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How a Diligent LP Finds Overlooked Private Equity Opportunities
From the Dec 2020 JP Morgan LDI Special Report
GCM Grosvenor’s Advance Strategy was formally launched in 2019 as an extension of the firm’s practice – dating back to 2005 – of investing with high quality, hard-to-access, and often overlooked private equity firms led by people of color and women with proven track records.0 Since then, GCM Grosvenor has committed approximately $5 billion to over 50 diverse private equity managers across 140 investments, while the seven members of the Advance Strategy team continue to track a universe of approximately 530 funds.
GCM Grosvenor has been a leader in growing the universe of private equity firms owned and led by people of color and women. Its experience with these managers includes:
- Commitments to 24 first-time funds and/or spinouts, with more than $670 million in capital commitments.
- The first-time funds raised ~13x on top of GCM Grosvenor capital, demonstrating an amplifying effect.0
- The firms have grown AUM over 5.5x since their respective Funds I, on an aggregate basis.0
- The firms currently have an aggregate AUM above $50 billion.
- The firm has committed ~$2.7 billion to 87 African American- and Hispanic-owned funds and co-investments, representing 65% of overall diverse manager commitments on a dollar-basis (as of December 31, 2019).
- GCM Grosvenor was an early investor in some of the largest and most visible diverse asset management firms, including Vista Equity Partners, Siris Capital, and Clearlake Capital, and has committed a total of more than $7 billion to diverse managers across private equity, infrastructure, real estate, and absolute return strategies. 0, 1
0Past performance is not necessarily indicative of future results. No assurance can be given that any investment will achieve its objectives or avoid losses.
1 This list represents a subset of managers with whom GCM Grosvenor has invested. The inclusion of a private equity fund manager or firm on this list does not mean that any fund raised by such manager or firm will offer investment opportunities during the life of any investment program, that such manager endorses an investment in any such program, or that GCM Grosvenor will be able to secure a portion of any available investment opportunities for any such program.
0 Special Report: Pension Fund Stabilization and the Evolution of LDI
Pension funding has improved materially over the past decade, and for many plan sponsors that means that the “end-game” strategy that once seemed a distant objective is now within reach. But caution may be needed, as some key conditions which gave rise to pension de-risking strategies no longer apply. Before continuing to push capital into low returning and increasingly inefficient LDI programs, a careful review of alternative options is called for. Many sponsors may wish to re-think the wisdom of hibernation and termination when the benefits of a well-funded and stabilized pension are added to the mix.
1 How a Diligent LP Finds Overlooked Private Equity Opportunities
As institutional investors crowd into alternatives in search of returns and diversification, the search for what is truly alternative in the big picture – and where there might be alpha – becomes more challenging and requires a more creative approach. One idea that investors might consider: Maybe it’s not what you’re investing in, but who you’re investing with.
“How do investors expect to find the potential for outperformance when everyone is fishing in the same pond?” asks Derek Jones, co-head of GCM Grosvenor’s private equity diverse manager practice, along with co-head Jason Howard. What Jones is getting at is the abundance of overlooked opportunity to be found in diverse, small, and emerging private equity managers. In the view shared by Jones and Howard, some of the most talented minds in the investment world are sometimes obscured because investors too often look at the size of the dog in the fight. As a team, Jones, Howard, and their colleagues specialize in spotting the tenacity, expertise, and performance of undersized or under-represented PE fund managers – and advocate and enable other LPs to do the same. II recently spoke with Jones and Howard about what motivates them, and how everyone involved benefits, including their firm, the PE managers, and other LPs.
What drives the small, emerging, and diverse manager practice? What’s the philosophy behind it, and how is it good for GCM Grosvenor overall?
Derek Jones: Our view of our fiduciary responsibility is the main driver. We cast as broad a net as possible to capture, understand, interview, and get to know all the human potential in the marketplace. The philosophy is simple – fair and equal consideration for everyone. That’s consistent with our firm’s culture, which fundamentally believes that diversity – of opinion, of sourcing, and ways of doing things – could and should lead to a better outcome.
We seek to run the business as an alpha generator. Over the most recent three years, a third of the capital that we’ve allocated across our private equity platform has gone to diverse managers. It’s integral to our core business, and we can pursue it because of what can be thought of as four Ps: We have the platform as a major capital allocator; presence in the marketplace with a strategy to make diverse managers aware that we’re open for business; the practice, which has now been developed over 15 years and 140 investments; and, the performance, demonstrated by our long and robust track record.0
You’ve developed a reputation as a “must-see LP” for diverse managers. What has contributed to that perception?
