PENSIONS - Washington State’s Doubling Down

Washington’s state investment board bets big on private equity and other illiquid assets, despite market turmoil.

Talk about the courage of your convictions.

For years the Washington State Investment Board has been a daring, cutting-edge investor, risking more of its now–$65.8 billion pension portfolio on private equity than any major state plan. Washington State got in the game early, with Kohlberg Kravis Roberts & Co.’s first fund in 1982, and as the returns poured in, the state pushed its target allocation ever higher — to 17 percent as of last year.

Then came the credit crunch. Suddenly, after years of riding high as one record-size leveraged buyout followed another, the private equity market tumbled. Deal terms stiffened, lenders balked, and credit all but evaporated; $154 billion worth of buyouts were pulled during 2007, up from $112 billion in 2006, according to Dealogic. KKR and its rivals took turns warning investors that they could expect lower returns in the future.

So what did Washington State do? Simple: It decided to increase its exposure to the sector even more.

On November 15 the board’s trustees voted to push their private equity target to 25 percent, well above the 14 percent targets of the next-most-aggressive state funds: Oregon Public Employees Retirement System and Pennsylvania State Employees’ Retirement System.


Combined with a smaller tweak in the portfolio that nudged real estate investments from 12 percent to 13 percent, Washington State plans to dedicate 38 percent of its assets to the two struggling sectors — one of the highest levels of investment in so-called alternatives of any major public plan. The Pennsylvania State Employees’ plans (with 28 percent in hedge funds) allocates half of its money to alternatives.

Washington State’s trustees approved two other changes proposed by chief investment officer Gary Bruebaker: They allocated 5 percent to such tangible assets as energy and infrastructure, and authorized up to 5 percent of assets to go into an “innovation portfolio” that allows for virtually any sort of investment. And after years of avoiding hedge funds, Bruebaker says he is now considering making the state’s first investments in that red-hot asset class, though not before 2009.

To make room for these new investments, Washington State will radically overhaul its portfolio, slicing its passively managed public equities from 46 percent of assets to 37 percent and paring fixed-income holdings from 25 percent to 20 percent. (Asset classes with similar characteristics will be drawn down to fund innovation portfolio investments.) The changes will be phased in over a decade.

The moves mark a signal victory for Bruebaker, who put his hard-won credibility on the line to argue that the long-term performance of the private equity market and the investment board’s own track record justify the bigger bets. His boss, executive director Joseph Dear, helped Bruebaker make his case by organizing a series of ten seminars with visiting academicians, actuaries and others over 16 months to educate trustees on risk, capital market assumptions and other topics.

“I don’t think we take advantage of the illiquidity that I think we can afford and should,” Bruebaker told the trustees at the decisive November 15 meeting.

To be sure, with current market volatility, the decision was not unanimous. After more than 90 minutes of debate, eight trustees supported the changes, but chairman Glenn Gorton and Assistant State Treasurer Allan Martin, sitting in for State Treasurer Michael Murphy, opposed them. Martin fretted that the ten or more years it could take to complete the reallocation of assets might be too long. “I’m not sure what’s going to happen tomorrow,” he said at the meeting. “I live in a world of operating funds, and . . . the possibility exists that someday you could find yourself needing cash to pay beneficiaries.”

Murphy, the only statewide elected official among the trustees, worries about so-called maverick risk — straying too far from what Washington State’s peers do. The average big-state pension plan has 9.6 percent allocated to alternative asset classes, according to the National Association of Retirement System Administrators.

Murphy worries that Washington State’s outsize private equity allocation increases the chance that reporting short-term returns dramatically worse than those of its peers might trigger an outcry among voters and politicians, and tempt the board to abandon its commitment at the bottom of the private equity cycle, resulting in the classic blunder of selling low.

“It’s one thing if we’re all wrong together,” Murphy tells Institutional Investor. “It’s another if we’re wrong all by ourselves.”

