CalSTRS and CalPERS Look to Significantly Increase Co-Investing; Other Public Pension Funds See Potential in Strategy

By David G. Barry

Despite generating strong returns from private equity investments, the $314 billion California State Teachers’ Retirement System (CalSTRS) and the $440 billion California Public Employees’ Retirement System (CalPERS) see a need to change their approach to private markets in the future.   

CalSTRS Chief Investment Officer Christopher Ailman and CalPERS CIO Nicole Musicco have expressed desires to deploy less of their capital into funds and more into deals alongside existing managers. Because of their size, moves by the pension funds are monitored closely by other institutional investors.

Ailman told Markets Group that over the next five years, he expects the co-investment portion of CalSTRS’ private equity portfolio to grow 100% to $15 billion. Musicco, who just joined CalPERS this spring, said during a recent press briefing that a “reasonable goal” is for CalPERS’ private markets’ portfolio to have a “50-50” split between fund and deal investing in five years.

The interest by CalSTRS, CalPERS and others in increasing their co-investment activity is due, in large part, to the potential cost savings. While PE firms typically charge a 2% management fee and a 20% performance fee for the right to invest in a fund, they generally do not charge LPs who co-invest in their deals. This can add up. The Pew Charitable Trusts, for instance, found that the fees that five pension funds pay out exceeds on average 2.75% of the value of their PE holdings.

Pension funds also are attracted to co-investments because of their ability to deploy larger amounts of capital to private markets and potentially generate greater returns than might come from investing.

Ailman, in fact, said that while private equity partnerships delivered a five-year internal rate of return (IRR) of 18.9%, co-investments generated an IRR of 27.1%.

“Co-investments are a key part of the CalSTRS Collaborative Model investment strategy,” he said.
That model, which has saved CalSTRS more than $780 million since 2017, focuses on managing more assets internally to reduce costs, control risks and increase expected returns, and leveraging external partnerships to achieve similar benefits.

Musicco said CalPERS hopes to build on the “great relationships” that the system’s private markets teams have developed over the past three years with not only private equity managers, but real estate, and infrastructure managers as well. CalPERS, which has $440 billion in assets, has begun implementing a new asset allocation strategy which increases its private equity target to 13% from 8%, its real assets target to 15% from 13%, and introduces a private credit target of 5%. The system also recently generated $6 billion through a secondary sale of private equity fund stakes.

Other Funds Taking Note


CalSTRS and CalPERS are hardly the only institutional investors seeking to ramp up their co-investing efforts – especially as they view the sizable fees they are paying to managers. Amy McGarrity, CIO of the $76.8 billion Public Employees’ Retirement Association of Colorado (PERA), tells Markets Group that the pension fund has investigated direct investing, but realized it didn’t fit with what the plan is trying to accomplish. PERA also, she said, “can’t necessarily” do what CalSTRS and CalPERS are planning, “but we are definitely thinking creatively about how best to invest those assets for the long term at the lowest possible cost, while still partnering with the best asset managers.”

Steven Hartt, a managing principal/private markets consultant with industry advisor Meketa, said many of the firm’s clients are considering co-investing as a means to add to their portfolio, and because of the “concept that investing additional capital with high-conviction managers often lowers fees and expenses at a rate greater than a co-mingled structure.”

Hartt, however, emphasized that moving from concept to execution can take time.

“Putting in new strategies and approaches for private equity investors – particularly large pension plans – can be like moving a battleship,” he said. “You don’t make tactical turns all that often once you have a strategy and plan in place. It takes a while to make strategic changes.”

Both Ailman and Musicco, however, realize that there are necessities to building successful large-scale co-investment programs.

A key one is staffing. Finding and keeping individuals with the knowledge and insights to successfully find, review and execute such transactions can be difficult. It is even more so in the current environment.

The challenges of doing such transactions are why many public pension funds limit themselves to either doing a few co-investment transactions a year in house or opting to utilize an outside manager.

The Connecticut Retirement Plans and Trust Funds (CRPTF), for instance, committed up to $125 million in 2021 for Morgan Stanley Investment Management (MSIM) to invest in real estate, infrastructure and natural resources – a partnership that will allow CRPTF to co-invest transactions by MSIM. It also committed $300 to HarbourVest Partners for co-investment opportunities in debt and private equity.

Earlier this year, Teachers’ Retirement System of Louisiana (TRSL) also selected HarbourVest Partners for a $300 million mandate to locate, evaluate and commit to co-invest opportunities by private market investment funds. It marked the first time that TRSL had issued such a mandate.

HarbourVest Managing Director Seth Palmer said institutions use firms like HarbourVest to manage or augment their co-investing activities because of limited resources, the pace of deals and/or a desire to diversify their portfolios. The firm provides institutions with the option of investing in its larger co-mingled fund or through a separately managed account.

