How PSERS' new chief investment officer Dr. Cotton is applying his knowledge of M&A best practices, working with the board, and changing a portfolio that was designed for a low interest rate environment.
By Christine Giordano
When new
chief investment officers take their respective helms, there are always a few
years of ‘watch-and-wait.’ Employees under their management have to prove
themselves all over again. Board members must learn to trust the new investors,
learn their strengths and try to anticipate their weaknesses. Communication can
make or break success. And a CIO’s true assessment is known to be made after
five years in the role. In many ways, it’s similar to a merger and
acquisition process.
Interestingly,
when Dr. Benjamin Cotton took the CIO seat at (what is now) the $76 billion
fund for PennPSERS in January, 2023, he was already a scholar of mergers and
acquisition processes.
In 2019, he
had enrolled in a program through Vanderbilt’s Peabody Education College
to earn his doctorate. His studies led him to a greater understanding of
what helps M&A relationships succeed over time.
Explained Cotton, “We took a little bit of a different approach. We focused on the investment banker’s role as an intermediary before the merger and acquisition occurs. We [explored] the elements associated with their processes, and whether it was productive for preparing the participants for what they were going to encounter after the mergers and acquisition.”
His research codified what one might intuit: it found that trust, and companies that already had an understanding of each other from having worked together in the past, are significant factors for success, albeit within limits.
Specific to
the intermediary's role, there were certain tensions associated with the
M&A process that could either hinder or help facilitate that development of
trust.
But
sometimes, oversharing information can pose a risk.
“To a point,
there's also this tension— if you overshare and/or provide information to too
many people, it creates misinformation opportunities and/or certain issues that
can interfere with the successful completion of the mergers and acquisitions.”
To tame that
tension, transparency and time constraints need to be managed in the merger and
acquisition process, “to help facilitate the development of trust for the later
aspects of the transaction,” he explained.
Yet within
M&As, workers often fear layoffs from redundancies. Which begs the
question, how much transparency is effective if layoffs are imminent?
Said Dr.
Cotton, “One of the [research] participants we interviewed indicated that his
job was to position all the employees … with the skills and capabilities so
that, as they move forward in their careers, they can do well, with the
understanding that there may be changes, but not always”
Why is
this important? Because
as a new CIO, Dr. Cotton stepped in to fill the rather large shoes left by the
outgoing CIO James Grossman Jr. (whose tenure began at the fund in 1997) and
Executive Director Glen Grell, who both retired during a time when PSERS' general
investment consultant AON made a calculation error that, once
resolved, resulted in higher contributions from some public school employee's
and sparked investigations by the SEC, the Department of Justice, and PSERS.
Grossman, Grell and the fund were subsequently cleared of any wrongdoing, the
fund terminated its contract with Aon, and filed a lawsuit against the firm
that has since been settled in consideration of a payment to PSERS for $7
million.
Starting in
the CIO role on the heels of that drama-filled year, meant that the board’s
choice in the new chief investor had to be right. It had to
find not only a sharp investor who understood pensions and the politics behind
them, but also a person fastidious to details and a sharp leader who could take
the ship and lead it in a positive direction through the stormy seas of the
post-pandemic markets, geopolitics and changing interest rates. With a goal to
be fully funded about two decades by year 2043, and with a funded rate of
61.6%, there wasn’t time for error or waste.
Applied
Knowledge
Cotton had been a mid-career with quite a bit of stateside and international experience as an investor by the time he had gone back to school for his Ph.D. After
serving the U.S. Marine Corps as a corporal, stationed primarily in Okinawa,
Japan, he did a 4-year stint in investment management and investment banking,
underwriting private assets in Southern California. He then joined the Ford
Motor Company in 2000 to be a part of its pension team, with a rotation through
other elements of Ford’s treasury, which included overseeing elements of an $86
billion securitization book. He had also managed a derivatives trading desk
that traded well over $100 billion in annual flows for foreign exchange,
interest rate derivatives, and other elements “that are important not only to
an automotive company but to the credit business that goes along with an
automotive company,” Cotton explained during a phone interview.
