NEWS

By Christine Giordano

Co-investments continue to be hot news. When BlackRock bought Global Infrastructure Partners as a game changer in January for $12.5 billion, it got some of us curious about pension funds that have taken co-investing to their in-house investment teams, and whether there was advice to be shared.

The $325.9 billion [as of January 31, 2024] California State Teachers' Retirement System's (CalSTRS’) famed Collaborative Model has reportedly saved $1.6 billion over five years. Scott Chan, deputy chief investment officer of CalSTRS, has been building the program since the first year he started at the mega fund in 2018 when CIO Christopher J. Ailman made it one of Chan’s priorities.

It has long been said that large pension funds usually make changes the way large cruise ships do – turning slowly to accommodate for their size. Smaller foundations, endowments, and family offices are sometimes envied for their ability to act quickly and nimbly. Yet despite its size as the second largest pension fund in the United States, a large piece of CalSTRS co-investment formula is the investment team’s ability to act swiftly and nimbly in the face of opportunities — swift enough to keep GPs satisfied and calling. And to find those opportunities, like new investments in geothermal technology, that will pay off in the years to come.

In this interview, we’ll discuss what needs to be in place to be responsive enough to GPs to keep offers rolling in and frame the program with enough due diligence that investments remain prudent and successful.

Chan was not new to co-investments when he arrived at CalSTRS. He had already been a chief investment officer at Sacramento County in California and a senior managing director at UC Regents.

Chan discusses how he and the investment team at CalSTRS built the program, how the investment team gained alignment with the board, and what guardrails needed to be in place to keep it successful, what investments in the new economy seem promising.

Christine Giordano: Since the Collaborative Model dictates the co-investments in the plan, let’s start there. The first phase of the Collaborative Model was to get every division and team to execute collaborative models in their own way. How did you encourage that?

Scott Chan: To step back, CalSTRS obviously is a very large organization with many parts. To be successful, I needed to create and execute a unified vision across the organization.

It started with the investment team and an investment strategy to help us improve the returns. That would obviously lead to greater work on their ends, but then we'd be at the forefront of finance and deepening our relationships with partners.

It eventually became a Top 3 Priority of the Investment Branch so that every division is held accountable for developing and executing an annual business plan. These are all components that I think helped us to get started. There were certain divisions where it was pretty automatic, like in private equity —  co-investing was a natural extension of the model for them.

They were going to focus on that, going from the, call it, 2.5% of NAV up to 20% to 25% today, targeting 35% in the future. It was very natural for them. In other areas like innovation and sustainable investing, we really needed to get examples of Collaborative Model structures set up. We did a few of those on the private side. One of the things we did in our Innovation portfolio was invest in a private credit manager where half of what we invested was within the fund and half of it was a co-investment vehicle. Then we also took some ownership interest in the fund.

Then every deal the Innovation team did after that, they structured in a collaborative way. Part of it was just pushing that rock uphill, making sure everyone had some examples to start with, and then I would say, it really started to get rolling and move downhill. At this point all the teams are clicking along in the area that is natural to them and in how they've structured their teams.

In the future, of course, we want every individual in investments to be trained and able to transact on any given structure, whether it be a co-investment SMA, a joint venture, or ownership of an asset manager. We are working on institutionalizing the expertise and knowledge of our complex relationship structures and hope to have the ability to map it across any asset class. There are different degrees of what we can do, and I would call ownership the most intensive out of all those areas.

Historically, we've implemented the Collaborative model across public and private markets. Our public markets do internal investing or direct investing in the traditional approach and hire teams and portfolio managers to do all of the trading and investing. We do all of that "in-house." On the private side, we never felt that we would be able to build our own internal Blackstone or Brookfield, etc. The point was to try to benefit similarly in a direct way but leverage our partners to do that in various ways and structures, from co-investing, to joint ventures, to SMAs, to ownership.

That's one element: building and developing the team. Other elements that I think might be useful to understanding this are the board, the enterprise support, and even the stakeholders. I think it needs to be a holistic vision to truly be able to do it right.

Getting the Resources

Chan: One of the first things people would raise their hands and say is, "Well, I don't know if we have the resources to do this correctly," right?

We had to work with the board to ensure we had the resources to grow this strategy and plan. In 2019, we accelerated our plan. We have a five-year resourcing plan. In Year Three of that plan, we accelerated it so that we could hire the balance of the positions within that year, and then in 2021 and 2022, we created a new plan. Those guaranteed the resources for us to do it.