Palmer said more institutions are generally interested in co-investing because they recognize the “two-fold opportunity” to bring down costs and provide equity support to some of their more important general partners.

“The large sophisticated public pension funds appreciate the magnitude of the opportunity,” Palmer said.


The Cost of Attrition

The Teacher Retirement System of Texas (TRS) has one of the more successful co-investing programs in the United States, with 37% of its private markets portfolio designated as “principal investments.” Those investments generated a one-year return of 30.7% and a five-year return of 15.1%. Eric Lang, TRS’ senior managing director of private markets, told the TRS Investment Committee that his goal is to have 40% of the portfolio going into non-fund transactions.

But pulling off such transactions means having a large and stable staff. As Lang and TRS CIO Jase Auby described during the meeting, TRS has had significant turnover over the last year. At its current pace, TRS’ investment management division will see a third of its staff turn over between January 2021 and December 2022, Auby said. Specifically, it has lost 21 people since the start of 2021, many of whom have been recruited to join private markets firms.

“Being an industry leader comes at the cost of attrition,” Lang said. “The market has realized we have good people. We’ve had a lot of people leave for private markets, unfortunately.”

Auby said that TRS has a “great training program. We train them well. We would just like to hold onto them longer. They are leaving earlier than our strategy planned.”

Such departures, he said, means TRS is not only missing that expertise but also needs remaining team members to spend increasing amounts of their time on recruiting and interviewing.

Neil Randall, a TRS managing director who heads private equity, told the investment committee that the departures have had a “tangible cost to us.” Specifically, he pointed out that they’ve had four different people cover one of their general partner relationships over the four years – a situation that he said, “does not allow us to have the type of consistency that we want to bring and that becomes a challenge.”  

Musicco indicated that CalPERS’ co-investment ambitions will be decided in part by its ability to staff appropriately.

Ailman told Markets Group that CalSTRS has grown its private equity team “by nearly double since 2018, in large part to hire staff with specialized experience in co-investments.” He is now trying to further grow the private equity team.

Ailman told the CalSTRS Investment Committee that by spending an additional $15 million annually on personnel and travel costs and an additional $25 million on consultants and advisors, the amount paid out to general partners could drop by $750 million. Calling the projected cost savings an “honest estimate,” Ailman told the board that CalSTRS will need to make some “hard decisions” to carry out the strategy, such as increasing compensation to attract and retain individuals with investment banking skills. Michael Graham, global head of private equity for Canadian pension plan OMERS, said the current economic downturn may actually make it an ideal time for CalPERS, CalSTRS and others seeking to build up their in-house deal teams. OMERS, as he recounted to Markets Group, made the decision to move from making fund investments and co-investing to simply doing deals directly during the midst of the Great Financial Crisis. With many people out of work, OMERS was able to scale rapidly. The fund’s private equity team, he said, had five people – including himself – in 2007. Today, it has 150, including 110 investment professionals.

The GFC, he said, made it “much easier to hire” and those coming on board saw the benefits in working for a firm with an “evergreen capital source” and stayed. Graham concedes that if OMERS had tried to do what it did last year “it would not have been as easy. The challenge is finding good people. But it may become easier given the market turmoil and the [possibility] of a recession,” he said.

Let’s Make a Deal


Aside from staffing, another key issue for institutional investors wishing to do more co-investing is getting into deals.

Many of the larger private market firms, said industry observers, have raised such sizable funds in recent years that they are able to do transactions without needing to go to their limited partners, or are doing so on a limited basis.

Texas TRS, for instance, is at its 50% goal for principal investments in real estate and 40% target for energy, natural resources and infrastructure, but is nearly 10% below its 35% goal for private equity.

TRS’ Lange said the pension plan is “struggling with private equity” because of the competition for deals.

Lange’s colleague, Randall, said a key issue for TRS is that the pension plan’s market position is “declining.” The private equity sector, he said, is simply growing at a faster rate than the pension plan. With retail investors starting to become bigger players, Randall expects fund sizes to continue to grow while TRS’ commitments will likely stay the same.

“There’s a lot more competition coming into co-investments, so we have to figure out how to be competitive,” Randall told the TRS Investment Committee.

One step TRS is taking is shifting more of its investment activity toward mid-market and small buyout firms and venture capital.

Such a strategy, say industry observers, may make sense as smaller private equity firms often rely more heavily on co-investments from limited partners to do deals.

HarbourVest’s Palmer said GPs – large and small – view co-investing as both a way of taking down larger deals and a way of providing a service to LPs who desire to co-invest.

“We see GPs across the size spectrum using co-invest as a tool to manage their internal portfolio construction needs as well as a service to their limited partners. It’s an important feature.”