“I also went
over to London and led the team that was responsible for auditing Ford's credit
throughout Europe and Asia Pacific,” he reflected during a phone
interview. Then from there, he was asked to work with Mazda, (then
affiliated with Ford) in Hiroshima to help “organize efforts to improve
internal controls over reporting for financial matters” in response to Japan’s
version of Sarbanes-Oxley compliance, a.k.a, JSOX, before he returned to
Ford and continued to work in treasury and investment related matters.
In 2009, he
was asked to join a team where he became senior managing director of the $58.6
billion United Auto Workers Retiree Medical Benefits Trust, ultimately spending
almost 10 years in this roll.
By 2019, he
was ready to go back to school. This time, he studied a bank’s best practices
within mergers and acquisitions, and came to conclusions that would help him in
his future role as CIO of PSERS.
When Dr.
Cotton took the investment office helm at PennPSERS, his philosophy, similarly to that of a
merger, was not to make massive changes, but to capitalize on core elements
that were working well, and to establish a foundation of trust with the board,
external stakeholders, and the investment team in order to move objectives
forward. (“You can't take the trust that you've developed over time for
granted. You can write a book over many years. It only takes one moment to burn
it,” he says.)
Although some
changes have been necessary. The fund’s core compass, its long-term direction,
was established during a time when interest rates were relatively low. Striving
for significant returns had meant taking on leverage. But times have obviously
changed.
“We have
slightly increased our growth equity risk today and reduced leverage,” said
Cotton. “Rates are much higher, so there's some benefit to be had from having
more exposure to investment-grade credit."
Portfolio changes for the changing economy
In 2023,
Cotton’s first year, the fund and the board made several changes to
allocations, cutting the 4% target allocation to absolute return and changing a
7.5% target to net leverage to zero; lowering the targets to
inflation-protected fixed income to 9% from 11%; dropping allocations to
international equities to 12% from 15% and public real estate to 2.5% from 4%;
trimming commodities to 5% from 7.5%, and lowering credit-related fixed income
to 4.5% from 6%, according to reports.
PSERS raised
target investment-grade fixed income to 14% from 10%; increasing the targets to
domestic equities to 18% from 15%.
Targets that
stayed steadfast were the 5% allocation to public infrastructure, and the 30%
target to private assets that now includes 12% private equity, 6% private real
estate, 7% private credit and 5% private infrastructure.
PSERS
returned 3.54% for the 2023 fiscal year, which was 33 basis points above the
policy benchmark.
“I suspect
we'll continue to do well from our private markets allocation over the long run
… However, I think it's important for investment professionals, particularly
allocators, to approach that market with skepticism in general,” keeping an eye
out for good returns, holding partners accountable, and “trying to drive
efficiencies in the way that they deliver that value,” Cotton told Markets
Group.
At a board
meeting in August of 2024, the PSERS investment team pitched investments around
digital infrastructure and cellphone towers, healthcare and technology from
firms such as LLR, Peppertree and Blackstone.
In 2024,
PSERS reported returns of 8.14% that beat the benchmark by 107 bps against a
fund record of 4.61% for 3 years; 7.60% for 5 years; 6.82% for 10 years;
8.54% for 15 years; and 7.05% for 20 years.
The fund is
now on a three-year path of re-evaluating its asset allocation targets. Once
they are set, the fund plans to stay the course.
In October
2024, the board approved more asset allocation changes, increasing the fund’s
public equity target by two percentage points to 32% and decreased the public
commodities and private real estate allocations by one percentage point each,
to 4% and 6%, respectively. The fund’s tail risk mitigation strategy was
eliminated. All changes can remain in effect for up to three years.
“The PSERS
Board of Trustees takes its fiduciary obligations to periodically review and
update the asset allocation very seriously,” said Investment Committee Chairman
Jason Davis in a press release. “These changes are a step toward aligning the
fund’s investment posture with our most recent market assumptions, liquidity
profile, and risk appetite.
