It is easy to conclude that general partners are just being shrewd these days by trying to pinch every dollar with more favorable fund terms. But Teacher Retirement System of Texas, the sixth largest public pension plan in the US, believes that skewing the terms towards general partners is simply being short-sighted.
Smart GPs, says Neil Randall, the senior director of private equity at TRS, take a long-term view on fund terms. “They don’t seek to squeeze out every last term-change possible because they know the markets will swing the other direction at some point,” Randall tells pfm’s sister title Private Equity International. “The goodwill achieved by not being too greedy in the good times will lead to shorter, more forgiving fundraising when LP capital is once again scarce.”
Austin-based TRS has a 13 percent allocation target for its private equity portfolio, which encompasses buyout; growth and venture capital; and credit and special situations. As of 31 August 2015, its actual allocation was 12.5 percent, or $16.03 billion. The pension fund kept busy in 2016 with more than a dozen private equity fund commitments, including $200 million to Vista Equity Partners Fund VI and €444.38 million to Permira VI, PEI data indicates.
According to a fund recommendation document obtained by PEI from another institutional investor, VEPF VI offers two classes for its LPs. Terms for Class A LPs include a 30 percent carried interest, 10 percent hurdle rate and 1 percent management fee, which falls to zero after the initial 10-year fund life expires, regardless of any fund extensions. Terms for Class B LPs include a 20 percent carry, 8 percent preferred return and 1.5 percent management fee that remains throughout the fund lifecycle, including any extensions.
Permira VI includes standard management fee and carry, a European distribution waterfall, an 8 percent hurdle rate and a 100 percent management fee offset terms for its LPs, according to an Oregon Investment Council document from June.
But other funds in the industry – not necessarily those TRS committed to – have radically amended traditional or standard fund terms. Some of the large fund closes of 2016 had no hurdle rate, the profitability point that a GP must reach before it can begin to earn carried interest.
Randall says while it’s not unusual to see periods where terms move away from LPs, it is crucial for investors to maintain strong discipline and know when terms are being stretched too far.
“The private equity business has been an attractive asset class for both LPs and GPs, and we should all focus on the long-term health of the industry versus seeking to maximize short-term incentives,” he says. TRS, which has one of the largest private market portfolios in the world with $35 billion in market value as of September, doesn’t shy away from letting that be known to private equity fund managers.
TRS senior managing director of external private markets Eric Lang says the pension fund has walked away from investment opportunities on certain occasions due to terms skewing towards GPs. “The fact is that we really have not seen many GPs proposing to lower the preferred rate, but when it has occurred we have stressed the importance of the term and in certain instances we have actually decided not to invest,” Lang says, adding that TRS views the hurdle rate as a “key component of downside protection” for LPs.
Founded in 1937, TRS’s historical private equity returns on average generated a 14 percent internal rate of return, according to a TRS investment management committee meeting book from September. It has consistently produced some of the top 10-year private equity portfolio returns among US public pension funds since 2013, as analysed by the American Investment Council. In the AIC’s report from this year, TRS came in first, with 15.4 percent in returns, reclaiming the top spot it held two years prior.
Lang points to the pension’s annual long-term return target of 8 percent to meet the needs of its beneficiaries. As a result, that 8 percent threshold is “pretty sacred ground” for TRS, which tries to avoid concessions to terms that might affect a risk transfer from the GP to the LP. “If the GPs are able to deliver the expected returns we anticipate from private equity, then the GP will be no worse off for maintaining the preferred return,” he says.
TRS is also active in making lead commitments and backing first-time funds. According to Lang, TRS has supported first-time funds on numerous occasions. The two main reasons are TRS’s Emerging Manager Program, which launched in 2005 and had made a total $3.4 billion in commitments since inception, according to the pension fund’s website; and the feeling that it should support one of TRS’s existing managers in a new strategy or product.
In the case of the latter, Lang says it has served as an efficient way to deepen its existing relationships. In January, TRS announced a $1.3 billion commitment for the next three years to its Emerging Manager Program, which includes private equity, real estate, energy and natural resources, and hedge funds.
The pension fund is also typically one of the anchor investors in almost every fund to which it commits. “We have a motto to not make anyone ‘half happy’, and as a result if there’s a GP we’re electing to commit to, we will most likely be one of their top five LPs and we will seek to be in the first close,” Randall says.
Some of TRS’s larger cheques to private equity funds this year included $300 million to Green Equity Investors VII, another $300 million to TPG Partners VII and $200 million to Kohlberg Investors VIII, according to PEI data.
At a time when the industry is becoming increasingly competitive with more players, dry powder at record levels, low interest rates and purchase price multiples that remain stubbornly high, what does TRS make of the 2016-vintage funds?
“While our current expectations are that the 2016 vintage year may be challenged due to the prevailing market conditions, we recognize that those funds will be investing in 2016 to 2020,” Lang says. “We tend to express our view on the current market environment by being more selective with our direct and co-investment program.”