I would say that one of the critical things for folks is to convince your board. You really have to sit down with them and walk them through what you think will be the benefits. Fortunately, we created a cost report under the leadership of April Wilcox, our Director of Investment Services. (I think we do an amazing job with that.) We essentially account for all the costs of all of our private partnerships.

Then, with that accounting, we could also slice and dice it and start to estimate our savings in developing some of these structures because co-investments, for example, in private equity, 100% of that is fee-free, carry-free structures. We could identify the benefits to the board, not only in cost savings but in the returns that we've been able to generate.

That goes a long way, I think, when you can monitor and report back your progress to the board and stakeholders. Because if you're going to hire resources, a.k.a., spend more money to build staff around this, then what's your return on investment at the end of the day? We had to build out an ecosystem of "How do we not only have the investment staff but what other staff are necessary to ensure that we mitigate the execution risk going forward"?

We naturally moved to the board, but then we naturally moved to the enterprise because, as we thought about it, [we thought,] "Look, if we're going to do a co-investment, we have to make sure we respond the same day," and typically, in the industry, it's within five days. Even just the calling of, say, [yes or no, on Day 1 or within the five days of the industry standard] —to do that, we needed expertise and the resources on the private equity team.

We also needed to streamline the entire organization’s operations to become nimble so that we could compete in the marketplace at anyone’s speed and scale. We worked across the organization, including resources, legal, technology, etc., to develop the strategy holistically so we could execute.

Giordano: Obviously, this isn't your first rodeo. You were a chief investment officer at Sacramento County and in senior management at Regents. You joined CalSTRS in 2018. In 2019, you started this build-out. Was this a priority for you?

Chan: Oh, it was definitely a priority. I spent a lot of time in the first 90-100 days interviewing staff, just spending time with them. I spent time with Chris Ailman in developing the strategy. This definitely became what Chris placed as one of my top priorities after we started to really get our arms around it.

The collaborative model, which includes co-investing within it, would be the overarching strategy across all the investment divisions, and it became probably my top priority in the first several years as we were building it out.

Measuring Success

Giordano: You mentioned communicating the ROI to the board. Specifically around the co-investments, how did you track your success?

Chan:  Every year, we produce our cost report, reporting all the costs across the entire investment division. Then we segmented each of the costs, how much were fees, how much was carry, how much was operational, how much was our own staff, how much were consultants. We sliced and diced it in any way the board wanted it.

We've been doing it for seven or eight years now. In any event, we've begun to produce a report on the cost-saving estimates. For example, over the last six years, we've saved over $1.6 billion in fees in executing this model. We saved $428 million in 2022, and we achieved the higher end of the range of our goals – now we have set a new target of an additional annual cost savings goal of $200-$300 million, and we are hoping to save $600-$700 million per year five years from now.

Giordano: What’s next there?

Chan: We started with the cost savings because they were very easy for us to estimate, right?

We could tag it. We could account for it. What's not so easy to estimate are the alpha portions of it, and what's even more difficult is the risk control. When we looked at the benefits, we felt there would be three primary benefits. One is cost savings, for sure. Secondly, there are increased returns. Many of the structures that we're executing now and as we move forward, we're trying to architect deals where there's some revenue sharing or ownership. If we look back, that has had the potential to add, call it, 3% to 7% to our IRRs. It's very significant, and we're starting to get our arms around trying to segment that, which might be more difficult to report on. And thirdly, better control of our risk is something that's in today's environment; you can just think about liquidity. We're not seeing a lot of exits coming back in many of our limited partnerships. However, in co-investing, for example, we control the timing of investments.

Giordano: How were you able to track the alpha from the co-investments?

Chan: We do have that performance. I can share that with you. We've been successful. We've been outperforming. The co-investment strategy, not surprisingly, has outperformed our limited partnership interests because of such a huge cost-saving experience. We always run the risk, and whatever we do in the Collaborative Model, including co-investing, what we're trying to build around is we need to either meet or exceed the return of our limited partnership interests and then have that differential, the cost savings boost the returns as well as some of the structural differences, like if we share the revenue or have ownership interests, have that be in addition to that.

