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Man in the Middle

With a big bet on private equity, the Oregon pension fund delivers strong returns. Investments director Ron Schmitz has kept the peace as well as the books.

Just 19, Ronald Schmitz was working a summer job as a foreman at a Chicago trucking company where he oversaw a rough-hewn crew of men in their 50s. Many of them saw him as an upstart college kid.

For days the gang had avoided loading a long, polelike package that interfered with the truckers' motto "pack 'em high and tight." Searching for a way to persuade the men to tackle the job, Schmitz settled finally on a quiet, humble approach.

"I'm not sure how you'd do it, but could you figure out a way to get that unusual piece of freight on its way?" he asked the men. They soon did. "If I had barked orders at them, they would have told me to take a hike."

Three decades later a patient, collaborative leadership style continues to serve Schmitz well in his post as director of the Oregon State Treasury's investment division. That job makes him effectively the chief investment officer of the state's top-performing, $54.4 billion retirement fund, which covers some 310,000 active and retired state employees.

"Ron is not strident," says Gerard Drummond, a former chairman of the Oregon Investment Council, the six-person board of trustees that establishes investment policy for the fund. "He has a mature, measured way of effecting change."

The Oregon Public Employees Retirement Fund is one smoothly humming investment engine. The plan returned 18.48 percent for the 12 months ended March 31, placing it in the eighth percentile of public funds with assets of more than $10 billion, according to consulting firm Wilshire Associates. The record is even stronger long term: The plan ranked in the first percentile over the past three- and five-year periods.

Credit first Oregon's big, lucrative bet on private equity. Its 8.6 percent allocation to the asset class -- almost double the average for public funds -- last year returned 26.91 percent, nearly three times its benchmark. A pioneer in the field of alternative investments, Oregon turned to private equity back in 1978, the first public fund to do so. Surprisingly, the plan has shunned hedge funds, worried about their leverage and lack of transparency. Still, a faith in active management (only 12 percent of assets are indexed) drives returns throughout the Oregon portfolio.

"Most managers tend to overdiversify their holdings," says Schmitz. "We try to find managers with concentrated portfolios who have a good shot of beating the market."

Oregon's investment engine has experienced a few knocks, however. For several years beginning in late 1999, trustees, consultants and the 15-person investment staff fought bitterly over policy and plan strategy. When the job of investment director opened up in mid-2002, State Treasurer Randall Edwards and several trustees turned to Schmitz, then CIO of the Illinois State Board of Investment, confident that he was just the man to bring the peace.

Schmidt wasn't completely prepared for what he found when he arrived in Salem at the start of 2003. "The depth of the enmity surprised me," he recalls. "This was a brain-damaged and dysfunctional family." Still, he felt certain he could chart a middle course between the warring factions. "I told Randall that this would be fixed in six months," Schmitz says. "I'm not so brilliant, but I know how to take a step back."

He healed that rift only to find himself embroiled in a public uproar over a private equity investment that had the appearance of being a sweetheart deal for former governor Neil Goldschmidt, (who later confessed to an affair, decades before, with a teenage baby-sitter [see box]).

Schmitz restored harmony to the organization while preserving its good performance. Now he wants to boost the authority and size of his 13-person staff, avoiding any recurrence of turmoil. Schmitz has no desire to change the plan's basic asset allocation: overweighting private equity and real estate, underweighting domestic stocks. But he would like the board, following its mandate to set investment policy, to focus more on broader policy issues and less on nitty-gritty investment decisions. Schmitz believes that his staff, which is charged with executing board policy, should have more freedom to invest.

"We've lost hundreds of millions of dollars in private equity and real estate investment opportunities because decisions were delayed," he says.

AT 6-FOOT-4 AND SOME 250 POUNDS, SCHMITZ IS an imposing figure, but he has never been one to throw his weight around.

The eldest of two boys, Schmitz was born in 1953 on Hickam Air Force Base in Honolulu and moved at an early age to Kansas City, Missouri, and then Chicago, where his father, Jerome, was an office manager for a trucking company. Schmitz earned a degree in finance from Macomb-based Western Illinois University in 1975; he obtained a master's degree in finance and marketing from Northwestern University's Kellogg School of Management in 1981.

