Friday, April 4, 2014

The Long Lives of Alternative Investments: The NC Treasurer’s Annual Report

The Long Lives of Alternative Investments: The NC Treasurer’s Annual Report 

A couple of days ago, The Annual Report of the North Carolina Treasurer for Fiscal 2013 was issued along with supplementary fee and performance data.[1]  The information provides a great deal of new detail into the fees and performance of the state pension plan.  There are many ways to parse the data, but I thought it would be interesting to sort all the data on alternative investments by treasurer and vintage year.  
Angel Agenda (2001)
While the State Treasurer can quickly hire or fire conventional stock and bond managers, once they are hired, most alternative managers remain until a fund is realized and liquidated.  As a result, Treasurer Cowell inherited a great deal of alternative exposure created by her predecessors.  Using the vintage years for every long-term alternative investment contained in the State Treasurer’s supplemental performance and fee reports, I was able to estimate which treasurer was responsible for each investment.  Treasurer Boyles was in office from 1977 to 2001, while Treasurer Moore served from 2001 to 2009.  There’s some guesswork involved, because certain investment decisions might h

ave been in process during the transition between treasurers.

Let’s begin with the overall picture.  In the last fiscal year, total fees were $416 million, including incentive fees, which came to 52 BPs.[2] While these figures are below the national average, they are rising.   The table below shows the fees by category and quickly demonstrates that it is relatively expensive to invest in alternative investments.  Global equities, which mainly consist of conventional stock portfolios, generated 23% of the fees but represented 70% of the external assets.     The remaining categories are generally lumped together in a broadly defined universe of alternative investments.  As you can see from the credit category, the fees can become large if managers generate strong performance, because of the incentive structure built into most alternative strategies.  Credit generated 28% of the fees, but only accounted for 6% of the assets. As I’ve said in previous posts, if you hire alternative managers you’d better hope that you have to pay performance fees.  Otherwise, you didn’t receive much in the way of performance.  

I decided to dig more deeply into the fees generated by four areas: real estate, private equity, credit, and inflation. These are categories where the pension makes long-term commitments that cannot easily be reversed.  When a pension makes a commitment to a fund in one these categories, it is likely to be around for at least a decade.  I’ll call these categories long-term alternatives for convenience sake.

LT Alternative Investments By Category and Term: The top part of the next table shows LT alternative investments and fees by type of investment, and the bottom part shows the same information by Treasurer.

In total, the pension plan has invested in 266 LT alternative funds, which were valued at $15.5 billion at the end of the last fiscal year.   Most of the allocations were to private equity and real estate.  The pension plan has another $5.5 billion yet to invest over the next several years and has received $8.4 billion in distributions in the past.  The performance of alternative is captured by TVPI or Total Valued to Paid-In.  This data shows that the pension has made $1.16 for every $1.00 it has invested in alternatives.  However, TVPI includes the estimated value of investments that haven’t been sold, plus distributions.  DPI or Distribution to Paid-In only takes into account capital returned to the pension.  It is a more conservative measure.  In other words, the pension has actually received 41¢ in cash for every $1.00 it has invested.  Neither of these figures is surprising given the fact that North Carolina only ramped up its alternative program in the last ten years.  There’s not yet enough evidence to know whether the pension will earn good returns from these investments in the long run.

Moving to the right side of the table, you’ll see that the pension paid $189.1 million in management fees and another $118 million in incentive fees.  This works out to roughly 2% of assets, which is about what one would expect. 

Shifting our attention to the bottom part of the table, we can see that Treasurer Moore made over half the commitments to alternatives ($13.4 billion). Moreover, there’s still $1.6 billion that is yet to be funded from his term.  While Treasurer Cowell is responsible for the oversight of the entire portfolio, she inherited a great deal of the alternative exposure from her predecessor.  As you look at the performance (TVPI and DPI), you might think that Treasurer Boyles is the investment champion, since his portion of the alternative portfolio is worth $1.83 per dollar invested.  Because those investments were made so long ago, the annual compound return (which can only be roughly estimated) is probably only in the mid to high single digits.  While the jury is still out on Treasurer Moore’s portion of the alternative program, as you’ll see in the next table, the credit crisis probably caused significant damage. 

When it comes to management fees, over half of them are attributable to investment decisions made by Treasurers Boyles and Moore ($99 million out of $189 million), although the vast majority of the performance fees are attributable to managers retained by Treasurer Cowell ($77 million of $118 million).  This is due almost entirely to the success of the credit portfolio in fiscal 2013.

LT Alternative Investments by Vintage: We need to look at one more table before we are done.  The table below shows the same financial information by vintage year: when an alternative investment was initiated.   Like fine wines, vintage year means a great deal in investing.  While we tend to focus on the manager, the timing and pacing of an alternative investment are all important in alternative investing.  So what can we discern from this table?

First and foremost, we see the damage done by North Carolina’s antiquated investment statute.  From 1984 through 2001, the statute limited alternative investments to real estate and a tiny amount of venture capital.  Thus the pension plan missed out entirely on the one time period when buy-outs and hedge funds worked.  In 2009, the pension was unable to invest much of anything because it had hit limits imposed by the legislature.  That year is likely to have been the equivalent of a 1960 French Bordeaux: excellent.

Second, we see the importance of pacing in making alternative investments.  In order to have any chance at achieving good long-term results, you have to maintain a steady tempo. You don’t know in advance which vintages will be exceptional and which will be bad. In 2005 through 2008 the pension committed over $11.8 billion to long-term alternatives.  Making big bets as the credit bubble inflated wasn’t a good thing.  We can see that those vintages were responsible for a good portion of the management fees, but only achieved a modest amount of incentive fees; a sign of limited success.  The TVPI and DPI for these vintages are fairly anemic.

While we can’t yet tell how the 2011 vintage will work out, we’re seeing another sudden acceleration in the pace of investments.  This speedup occurred because the General Assembly finally approved an increase in investment authority, and the treasurer was able to resume making commitments.  It looks like the pension was trying to make up for lost time.

My tenure is, of course, included in this table.  I’ve previously referred to this period as an experiment in alternatives, and you can see why.  During my stint as CIO, the pension plan only committed about $1.7 billion with a TVPI of roughly 1.4 ($1.40 in total value per dollar invested).  Vintage 2001, my first year, was good, and the rest of the results are okay.  I was lucky to be investing during a period of good vintages and relatively small-scale investments.

I remain an alternative investment skeptic.  While I think the fees are too high, it’s clear that North Carolina is merely paying market prices for its alternative investments.  If anything, it is getting the discounts usually awarded to larger investors.  Fees aren’t the main issue.  Rather, there’s a bigger investment question concerning the efficacy of large commitments to alternatives.   The question isn’t unique to North Carolina.  Too many investors are throwing money at alternatives.  When everyone runs to one side of a boat, the boat tends to capsize. North Carolina’s alternative program is still relatively new, so long-term performance of the pension’s alternative investments is still unknown.   However as the data shows, the decisions made by the incumbent Treasurer will bind her successors, just as the decisions of Treasurers Boyles and Moore still affect the portfolio.


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