That's certainly been the case, and we've been outperforming, quite substantially, the limited partnership interests over the long term. We've been doing that even though we're unlevered and our partners are levered. That is, I think, a very strong statement of the performance. All the credit goes to our strong private equity team, which I hope we get a chance to discuss. 

Giordano: You’re completely unlevered?

Chan: It’s nuanced. Essentially, we don't leverage our co-investments, but then the private equity firms and limited partnerships do use leverage. That's what boosts their returns. Another way to look at it is that we're more conservative, and we have less risk in terms of how we're running the program.

The main point is that as we look at what we do in the private model, we have to outperform the other strategy. Otherwise, we might as well just join a commingled fund, right? We might as well just be an LP, right? Why do the co-investments direct? It's been building for a long time. We've been at this for a very long time in terms of the history of co-investing.

When I say we started in 2018/2019 with 2.5% of the NAV, CalSTRS started co-investing long before, so we have a long track record. For us to build on that, it was certainly the right time and the right evolution. We really needed to build out a team to do it right. We started with this great core team. It was with Margot (Wirth) and Robert (Ross). Margot was and is the head of private equity. Rob and Seth (Hall) and Tom (Baker) are on the private equity staff.

Margot oversaw and hired some great folks to supplement and complement that core team. Aizaz Ali came from ADIA.  Georgia Pappas was a VP from KKR and formerly CPPIB. Josh Ungar came from a family office that invested in Venture FOF’s, Carlos Monfiglio was a former co-head of General Electric's private equity, and Nadiath Adechoubou came from E&Y. We've been able to recruit and retain that talent to build up the team. Certainly, the biggest tip, if you start trying to build a co-investing program: it all starts with the team.

Giordano: Yes, that makes sense. How large is your team now?

Chan: Around 40 on the private equity team. Private equity is where we probably do the majority of our co-investing today. To a lesser extent, we also do co-investing in real estate and infrastructure, or what we call inflation-sensitive, and sustainable investing, particularly in the energy transition space. It's hard to characterize the whole because we don't really break down the organization in terms of co-investing; we break it down into different divisions, and I just know where they are doing a lot of co-investing.

In real estate and infrastructure, they also do a lot of other structures like ownership and joint ventures alongside the co-investments. That's why, in private equity, that's their main Collaborative Model strategy. That's why the majority is private equity, just to orientate you across the organization. I would say every investment professional is called on to execute the Collaborative model in their different divisions.

Investments for the Current Economy

Giordano: What co-investments do you find are really working in this economy?

Chan: I think that, first and foremost, we're trying to build a diversified portfolio of co-investments across business units and sectors. Since we've been doing it a long time, you will notice if you lean in too much to something, it makes for a much more volatile performance. What we try to do, first and foremost, is to partner with the best general partners in the world.

I think that we've developed that. Through many years, we have arguably some of the best partners in the world. I would say that the vast majority of our co-investments come from our general partners. It's a matter of finding the best partners so that we can get to the best transactions and for the best co-investments. Then we're trying to build a diversified portfolio across business units, sectors, and position sizes. That's one facet.

Another way I could look at your question is, "Hey, across CalSTRS, where are you finding opportunities?" Today, across many of the private market asset classes, they're saying that they're favoring debt over equity because it tends to be a better risk-reward, and a lot of times, the returns are right on top of each other. For example, you could be in asset-backed in real estate. You could be in asset-backed in infrastructure, and the return is the same as writing an equity check if you're so much higher in the cap structure with better terms.

A lot of folks are leaning into the debt versus equity side in private markets. Energy transition is another area where we're finding opportunities, I think, because there are just some gaps and inefficiencies in the marketplace. Therefore, we formed a private portfolio between the risk-return of private equity and infrastructure. I think that having that capability is helping us find opportunities in those areas.

Given all the uncertainty and interest rates going up, and maybe the Fed pivoting and geopolitics, we're expanding or planning to expand our innovation portfolio to have greater flexibility to capture opportunities at scale across the organization. A lot of times, the market will come to you, right? For example, if there is, God forbid, a market disruption, there are going to be a lot of opportunities.

Having greater flexibility for us and having an opportunities portfolio to flex into, with investments that aren’t necessarily a great fit for any asset class, that can really help us. Today, we are seeing opportunities, for example, due to the upcoming Basel 3 framework, and banks and other financial institutions are accelerating their move out of lending to areas like asset-backed securities.  Those are three areas I would point out that we've been thinking about and leaning into.