Murphy is not alone in his concern. Even Bruebaker says, “There will be a time, I can’t say when, when short-term results say this has been a foolish move. The risk is that if we get a board with a different view, they could abandon the strategy at the wrong time.”

Executive director Dear remains positive. “You’ve got to have confidence that the board and the staff have the conviction to stick with the program even if it’s criticized.”

And Bruebaker is nothing if not steadfast in his conviction that he has the right mix of alternatives, anchored by private equity. Since the state committed to KKR’s first fund, its private equity portfolio has generated more than $12.5 billion in profits, or nearly $21,000 for each of the plan’s more than 596,000 active, inactive and retired members. Through its most recent fiscal year, ended June 30, 2007, its 15.7 percent annualized internal rate of return had fallen short of the 18.3 percent return of the fund’s benchmark, the Standard & Poor’s 500 index plus 500 basis points. But the recent past has been far stronger, with private equity beating its benchmark for the last one-, three-, five- and ten-year periods. It returned 29 percent for the year ended June 30, versus its 17 percent benchmark, and 30 percent for the previous three years, double its 15 percent benchmark. Bruebaker believes that the asset class will outperform public equities by 400 basis points annually over the long haul.

“We’re not trying to be different or look different,” he says. “We’re just trying to identify where we can get compensated for needing less liquidity.”

But Washington State is undeniably blazing a maverick trail: The new allocations will give it a profile more akin to an endowment than a public pension fund. That’s good and bad. Endowments, like those at Yale University and Harvard University, have compiled extraordinary investment records in recent years, in large part thanks to big bets on alternatives, which frequently exceed 50 percent of assets. But along with outsize returns come outsize risks that need to be carefully monitored and managed — a challenge for often underresourced state plans.

“Risk is the single most important issue we have going forward,” acknowledges Bruebaker, who concedes that Washington State’s risk management systems are not yet adequate for the changes it is planning. As a result, the board is spending $5 million to develop a proprietary risk-analysis system, specifically tailored to its portfolio structure, that should be ready next year.

One big risk is whether Washington State can continue to count on outperformance from the private equity firms in which it invests. The plan has built deep relationships with elite private equity partnerships like KKR and TPG Capital. Eighty percent of its current $13.5 billion in private equity investment are in those and other top-quartile firms. The size of these firms — the only ones to significantly and persistently outperform public equity markets, according to McKinsey & Co. — will enable Washington State to deploy an estimated $10 billion of additional funds in the asset class over the next decade.

Washington State’s stakes are certainly high. Bruebaker figures that if his fund’s private equity investments hit their benchmark over the next 15 years, raising the allocation will earn an additional $17 billion. It’s a bet that might make other fiduciaries nervous, but, says Charles Kaminski, a nonvoting member of the investment board who manages portfolios for high-net-worth clients, “What’s comfortable to us would be totally out of bounds for a plan that has not ventured into this category before.”

Comfortable, indeed. Private equity has made Washington State the envy of most public pension systems. Its one- and three-year returns of 21.4 percent and 17 percent, respectively, through June 30 were in the top 1 percent of its peer group, according to Wilshire Associates, while its five-year return of 14 percent lands it in the top 2 percent. The system is 100 percent funded, compared with the 83.5 percent median for other major public plans.

“We’ve benefited from years of great decision making and are at a point where we can continue to build on this skill set,” says Kaminski.

Is Washington State going too far out on a limb? Even Bruebaker himself readily concedes that the recent boom in private equity returns is over: “We all know that debt was too easily available and that trees don’t grow to the sky.”

His strong bias toward private equity stems from a belief that “private equity firms have a lot more tools in their tool kits” than do public companies. He also values an “alignment of interest that you don’t get with investments in stock.” At public companies, he told the board in November, “managers don’t listen to you. You can vote proxies, but it doesn’t matter. It’s more about maximizing personal wealth than shareholders’.”

Still, there’s no denying the troubling signs in the market. Too much capital is chasing deals, threatening to lower returns. The end of easy, cheap credit means buyout firms won’t be able to lever up deals as much to enhance profits; low-cost recapitalizations that enabled firms to refinance their acquisitions and pay themselves return-boosting dividends will also fade, notes Sanjay Mansukhani, head of private equity research for consulting firm Watson Wyatt Worldwide.