A
Scholarly Approach to Deglobalization
Dr. Cotton
spoke to key investment themes, one of which is the fact that globalization is
not what it once was.
Having spent
most of his investment career evaluating and anticipating the results of
globalization, Dr. Cotton believes the path has now paused, if not reversed
itself. The discussion is about polarizations and whether there are different
geographical regions of influence.
Cotton, who
was also a college instructor during his career, spoke deliberately, carefully
choosing his words.
The shift
actually changes the nature of due diligence. Investors need to pay even more
attention to the political relationships across global regions.
“That's
important because you have to actually go a lot deeper into the sustainability
of the trade relationships that are underlying the businesses that you're
underwriting, as well as the different, national-level policies that make it
more productive and/or economically feasible for that business to continue on,”
he explained.
In doing
research, you must look much deeper than the typical approach.
“Now it
becomes much more important to understand the risk associated with doing
businesses in different regions because it's no longer a move towards a rising
tide lifting all ships. There are actually very different seas that you need to
navigate in different regions, and you need to understand those well.”
Interest
Rates
Interest
rates are another theme. Since rates began rising, they have controlled much of
the investment universe as well as its conversations. It’s another theme within
the PSERS portfolio. The aforementioned risk that portfolios needed to take on
in order to meet return expectations is not what it was. “That's turned on its
head today. We've got cash rates now that are just under 5%. Yes, they could
come down, but they're still very high relative to where they were,” reflected
Cotton in the autumn of 2024.
“You had a
whole class of assets that were becoming very difficult to defend in the asset
allocation that are extremely attractive right now and provide a very good
risk-adjusted rate of return,” he said.
Yet, Cotton
is expecting some follow-on effects.
“The higher
rate environment means that those who bought assets in a lower rate environment
hold them at valuations and expectations on exit multiples that are going to be
difficult because the buyers now have a higher cost of capital that they
need to meet in order to buy those assets.
“As a
consequence, we've seen less activity in the private markets, less assets
changing hands and/or transactions occurring in private markets because there
is that disconnect a What will happen is, over time, the economic activity for
those businesses and the valuations will reach a clearing point where markets
can transact and things will move back to normal after that occurs. It'll take
some time for that to occur,” said Dr. Cotton.
Board
Environment
Some wondered
if the board would be extra cautious with the new CIO, but Cotton has observed
the environment to be positive. “There seems to be a really strong desire for
collaboration amongst all our board members and between the board members and
staff.”
There’s a
synergy between the new CIO and the executive director Terrill (Terri) J.
Sanchez who returned to PSERS where she had served 26 years, after spending
almost 4 years as executive director of Pennsylvania State Employees’
Retirement System. This January, Chair Richard Vague, managing director of
Gabriel Investments, book author of The Paradox of Debt, and former Pennsylvania Secretary of
Banking and Securities, was re-elected to chairman following his first term as
a governor appointee.
“We have
great executives on board now with Terrill (Terri) J. Sanchez, PSERS Executive
Director, and the supporting executives on our teams. And, we are well
aligned. We're making sure that we keep a positive relationship with our board
but also translating that into what would be great outcomes for our plan, which
means then great outcomes for the beneficiary of our plans, the teachers, and
public school employees throughout the Commonwealth,” said Cotton.
Plumber
and Poet
Cotton leaves
the interview citing one last adage, from the late James March, a researcher
out of Stanford University, who spoke of leadership as a combination of poetry
and plumbing and that a solid leader is someone who can balance both. If you're
all poetry, you're going to lose it in the plumbing. If you're all plumbing,
you can never get to the poetry.
“In
investments, I think of the poetry as the investment strategy and the big ideas
we have as far as moving a portfolio forward. The plumbing is all the
operational and control aspects associated with doing that in a controlled way.
One of our main objectives, not just for me, but for PSERS overall, initially
focused on the plumbing, making sure we have a sound base from which we're
operating so that as we're not distracted with issues of internal control
and/or control lapses that could detract from the trust it takes to execute on
the strategic expectations and directions as set by the board,” said Cotton.