Giordano: As far as the energy transition, what part of it do you find your opportunities? Is it the pipeline? Is it the building of the wind turbines? Is it retraining? I know Chris talks about just transition a lot, but as far as co-investing is concerned, where does it hit ground?

Chan: I'll give a lot of credit to our major asset classes for capturing some of those main opportunities. We have a North American renewables platform in our infrastructure inflation-sensitive division. We're in many of the growth and buyout elements within our private equity funds. On the other end, I think where there is a gap is that area that I was talking about in between the risk-return of private equity and infrastructure.

Investments in harder to “abate” sectors —  it's maybe technologies that are mature but just haven't been scaled that are needed in this climate change area, and we've been building that ecosystem where from a co-investment perspective, we have an advantage now – an advantage in validating management and technologies. For example, we recently did a co-investment in what I consider a mature kind of geothermal technology.

Upstream to that, we have growth funds that are helping us validate that. Yes, even though that was initially in one of our venture portfolios, it looks like the growth and buyout funds are going to back that organization. Even if we look at the public companies in the traditional energy sector, because we're invested in a lot of public companies, these companies have visibility there as well; they're validating that technology as well, so we can look at the co-investment. We certainly have experts on our staff who can then go through our whole ecosystem and be able to validate and verify it on a better basis.

Giordano: Makes sense.

Chan: I feel good about how we're developing it because we've developed partnerships early on, where we're taking ownership stakes early. And I think this could very well be an area that becomes the next asset class. At that point when it's scalable, we'll be in a great position because we'll have worked with all these organizations.

Giordano: Regarding the geothermal tech, can you go into detail on what that is? Is it cloud seeding?

Chan: I just provided an example of how it relates to the Collaborative model. I don't want to get into specifics because I think we try not to have our investments identified. I think the important point is developing that whole ecosystem.

Giordano: It does sound like a promising new asset class to invest in. I know it was reported that your new target for private equity co-investments is 35%, up from 2.5% 5 years ago. When you are searching for co-investments, what do you look for, and how do you kick the tires?

Chan: Yes. We kick the tires mainly through the team that we've developed. As I've mentioned, we have a whole ecosystem as well of partners, which I think really enhances our expertise. I would say it starts and ends with the team. One of the things that we do well, I believe, is that we empower the team. We develop team delegation from the board to staff and down the chain. And that's really important for the general partners when they look at our co-investment teams, whether they’re in private equity or real estate or infrastructure or others, that they can make a decision, and they can make a decision quickly! We can act very nimbly around that. What we try to do is build teams across asset classes to be able to help us with the appropriate expertise.

We also develop our relationships with each of the partners and know what they do and don’t do well. Essentially, we're looking at them trying to underwrite each of their partners and review teams and say, "Do they have a history of doing this? Do they have a history of doing it really well?" which gives us a lot more conviction, and then being able to channel-check and talk to other folks in our ecosystem to be able to validate that.

Our team verifies and validates every investment, but we're not at the point where we're leading investments. Our job is to work alongside those GPs and ensure we're selecting the right co-investments. We're looking at anywhere between $100 to $250 million or so in a single co-investment. That's been trending upward over time. If we're talking a year from now, two years, or three years, that likely will have trended upwards. Again, we're building a diversified portfolio as we go along and as we build this year by year. Those are just some of the elements that we're looking for.

Giordano: Going back over looking at your portfolio, can you talk about the changing environment with the higher interest rates and such? I know you're risk-averse and you're very aware of risks within the portfolio being that you don't leverage. But what do you see as taking shape in this new economy with the higher interest rates as far as good co-investments are concerned, if you were to guide someone else trying to learn about this?

Chan: With the Fed increasing rates by over 500 basis points, what it really shone a light on was raising the cost of capital, raising the hurdle for a deal to get done. I think now, you really have to look at the stability of the cash flows as you're underwriting these co-investments. There's been a little bit of a reckoning from this growth at any cost because there was no cost to build, right? You could borrow at ridiculously low rates.

Now, as you look forward, a company has to have projects that would justify a higher cost of capital. If they were to put debt on the balance sheet, which they will (any portfolio company likely will), then that really has to be justified through much higher project returns. We've seen that reckoning happening over the last one or two years.

It's still ongoing, but as you look at new investments, I think it's a really healthy position to be in. It's changed the co-investing landscape because, now, the hurdle has been raised quite a bit.