Meketa’s Hartt concurred, saying that “I think GPs realize how valuable co-investment is for some of their relationships and look to offer those co-investments to solidify those relationships. That’s an important motivator to offer co-invest capital.”

BC Partners, for example, has made it part of its DNA, having generated more than €11 billion ($11.2 billion) of co-investment to more than 80 unique limited partners.

BC brings its fund investors into its deals in two ways, said Alexis Maskell, a BC partner and global head of investor relations. In some instances, he said, BC will bring “sophisticated” LPs who are capable of co-underwriting/co-sponsoring an investment into a deal early, and by doing so ensure they can “get comfortable” with the transaction as well as BC’s thesis and value-creation plan.

“It’s a collaborative process,” Maskell said.

The second way BC involves LPs is through syndication after a deal is struck. BC will reach out to LPs, he said, who usually do not have the bandwidth or a dedicated investment team to execute on a co-underwrite basis. BC provides the needed information to have a deal evaluated and approved. Maskell describes this process as a relationship tool vs. a de-risking tool, a key reason why BC tries to provide co-investment opportunities across its LP base, regardless of size.

Maskell said that deciding which LPs to contact for co-investment opportunities and how much to allocate is driven by the firm’s “deep knowledge” of its LP base and is more of an “art than a science.” The aim, of course, is to find LPs who are interested, able to move quickly and are comfortable with the deal and their role, he said.

“Above all, we want to give them first row access into the thematic investment approach, sourcing and value-creation process,” Maskell said.

Institutional investors in recent years have benefitted from being co-investors in transactions done by BC as well as other PE firms. It has, in a sense, said Maskell been a “relatively
 risk-free exercise” as valuations have continued to go up. But now, he points out, that is no longer the case. The industry is entering an environment where the “paradigm has shifted.” As a result, LPs taking part in co-investment deals will need to get comfortable with the “valuation perimeters” and, of course, the risk that not every deal is going to be a home run.

CalSTRS’ Ailman told his investment committee that getting access to co-investment opportunities may be the biggest challenge. The system, he said, will be battling to get into deals versus others who are active or are looking to get active as co-investors, such as CalPERS, CPP Investments, GIC, Texas TRS and Abu Dhabi Investment Authority.

“We have to be a good partner,” he said.

Hartt of Meketa said another way that LPs are becoming or may become more active on the co-investment front is through GP-led secondary transactions. Private equity firms, left with just a company or two in a fund, are increasingly opting to raise smaller funds to lift that asset out of the fund. More LPs are becoming comfortable with such transactions and are stepping up to back the secondary transaction.

“That’s additional transaction flow for LPs,” he said.

Dealing Direct


One way of course, is to avoid the stress of finding partners to do transactions with and do deals directly – much like many of the Canadian pension plans and such sovereign wealth funds as GIC and the Abu Dhabi Investment Authority are doing.

Ailman says he is aware of those plans’ efforts on the direct side but says simply that “we do not have the right business model, in my view, to properly and successfully execute direct investments at this time. So, we will stick to our knitting.”

Musicco, speaking at’s Fiduciary Investors Symposium, said that given CalPERS’ size, it has “ample opportunity to be leaning more into the private markets space.” But the CalPERS CIO, whose background includes overseeing private equity at the Ontario Teachers’ Pension Plan, said that building the staff to do direct investing “takes a good decade” and the plan would continue to rely on fund managers.

OMERS, in a sense, provides inspiration for public pension funds looking to move away from investing in funds and co-investments and doing deals directly. The fund’s private equity, infrastructure and real estate groups all operate essentially as stand-alone firms.

“We’re able to mandate our own destiny,” said Graham.

The shift toward doing direct deals came out of the OMERS’ team looking at the results and seeing that its efforts on the direct side were as good, if not better, than what it was achieving through investing in funds. The private equity team also realized that “it’s hard to be a direct investor, a fund investor and a co-investor,” he said. The plan was thus made to simplify and focus on deals.

And it has worked well. To illustrate the types of deals that OMERS can do, Graham points to portfolio company Caliber Collision, which operates auto body collision repair centers. OMERS Private Equity invested in the company in November 2013, when it had 157 collision centers in five states. OMERS later sold a minority stake in the business to Leonard Green & Partners. Together, the firms helped build Caliber to more than 630 centers in 19 states before selling it in December 2018 to another private equity firm, Hellman & Friedman, who merged it with another collision repair company. OMERS, however, retained a minority stake and today, Caliber, said Graham, has an EBITDA that is 10 times what it was when OMERS originally invested in it.

“We never paid fee or carry, we sold part of the business. We kept a minority stake. That’s great color to bring to the OMERS’ board.”