US Pension Plans’ Private Markets Activity – Summer 2018 Recap

1. Orange County Employees Retirement System – Private Debt Strategic Plan –  August

An August meeting held by Meketa and Orange County Employees Retirement System (OCERS) Staff reviewed the plan’s Private Credit allocation and portfolio, around 12 months after a re-structuring of the OCERS’ Direct Lending portfolio.

As outlined in the document, in September 2017 the Investment Committee and Staff reviewed the Direct Lending portfolio and established new sub-asset class categories and targets.  With this, managers in OCERS’ portfolio were re-categorized into the new sub-asset classes of Private Debt (higher risk-return, less liquidity) and Private Credit (lower risk-return, less levered). The meeting in August focused on the Private Credit portion of the Direct Lending portfolio.

Strategic Focus

Meketa and OCERS staff recommended two key strategic goals for the private credit allocation:

• “Move toward a more balanced geographic split between the U.S. and the rest of the world.”
• “Continue to consolidate the credit manager roster toward high conviction managers.”

As of June 30, OCERS’ Private Credit portfolio had a market value of $404m and was 2.5% of OCERS’ total portfolio. To maintain the 2.5% allocation, Meketa recommended that OCERS continue to make Private Credit commitments annually at a pace of $150m a year through 2023, increasing to $200m from 2024 through 2028.

Further recommendations included:

• Setting geographic diversifications targets: 60% U.S. (+/-20%), 40%% Europe (+/- 20%), and 0% Asia (up to 15%).
• Focus allocation on senior SME lending (first lien and unitranche).
• Narrow manager roster to focus on 2-3 U.S. and 1-2 European.

2. Oklahoma Teachers Retirement System – Non-Core Real Estate RFP Review – June 2018

In June, Okalahoma Teachers Retirement System (OTRS) consultant, AndCo, presented an update on the status of the search for a Non-Core Real Estate fund, issued in April 2018.

The RFP comes as OTRS looks to make $120m of new commitments annually from 2018 to 2021 to achieve a 9% allocation to real estate (currently 7.4%) and have Non-Core make up an increasingly bigger portion of the Real Estate portfolio – from 26% to 38% by 2022.

A total of 30 firms submitted a response to OTRS’ RFP, with only six of these firms being listed as finalists.

OTRS Research Funnel

OTRS’ and AndCo’s research process eliminated firms due to a range of factors:

• 3 excluded as the investment would be too large and represent a significant portion of the total commitments to the fund.
• 10 firms excluded based on the fit of the strategy with the current portfolio construction of the OTRS non-core RE allocation.
• 3 firms excluded due to high turnover of investment professionals.
• 4 firms excluded based on their track record
• 4 firms excluded based on a qualitative comparison with the finalists.
• 6 firms were listed as finalists.

Fee Comparison

A thorough analysis of each manager and strategy was carried out by AndCo, including a Fees and Terms comparison. While the finalists’ target fund sizes range from $500m to $2.5bn, preferred return targets were fairly standardized (between 8-9% IRR). Management fees were also largely similar across the finalists at 1.5%on committed capital during the investment period and 1.5% on contributed capital thereafter, with two out of the six offering discounts based on commitment size. A 20% incentive fee was standard across all.

As per the due diligence process outlined by AndCo, commitment decisions and execution of investment are to be made in September.

3. Ventura County Employees’ Retirement Association – Private Debt Research –  July

Ventura County Employees’ Retirement Association’s Debt portfolio is currently relatively nascent, with one commitment to a Direct Lending fund ($30m). However, the recommendation of their consultant, NEPC, is to maintain a commitment pace of $75m per year to private credit through 2023.

A recent research piece by NEPC for Ventura explored their views on the current market conditions and specific strategies that will shape Ventura’s commitment decisions.