He remained in Chicago, where he held pension management and consulting jobs at Kraft Foods; Sears, Roebuck and Co.; and Stratford Advisory Group before moving in 1988 to Blue Cross Blue Shield Association. There he managed some $2 billion in pension assets for the group's operating companies.

Schmitz learned to finesse a polarized board after he joined the $11 billion Illinois State Board of Investment as CIO in 1998. The following year newly elected governor George Ryan appointed a new chairman and two other members to the nine-person board, changing its character, says Schmitz, "from a laissez-faire approach focused on maximizing returns to one that had a faction that wanted to make socially responsible investments." Schmitz and his staff didn't object to hiring more minority managers and brokers, but they opposed investing in funds that aimed, say, to create jobs for unionized workers. Rather than alienate half the board, however, Schmitz tempered his opposition. He argued that socially responsible investments were reasonable if the goal was to promote the public good, but he stopped short of a forceful recommendation. "It was a way to bridge two warring factions on the board," he says.

In the end the board compromised, hiring more minority managers but rejecting proposals to invest in urban renewal projects and fund a union-oriented investment vehicle. Over the three years ended December 2001, assets managed by Schmitz returned an average annual 3.9 percent, besting the 2.89 percent median return for public funds with assets of more than $1 billion, according to Wilshire.

By 2002, Schmitz and his wife, Melissa, were ready for a change of scene. Their daughter, Rebecca, had completed college and their son, Scott, had finished high school. Schmitz had traveled to Portland, Oregon, frequently during his Blue Cross days, and he liked its temperate climate and outdoors culture. When he learned of the Oregon pension job, Schmitz fired off an e-mail and, after hearing nothing for weeks, followed up with a phone call.

Meeting with State Treasurer Edwards and then­OIC chairman Drummond in Edwards's office in the Greek-style capitol building in Salem, Schmitz found himself answering questions that had less to do with investment philosophy than with staff management. The pattern repeated when Edwards and Drummond checked his references. "They didn't really ask if I knew what I was talking about on investments," says Schmitz. "All they wanted to know about was how I managed board and staff relations."

For a very good reason, as it turned out.

RELATIONS BETWEEN THE OREGON BOARD AND the staff are governed by a structure that is traditional for public plans. Under the supervision of the state treasurer, the six-person OIC, now chaired by Richard Solomon, a Portland tax accountant, sets the plan's investment policy, following a simple mandate: to achieve the highest return possible. Four of the five board members are appointed by the governor. The sole ex officio member is the state treasurer.

Schmitz, who reports to Edwards, leads a 14-person staff whose brief is to execute the plan's investment objectives. The staff vets and recommends portfolio managers to the OIC and monitors their performance. Both the OIC and the staff draw upon the advice and counsel of the plan's consultants.

Shortly after Schmitz signed on in Salem at the beginning of 2003, replacing Dan Smith, who had retired, he realized that the plan desperately needed someone to restore the peace. Staffers were openly ridiculing the OIC, and many board members in turn criticized the staff as arrogant and slipshod.

Fixing the problems, Schmitz concluded, would require dismissing the plan's consultants, reading the riot act to his staff and spending time individually with members of the OIC.

The troubles stemmed from an unusual arrangement in which two consultants with different investment philosophies and strategies were vying for the support of the staff and the OIC. Oregon's longtime consultant, Russell Investment Group, had been on the plan payroll for more than two decades and took a bottom-up approach: It first weighed the investment processes and disciplines of money managers, instead of employing a top-down approach and beginning with a quantitative analysis. Russell generally counseled that pension funds shouldn't be too quick to dismiss underperforming money managers. Lagging a benchmark for a quarter or two, the firm believed, shouldn't be a firing offense.