Despite the change, there is no slowdown in limited partners’ appetite for private equity. Private Equity Intelligence, a research firm based in London, estimates the global value of private equity and real estate funds raised last year was $518 billion, up from $517 billion the year before. Its poll of more than 100 institutions worldwide found that 52 percent were planning to increase their private equity allocations, with the other 48 percent planning to keep their allocations the same. The research firm says that the global value of private equity assets under management, including private real estate funds, broke through the $2 trillion barrier last July, doubling in the preceding four years. It projects assets under management will double again in the next five to seven years.

Real estate also appears problematic, with the downturn in the subprime-pummeled residential property market showing signs of spilling over into commercial properties. “The mortgage black hole is, I think, worse than anyone thought — deeper, darker, scarier than what the banks thought,” Hamilton (Tony) James, president and COO of Blackstone Group, said in a November earnings call.

Of Washington State’s $7.5 billion real estate portfolio, 61.3 percent is in the U.S., and 14 percent of the domestic total is concentrated in hard-hit California and Nevada. Residential properties make up 20.8 percent of Washington State’s global property portfolio; offices, 16.9 percent; industrial, 14 percent; and retail, 10.6 percent. Hotels, land and natural-resource properties account for most of the rest. Through September 30, Washington State’s one- and three-year real estate returns were 30.87 percent and 26.79 percent, respectively. Alas, in September, Courtland Partners, Washington State’s real estate consultant, told the investment board that 2006 marked the top of the appreciation return cycle. Looking ahead, Courtland forecasted unleveraged ten-year returns ranging from 5.4 percent for industrial properties to 12.1 percent for hotels.

Yet the clouding market prospects failed to dim the trustee majority’s willingness to take on more risk — at least, not after Dear’s educational efforts. A key moment came in July, when Andrew Lo, a professor at the Massachusetts Institute of Technology and director of its Laboratory for Financial Engineering, attended the board’s two-day summer retreat at a resort in Port Ludlow, northwest of Seattle.

A theoretician and hedge fund manager, Lo argued that as market conditions change, opportunities to create alpha, or outperformance, wax and wane in a dynamic process. “The implication for Washington State,” Lo says in an interview, “is that rather than trying to focus on a purely passive strategy of holding certain proportions of assets in one asset class, they should think about different cycles — the equity cycle, the fixed-income cycle, the volatility cycle and so on — and about how various asset classes are related to each other.”

His analysis encompasses more than alternative-asset classes. Washington State has typically steered clear of actively managing U.S. stocks; its domestic holdings are either indexed or in enhanced indexed strategies. But that’s changing, thanks to Lo, says David Nierenberg, a private sector money manager and one of the fund’s five nonvoting board members. In December, Bruebaker allocated 1 percent of the portfolio to active global equity managers, a category that includes U.S. stocks. “Active stock picking will become a more prominent part of our thinking,” says Nierenberg.

Bruebaker maintains Washington State can afford to take more risk because the chance of the fund’s facing a liquidity crunch is close to zero. Analyses by Mellon Financial Corp.’s Human Resources & Investor Solutions in 2004 and by the state actuary in 2006 found that net outflows to beneficiaries were only 2 percent of assets. Even if contribution rates were close to zero, the maximum outflow would be about 3 percent. Washington State’s 2 percent outflow is typical for public pension plans but far below the 5 percent annual expenditure the Internal Revenue Service requires of endowments and foundations, which routinely make high allocations to illiquid assets.

Chief operating officer Theresa Whitmarsh says that Washington State manages operational and reputational risks effectively but that it has been more of a struggle to stay on top of investment risks such as overconcentration and credit exposure. “It’s tough for us to stand back and look at major market moves and even know directly how they’re going to impact our portfolio,” she says.