Private Credit Outlook

Private Credit has drawn a lot of attention and commitments within the private markets space in recent years. However, NEPC highlighted in their “Current Market Environment” overview that due to these same factors, the attractiveness of both US and European direct lending has “diminished compared to what it was several years ago.” NEPC reported that increased competition in the space has caused yields to decline. A flood of new entrants that are less experienced in credit underwriting, more willing to stretch on discipline and enact covenant-lite loans has made it challenging for some investors to carry out due diligence and deploy capital.

In this presentation, NEPC also noted tax changes having the potential to affect “supply/demand dynamics.” With tax cuts in the U.S. benefiting lower levered companies, they posited that Leveraged Buyouts may put less leverage on deals to avoid the negative impact.

While the market conditions may present a verging-on-bleak outlook, NEPC positioned Direct Lending as still an attractive strategy on a relative basis. The report commented that diversified middle market lending is yielding 150-200 basis points over public market alternatives. It also highlighted that the historically lower default rates of Direct Lending, compared to more liquid instruments, makes it still an attractive strategy. The data presented by NEPC show “Middle Market” lending’s average default rate of 3.8% and recovery rate of 83.2%, compared to 4.8% and 80.3% rates for “Large Corporate” loan defaults and recovery respectively.

4. Florida State Board of Administration – Private Equity Program Review – June

Florida State Board of Administration (SBA) Staff presented a review of the Private Equity Program at an Investment Advisory Council in June. The presentation covered a review of the portfolio and an outline of future commitment plans and priorities.

At 6.5% of the total fund, SBA’s private equity allocation is within the 2-9% target range and has a NAV of $10.9bn. While the NAV has almost doubled since 2011, ($5.77bn at June 30, 2011), SBA’s number of active relationships has moved inversely – the report states 59 active relationships in 2011 and 48 as of December 31, 2017 – suggesting a preference for deploying more capital across fewer managers.

SBA’s Private Equity Program invests across Buyout, Venture, Distressed and Secondaries, with Distressed leading portfolio performance on both IRR (20.6%) and TVPI (1.7x) on a since inception time period. Buyout performance was reported at 12.4% since inception, beating both SBA’s private markets benchmark (12.1%) and its chosen Public Market Equivalent (MSCI ACWI IMI) for the same periods.

Planned Commitment Pacing

Commitments over the next three years are outlined in the report and remain steady. Total private equity commitments are planned at an average of $1.76bn per year over 3 years ending 2021, with a target of 69% in Buyout, 7% VC, 18% Distressed, and 6% Secondary.

The report also highlighted SBA’s annual investment plan, noting the priority rankings for fund strategies and regions:

• High Priority
  • North American Small Buyout and Distressed/Turnaround.
  • European Small Buyout.
  • Asian Mid-Market and Small Buyout, Growth Equity and Venture.
• Low Priority
  • Large buyout across all Geographies.
  • Growth Equity in all regions excluding Asia.

5. Montana Board of Investments – Real Assets Strategic Plan – August

An August meeting by Montana Board of Investments (MBOI) Staff offered eVestment Private Markets’ subscribers a comprehensive view of its Real Estate program and future strategy.

At 7.15% of the total portfolio as of June 30 2018, BOI’s real estate allocation sat within their 4% to 12% approved ranges. The BOI real estate portfolio is comprised of both Core and Non-Core, with a focus on increased core real estate exposure since late 2016. Non-Core comprises a large portion of BOI’s portfolio with steady annual commitments of between $75m to $125m over the past five years through 2017. The report shows that commitments to Non-Core are planned at a pace of $120m through 2022.

BOI also plan for an average commitment size of $30m for Non-Core funds, splitting the allocation across 4 funds per year.

Strategy & Rationale

The report by BOI Staff outlined the current real estate strategy and rationale underpinning it. Key focus areas include:

• “Focus on North America – Well understood, resource constraints, deepest, most liquid.”
• “Preference for pure-play, vertically integrated real estate operator GPs – Positioned to be more nimble and responsive to shifts in the market, closer to the asset.”
• “Opportunistically add real estate debt and publicly traded real estate exposure – Differentiated return drivers, diversification of current exposure beyond real estate equity and focus on current income.”