Beginning in mid-2000, however, board members Diana Goldschmidt (the wife of Neil Goldschmidt, she had joined the board in 1998, seven years after her husband's term as governor had ended) and Mark Gardiner, who joined in 1999, frequently challenged Russell's advice. "Diana was always pounding the desk, saying, 'Why aren't our managers always in the top 5 percent?'" says Randall Pozdena, who served on the OIC from 1992 to 2001, the last four years as chairman.

Goldschmidt says she didn't insist on top 5 percent performance but grew annoyed when Russell recommended managers who hadn't ranked at the top of its own 4-point scale. "I pushed back pretty hard," says Goldschmidt, who has retired with her husband to a 20-acre vineyard outside Portland. "They were very reluctant to discuss it and never wanted to fire anyone."

Pozdena thought that hiring a performance measurement consultant would vindicate Russell's judgment. He persuaded the OIC to sign up Portland-based (now Miami-based) Compass Advisors in December 2000 to provide performance measurements on a monthly basis, augmenting Russell's quarterly reports.

The strategy backfired. Compass provided not only data, but opinions that differed from Russell's regarding managers. "Russell believed that slow and steady wins the race, whereas Compass believed in flipping to the manager du jour," says Pozdena.

"Shame on him," says Compass CEO Joseph Meyer, referring to Pozdena. "It's the hallmark of Compass to seek meaningful excess returns over a long period of time."

Increasingly, Goldschmidt and Gardiner aligned their views with those of Compass, which recommended drastic changes to Oregon's lineup in 2001, when the fund lost 6.2 percent, versus the large-public-fund median of ­5.2 percent. Compass proposed that the OIC dump its entire lineup of passive equity and fixed-income managers and terminate active equity managers such as Acadian Asset Management and minority-owned growth manager Brown Capital Management. "They were tremendously overdiversified," says Meyer.

In contrast, staffers almost universally sided with Russell. At public OIC meetings, Schmitz recalls, some huddled together and mocked questions from OIC members that were critical of Russell.

Concerned that it had lost the confidence of the OIC, Russell decided not to seek renewal of its consulting contract at the end of 2003. The board considered several replacements, including Mercer Investment Consulting and Callan Associates; ultimately, the OIC unanimously chose San Francisco­based Strategic Investment Solutions. At the time, Russell owned 19.9 percent of SIS, which had access to Russell's research and had adopted a similar bottom-up approach to manager selection. (SIS bought back the stake in March 2005.)

"When SIS was chosen I said, 'Let's also get rid of Compass,'" says Schmitz. "They had been doing everything they could to sabotage Russell's relationship with the council."

Compass CEO Meyer disputes that view. "The staff moved against us because they didn't want to hear that some of their managers should be fired for poor performance," he says.

Ironically, even as the board and staff bickered, Schmitz and his colleagues could point to one of the best investment records in the public fund universe. "People can say what they want," says State Treasurer Edwards. "The track record is there."

Indeed it is, thanks to a tradition of innovative investing.

When it took a $10 million stake in a Kohlberg Kravis Roberts & Co. fund in 1978, Oregon became the first public plan to invest in private equity. Then in 1981 it made a colossal bet on the asset class, committing $178 million, or about 9 percent of total assets, to a single KKR deal -- the $420 million buyout of Fred Meyer, a Portland, Oregon­based regional grocer and retailer that is now part of Kroger Co.

Oregon continues to maintain an especially close relationship with KKR. As of September 30, 2005, the firm represented 31.1 percent of the plan's entire alternatives portfolio; Texas Pacific Group accounted for an additional 13 percent. Since 1981, Oregon has invested $4.5 billion in KKR funds; earlier this year it committed $1.5 billion to the firm's KKR 2006 Fund. Oregon has invested $828.2 million in four TPG funds since 1994. It's a highly concentrated bet on two of the industry's big names, and it has paid off. Dating back to the early 1980s, KKR's funds have delivered a cumulative internal rate of return of 20.8 percent, while TPG's funds since 1994 have generated a cumulative internal rate of return of 22.5 percent. The remainder of the plan's alternatives portfolio is split among 53 firms, including funds of funds. Over the five years ended in September, Oregon's alternatives portfolio returned 8 percent, versus its 6.97 percent benchmark.