You know this, I'm probably not breaking news to you, but when private market transactions are down, we call it 50% to 80%. They're not exiting their transactions, and it's been a very slow market as the market is adjusting to what price you pay them in order to make the IRRs work.

The question is kind of a waiting game of if we're in a recession, right? The prices would go way down to this new cost of capital adjustment, but if we have a soft landing or the economy continues to grow really well, then maybe it'll be just an adjustment that happens over several more quarters. That's the dilemma now that you're seeing in the market: the bid-ask spread is pretty large, so fewer transactions are getting done. I know there's an army of investment bankers out there trying to get deals done, but we're not seeing a whole lot in comparison to the prior, call it, five years.

Giordano: On a very high level with BlackRock buying GIP, what does that signal? Does that mean that co-investments are the hot new investment, or will continue to be the hottest horse to bet on in this economy?

Chan: I can't really talk specifically about that transaction, but I can say that as for us, we built a team, and I think if you look back in history, you didn't necessarily need a team to select co-investments because private equity was doing extremely well, right? But I feel confident because over many cycles (up and down cycles) we're going to have the team selecting the right co-investment set that I think will do well for CalSTRS.

If you don't have that, if you haven't built the ecosystem, I would caution people about getting into the co-investment space because, essentially, you need a team to select the right investments fundamentally for your organization. We haven't been in that market cycle, right? We haven't been in a cycle where it matters because we've been in a low-interest rate cycle where everything works, right?

I guess what I'm proposing is that the cycle in front of us most likely won’t be one where everything's going to work. I think that, as people get into it, they really have to build a holistic vision around it, and they need a team to prosecute these deals. If they don't, they're taking on a lot of risk.

Giordano: Everyone seems to be envious of CalSTRS' team size. That's always my feedback. Is there a suitable size team that you think would be able to handle this if it was a smaller investment team office, or is it the quality of the people that you've recruited? If you could weigh those two for me, is there a way that a smaller team could actually move like the giant like you guys are?

Chan: A smaller team would have to structure things differently because every co-investment, you're going to say yes or no within a day, or certainly within the first five days. You need the team to be really responsive whenever you get the call. The second is they're going to do 6 to 8 weeks of due diligence on every single investment, which is pretty intense.

If you're going to select every co-investment, you can't really shortchange that process or the expertise you need to have to do it. But structurally, there could be ways upfront, where you structure something with a GP where they will be doing more of the selecting to make sure that you have some governance and are able to opt out and/or if it's something where we're developing something diversified for you in a certain bite size.

It's hard for me to put myself in their shoes, but if I were in their shoes, I would probably develop a different strategy than CalSTRS, given that ours is dependent on a team.

Giordano: I wasn't sure if you did co-investments when you were at Sacramento or smaller funds.

Chan: Yes. Well, we did, and we structured it differently. We made sure that it worked for a much smaller staff, and the governance works differently, too.  We structured it with the GP having the discretion around developing a diversified co-investment portfolio, but we had opt-out rights for each investment.

Giordano: Because you're governing now GPs more or because they have more of a role?

Chan: It would develop differently, but I think the components remain the same, right? You have to decide what you can do with your team. You have to make sure your board is with you. You have to build out the rest of the enterprise to help you mitigate the risks and to be able to respond. These are the same questions, but they would just be answered vastly differently if you knew that you wouldn't be able to have resources.

Giordano: Is there anything someone should definitely have in place, or a piece of advice not to be missed or overlooked when developing a co-investment program? I know you went into a lot of it already. What would you say is key or an often overlooked thing that's very important?

Chan: I think I'll reflect to what a lot of the GPs and partners tell me, which is that there's only really a handful of clients that they believe actually can do co-investments alongside them. It's not easy to build out the team and the ecosystem around being able to respond, and then perform well over time.

The main tip would be just to really assess whether you can do this well because your goal will be to beat the performance of your LPs with a co-investment program. If you don't, why do it, right? It's something that you have to be very thoughtful about whether you can succeed or not.

Even though you have the advantage of the fee differential, which seems like a lot, it's not easy to beat the LPs in terms of even having that cost differential spread.

Giordano: Well, I guess you didn't start from scratch. You have a powerful team of people who've been doing this quite a while.

Chan: Yes, we do.

Giordano: Thank you, Scott.