“Our co-investments have absolutely outperformed our regular funds, but we always ask ourselves if we are getting the best or the worst deals,” Polewik said.
The team also reviews the deals it passes up. On a gross basis, excluding fees, even those deals have been outperforming the funds themselves, according to Polewik.
“Co-investment deals are part of a broader relationship. GPs don’t want to show us bad deals today and have us not come back in their next fund in three years,” Randall said.
But Texas TRS places a lot of worth on its own homework and due diligence.
“We have conviction based on the work we do,” Randall said.
Apart from the obvious benefits of fee savings, the co-investment programme has added value to the team in other ways. For instance, it gets insights seldom provided by traditional fund investments, such as how GPs are thinking about deals and how they work together as a team.
“Overall, it has been reassuring to note that GPs are quite disciplined about their investment process,” Polewik said.
Changing market dynamics
The increased demand for co-investments makes TRS cautious. It wants its GPs to execute the best deals in their strategy and focus on their performance instead of being pressured on co-investments.
“We keep our underwriting bar very high, because while we have an enormous responsibility of maximising value we also need to think about the risk-adjusted element of our investments,” Polewik said.
Deal sourcing has become increasingly competitive, Randall said. There used to be a notion that all LPs want co-investments but very few are able to follow through on them, but that is less and less the case.
“I still hear that on occasion, but we now see a lot of LPs being able to come through on investments,” Randall said.
Additionally, market dynamics are changing as more pension systems and third-party administrators manage money on behalf of investors are looking to expand their co-investment portfolios.
Texas TRS’s size helps limit competition to a select few peers, but some market participants are using speed as their differentiator, Polewik said.
For instance, TRS turned down a deal that had a one-week window for review.
“We pride ourselves on our speed but felt we could not prudently review the opportunity in the short time period and declined,” Polewik said.
While other investors they respect for their due diligence didn’t participate in the co-investment, other investors did close it within the given time.
“We are cautious about getting caught up in this frenzy,” Polewik said.
Many LPs don’t understand what they are getting in the co-investment commitment and what it takes to make it successful, Randall said. Investors need to consider that while an investment might be made in a benign market environment, it may run into trouble when the market turns.
“When the market turns, it’s possible that co-investments will create challenges for some organisations, because people didn’t do it with enough advance preparation,” Randall said.
This story was updated to show Tamara Polewik is a director in Texas’ private equity co-investment programme.