For decades, public pension funds have bankrolled the private equity industry, investing billions of dollars with large firms like Apollo Global Management and the Blackstone Group .
Now, frustrated by what it sees as expensive fees and lack of transparency at private equity firms, one state has decided on a do-it-yourself approach.
South Carolina’s pension fund is creating an independent firm to oversee the fund’s private equity holdings — doing what it would have paid a private equity firm to do. The effort is similar to the direct investment funds created by two of Canada’s biggest pension plans — Ontario Teachers’ Pension Plan and the Canada Pension Plan Investment Board — but is believed to the first of its kind in the United States.
“It’s high time that state pension funds are able to develop structures that have greater transparency and lower costs,” said Robert L. Borden, the chief investment officer of the South Carolina Retirement System Investment Commission, which oversees the management of the state’s $25 billion pension fund. Mr. Borden will run the firm under a plan approved last week.
Mr. Borden is particularly critical of funds of funds, which are firms that manage a portfolio of private equity funds. “There are layers of fees, your control rights are zero and your costs are astronomical,” he said. “We’re trying to tackle that model.”
Although South Carolina has a relatively small $5 billion private equity portfolio, the initiative has raised eyebrows in the industry. State public pension funds account for about 35 percent of private equity assets, according to data provider Preqin, by far the industry’s largest backer.
“This reflects how desperate state pension funds are,” said Colin C. Blaydon, director of the Center for Private Equity and Entrepreneurship at the Tuck School of Business at Dartmouth College in Hanover, N.H. “They’re looking to get big returns and put large chunks of money to work in private equity, but don’t want to pay the expensive fees.”
By reducing its reliance on outside money managers and investing directly in companies and real estate, the pension fund could eliminate about $2 billion in fees and other costs over the next decade, according to a study by consulting firm Booz & Company. The firm would charge the pension fund less than the lucrative fees — typically a 2 percent management fee and 20 percent of a fund’s profits — commanded by outside private equity firms.
Other state pension funds are starting to take more control over their private equity portfolios as they try to find ways to increase investment returns and cut costs. Earlier this year, the California Public Employees’ Retirement System announced plans to create portfolios with outside managers that would charge lower fees and offer more customized strategies. The Teacher Retirement System of Texas has expanded its program of co-investing in deals alongside outside private equity firms.
But creating an independent firm 100 percent owned by a state pension fund is novel.
“By creating it, we can build value for ourselves rather than buy into someone else’s firm,” said the 47-year-old Mr. Borden.
South Carolina is also increasing its allocation to private equity, which has historically generated higher returns than such traditional investments as stocks and bonds. After a decade of sluggish performance that made it difficult to achieve the fund’s target investment returns, the state hopes that raising its private equity exposure will help it to meet those goals. Over time, the fund is looking to commit as much as $8.7 billion to the strategy, according to fund documents.
South Carolina’s roughly $5 billion allocated to private equity has investments in some of the most prominent buyout shops, including Apollo, Apax Partners and Clayton, Dubilier & Rice, according to the fund documents.
The enterprise still plans to collaborate with these outside private equity funds. It expects to allocate as much as 40 percent of its assets to strategic partnerships and so-called co-investment opportunities in which the firm would piggyback on other funds’ deals. For instance, South Carolina already has a venture with Apollo, called Palmetto, in which it invests in European assets.
The South Carolina pension fund has approved $15 million in start-up costs for the firm, which is set to begin next month.
Hiring personnel will be a major challenge for the firm, which will have its headquarters in Charleston and an office in New York. Initial plans call for hiring 30 professionals by next year and ultimately more than 60 people, according to the fund’s documents. Although its reduced fees will save South Carolina money, the firm’s lower revenue will make it hard to pay compensation on par with Wall Street.
Another potential issue: Private equity professionals may see the firm’s link to the state pension fund — along with its unproven track record — as less appealing or prestigious than working for an established firm.
Mr. Borden pointed to a number of factors in its favor. The dislocation on Wall Street has resulted in a greater supply of financiers looking for new opportunities. And the firm would not have to court investors in a difficult fund-raising climate.
“Capital is scarce and talent is readily available,” Mr. Borden said. “We couldn’t have done this in 2007.”