Whitmarsh is building a new risk system, similar to those at the California Public Employees’ Retirement System, Ontario Teachers’ Pension Plan and the Virginia Retirement System, that will use public-market equivalents as proxies for valuing private equity holdings. But she doubts that purely quantitative proxies are sufficient. So the proprietary system scheduled for deployment next year will also integrate qualitative information, serving both to measure portfolio risks and to aid research on individual deals and companies. “We want to facilitate a more rigorous discussion,” Whitmarsh says. “Now it’s a bit ad hoc and informal.” Bruebaker looks to the system upgrade to literally add dimensions to the fund’s risk analytics: “As with 3-D chess, I want to be able to look at our private equity portfolio from any angle and find out what my exposures are.”

Like many public pension plans but unlike endowments and foundations, Washington State’s fund is not controlled by professional investors. Two of the investment board’s ten voting members are legislators. Five represent state retirement system members and are appointed by the governor and the superintendent of public instruction. (One of these is chairman Gorton, a maintenance and transportation technician who represents the School Employees’ Retirement System.) The other three — the state treasurer and the directors of the Department of Retirement Services and the Department of Labor and Industries — are ex officio. The five nonvoting members are investment professionals whose role is to raise the board’s level of sophistication in overseeing the assets of its 16 separate retirement plans for public employees, teachers, police officers, firefighters and judges.

Bruebaker is confident, though, that the board won’t bail out of illiquid assets when the going gets tough. “It won’t happen if they look at our history,” he says.

Washington State was among the pioneering pension funds investing in alternatives. Its 1981 pledge of $13 million for KKR’s first fund put it alongside the Oregon Investment Council on the leading edge of private equity investing. But Washington State’s investment processes were ad hoc. Then–executive director John Hitchman and the five nonvoting members called the shots. “If you weren’t part of that group, you were supposed to come to the board meetings and shut up,” recalls Dear, who became an ex officio trustee in 1987 as the Department of Labor and Industries’ representative. In his trustee capacity, Dear was routinely asked to approve recommendations for $50 million or $100 million private equity investments. He says that the responsibility, with no input from staff or consultants, made him “tremendously anxious.”

By 1991 real estate investments had topped $1 billion, and private equity, much of it with KKR, totaled $2 billion as of that June. But there was only one staff person overseeing real estate, no one supervised venture capital and buyout investments, and the fund had no consultants, outside lawyers or formal processes for preparing investment memorandums.

In the year ended June 30, 1991, the total trust fund gained 9.5 percent, 50 basis points better than the SEI Investments balanced funds median. But the portfolio components were all over the map: Buyouts returned a sparkling 46.7 percent, but venture capital fell 8.6 percent. Real estate, stung by a costly $500 million investment with Cadillac Fairview Corp., whose highly leveraged commercial properties were hurt by the early 1990s recession, declined 10.4 percent.

By the end of that year, the investment board, under then-chairman Dear, had initiated a series of structural moves to improve its governance. In September 1991 it hired as executive director Basil Schwan, previously the assistant executive officer of investment operations at CalPERS. Over the next year Washington State formed separate committees for public and private equities, audit and administration, and hired consultants including Wilshire Associates, Brinson Partners and Townsend Group.

After several years of reduced private equity investing — a reaction to having lost 96 percent of a $42.6 million 1989 investment in venture capital firm KBA Partners, which had steered the money into nonventure investments — the board in 1997 increased its allocation from 10 percent to the pre-KBA level of 15 percent. It also began diversifying its general partner roster, adding such names as Blackstone, TPG and Warburg Pincus.

Despite Dear’s reforms, the board’s workings were less than democratic through the 1990s. Decisions were dominated by a handful of voting and nonvoting members, who tended to run roughshod over staff and consultants, especially when it came to private equity.