The plan has also made an outsize bet on real estate that has delivered strong results. About 7 percent of Oregon's fund is in this asset class, compared with an average of 4.2 percent for other state systems. Last year, real estate returned 41.48 percent, more than double the 20.06 percent return for its benchmark.

In another break from the crowd, Oregon keeps considerably less in domestic equities than its public plan peers do. U.S. stocks comprise just 35.1 percent of its portfolio, compared with the 44.0 percent median for other state systems. Only 25 percent of domestic equities are indexed.

Nor has the state felt obliged to invest in hedge funds, commodities, portable alpha and other increasingly popular strategies. Oregon bristles at hedge funds' opacity and use of leverage; moreover, over the past few years, it has been difficult to access the top-performing hedge funds. "It's not like we're compelled to invest in hedge funds for fear of missing something," says Jay Fewel, Oregon's point man on private equity. "We don't want to be the last ones in the door before it slaps our ass."

Armed with support from the state treasurer, Schmitz plans to ask the legislature to hire three or four additional staffers, to bring in-house a portion of the enhanced indexed part of Oregon's domestic stock portfolio -- beginning with as much as $2 billion out of $4.4 billion. The fund pays management fees of roughly 20 basis points on its enhanced indexed equities and Schmitz reckons that by running these funds in-house, he can cut the cost to a couple of basis points.

Schmitz would like the OIC to focus more on broader policy issues, such as asset allocation and the growth in liabilities, and to delegate investment strategy decisions to him and his staff. This year, OIC chairman Solomon says, the board is likely to increase the size of investments that staff-led private equity and real estate committees can independently authorize; the current limits are $200 million and $100 million for private equity and real estate partnerships, respectively.

Looking, as always, to build a consensus and keep the peace, Schmitz would like his staff and the OIC to jointly hear presentations by key fund managers and experts in asset classes that Oregon has yet to invest in. Currently, only staffers attend the meetings. Schmitz believes the interaction would be a symbolic gesture affirming the unity of purpose among the staff and the board. "This way we can build trust," he says.

Close call: Controversial decision by the trustees

The board of the Oregon pension fund has made some controversial decisions in its time, but nothing set off sparks like one unanimous vote it took in October 2003. That's when the Oregon Investment Council approved the plan's $300 million investment in Texas Pacific Group's TPG Partners IV fund. Just 24 hours later TPG hired the husband of OIC trustee Diana Goldschmidt, Neil Goldschmidt, who had been Oregon's governor from 1987 to 1991. TPG wanted the ex-governor to help smooth a controversial takeover by TPG-backed Oregon Electric Utility Co. of Portland General Electric Co., the state's biggest utility, owned by the creditors of bankrupt Enron Corp. Neil Goldschmidt reportedly stood to earn at least several million dollars over three years.

Diana Goldschmidt, appointed to the OIC in 1998 by then-governor John Kitzhaber (she was reappointed by Kitzhaber in 2002) denied foreknowledge of her husband's hiring by TPG and refused to resign from the board. Governor Ted Kulongoski removed her from office in September 2004. Oregon's attorney general, however, cleared Diana Goldschmidt of any wrongdoing in January 2005.

"It was just a series of amazing coincidences. There was no smoking gun," says Randall Edwards, Oregon State Treasurer and ex officio OIC board member.

Though Diana Goldschmidt was cleared of wrongdoing, it was too late to salvage the utility deal -- or Neil Goldschmidt's reputation. In May 2004, Portland's alternative weekly newspaper, Willamette Week, reported that he had had sex with a teenage baby-sitter over a three-year period in the early 1970s, when he was Portland's mayor. The story won author Nigel Jaquiss a Pulitzer Prize for investigative reporting. Neil Goldschmidt resigned from Oregon's State Board of Higher Education and took a leave of absence from his consulting firm, which counted TPG among its clients. Oregon's Public Utility Commission nixed the sale of PGE in March 2005. It went public in April 2006. --S.B.