“It was a completely divided shop,” says Christopher Ailman, CIO of the California State Teachers’ Retirement System, who was Washington State’s CIO from 1996 to 2000. He estimates that commitments to private equity funds exceeded the staff’s recommendations more than half the time during his tenure. In 2001, for example, when KKR solicited capital for its $6 billion Millennium Fund, Washington State consultant Brinson Partners recommended a $400 million allocation. The staff proposed $600 million, yet the board approved $1.5 billion. In hindsight, the board did right: Including reinvestments, Washington State has pumped $2 billion into the fund, which had an internal rate of return of 38.5 percent through June 2007.

“The board looked at KKR as an anchor,” says James Parker, who served as executive director between 1994 and 2002. “They thought KKR would not hit home runs as much as singles and doubles, and would be unlikely to strike out.”

As a by-product of its relationship with the pension fund, KKR grew into one of the state’s biggest employers in the 1990s, gaining occasional access to the governor to discuss labor and other issues. In 1985, for instance, Washington State invested $108 million in the KKR Red Lion Fund, which acquired Red Lion Hotels, based in Spokane. It owned the hotel chain for 11 years before selling to Doubletree Corp. for $1.2 billion. In 1986, KKR acquired Pleasanton, California-based supermarket chain Safeway, taking it private in an LBO along with the company’s senior management. Safeway went public again in 1990.

When longtime trustee Dear became executive director in late 2002, he focused anew on governance. “There were huge communication problems between the staff and the board,” he says. “Inside the organization, people were so siloed that it was hard to have cooperation.”

Just three weeks after Dear took the management job, KKR proposed that Washington State make a $1 billion equity investment in the firm. The staff joined with some key board members in opposing the deal, in part because they didn’t like the 20-year requirement that profits from Washington’s investment in the Millennium Fund be reinvested in KKR. In December 2002 the board tabled the proposal.

The rebuffed KKR sought to restore its influence with the Washington State board. In January 2003, George Roberts and other KKR partners visited then-governor Gary Locke to talk up KKR’s contribution to Washington’s economy. Then KKR commissioned a local lobbying firm, Pacific Public Relations, to promote amendments to a bill in the state legislature that would have given the governor authority to add two voting members to the board. The bill would have set up a new committee of the investment board to nominate the five nonvoting members — a task that had been the entire board’s responsibility. It also would have shortened their terms to two years from three and given the committee the ability to fire them without cause. The bill passed the state senate but died in the house in March.

“It seemed very self-serving and inappropriate for a vendor that comes before the board and asks for business to work behind the scenes to alter the structure of the board,” says State Treasurer Murphy. KKR declines to comment on the incident.

The events “left a taste in our mouths we didn’t care for,” Murphy says. Dear used that summer’s board retreat to initiate a review of all charters and policies. One result was a more democratic committee structure: Instead of the board’s chairman unilaterally naming committee members, he or she would have to get the entire board’s approval. That made it far more difficult for a small group to dominate decision making.

With the board functioning more smoothly, Dear worked with Bruebaker to orchestrate an educational process that they hoped would raise the trustees’ comfort level with, and hence allocations to, illiquid assets. In just the past year, board members have attended sessions on liabilities, capital market assumptions, risk, investment beliefs and peer review. They have heard presentations by economist Horace (Woody) Brock, president of New York–based Strategic Economic Decisions; Harvard Business School professor and private equity expert Josh Lerner; and MIT’s Lo.

“These people are brilliant, and the education is tremendously valuable,” says board member Sandra Matheson, director of the Washington State Department of Retirement Systems. “I’m comfortable with the notion that volatility exists in a portfolio that isn’t a zero-risk asset. Volatility is part of life.” Says Dear, “When you think about the attributes of public pension funds, the major advantage is the ability to take a really long view, which leads you to private equity, real estate, real assets and other forms where we can take advantage of that long horizon.”

That assumes that cyclical eruptions like today’s credit crisis will recede into short-term insignificance and that strategic consistency and savvy risk management will keep Washington State on top of the pension game. The former isn’t consensus economic wisdom at the moment, but the latter is within the investment board’s grasp. For Dear, the evidence will not be only quantitative: “We want people to look back in 20 years and go, ‘Wow, those people were really thinking ahead.’”