Jason Howard: It’s a fun way to talk about what we do, but what stands behind it is our approach to the marketplace. Said simply, we want to be early and be helpful as we work with managers in this space. We help provide perspective to GPs as they build their teams, deal pipeline, and operational infrastructure. By “early,” we mean in terms of giving advice, sharing best practices, and, in select cases, serving as the first LP to anchor a new fund’s launch. Committing to an investment takes time and requires our usual rigorous process. Still, along the way, we can point out details and issues they should be aware of as they build their operational infrastructure.
A huge amount of capital has been committed and invested by GCM Grosvenor and your team with small, emerging, and diverse private equity managers – more than $15 billion all in, or roughly 35% of all private equity allocations by the firm. What have you learned about the managers you invest in or with?
Howard: Our experience from investing about $5 billion of capital with diverse private equity managers in particular, is that this universe of managers frequently performs as well as, if not better than, the broader PE universe.0 That’s in part because we have identified exceptional managers who have demonstrated extraordinary performance in their strategies, and notable resilience in their ability to overcome hurdles faced throughout their academic and professional experiences.0
We’ve also seen opportunity and performance through co-investing with some managers when they find deals and don’t have sufficient capital to execute them. Having strategic capital that we can co-invest to consummate deals, expand managers’ track records, and demonstrate the quality of deals they can create is exciting – and it can also be materially additive for our clients and their portfolios.
Jones: We have relationships with established diverse managers and emerging diverse managers. We were fortunate to invest very early in what today are identified as some of the best private equity managers in the world, and that has created a sort of multiplier effect in terms of the capital. If you’re raising several billion dollars in any fund, you’re doing that based in part on performance. The same goes for us as a firm – we wouldn’t have a third of our private equity capital invested or co-invested with these managers if the performance weren’t there.0
What is the process you go through when deciding to invest or co-invest with a fund? Beyond diversity, what are you looking for in the leadership at the manager?
Jones: Diverse managers go through the same funnel and investment committee and are held to the same quantitative and qualitative performance metrics that we look for whenever we commit capital as a firm. There are no free passes. We’re essentially underwriting what I would call the front end, so we’re looking at the team, the historical track record, and the strategy. 0 These days we’re looking for a specialty, too, because there is a need to differentiate from so many firms in the PE space. Is the manager a sector specialist, or have they built an ecosystem around a handful of sectors? Has that given them an advantage in the marketplace?
In the COVID-19 environment, we have seen the benefits of knowing most managers in the space. Having what we feel is an unparalleled knowledge of the diverse manager universe allows us to continue giving clients access to opportunities without disruption.
We’re also looking at alignment, team dynamics, and the ownership structure. These managers are often motivated to leave another platform and set up their shop because they want to create their own culture, including how they work with their partners. That’s the front end. On the back end, we have an operational due diligence team of 16 people who evaluate the manager’s non-investment infrastructure, and at how they’re handling compliance.1 Background checks are performed on senior investment and operations professionals to assess conflicts of interests, reputational risk, etc. We also look to understand who can wire money in and out of the vehicles they’ve invested. We also evaluate their key service providers, their cybersecurity plan, and so on – all the things that we believe are necessary, and in some cases are required or recommended by regulators. We need approval on the front end with our investment committee, and we have a separate operations committee that approves the back end, the operational infrastructure. Both approvals are required before we make the commitment. That’s for every manager that we underwrite, whether they’re diverse or not.
What are some of the best practices you share with managers to help them in their evolution as a firm?
Jones: We share how a manager may best tell its story in the hour allotted to do so. Our platform sees one to two managers a day, so there’s a lot of traffic. In the typical one-hour meeting, we see a lot of iterations of how managers discuss their strategy, differentiation and competitive advantage, and performance. We also have a wide view of the market and deep pipelines, so we have a good idea who we believe is raising money or who’s likely to raise money over the next three years. Through our proprietary databases, and the market index measures, we have a lot of information and context – we have more resources that allow us to share with managers how their performance may be seen in the marketplace. 0 Is it upper quartile? What are the strengths and weaknesses of their track record? Those two things are super important.
On the operations and due diligence side, we may introduce them to one of our colleagues who will take the time to analyze their organizational structure and provide feedback on how they can improve on things required by us and similar institutional investors, and how they can continue to fulfill those requirements as the fund grows and they raise more money. This is a business where we’re looking to curate the best of the best.0 With private equity, whether the leadership of your firm is diverse or not, it’s a big funnel, and you are distilling that to a small percentage.
In addition, our team of seven who focus on sourcing and investing with diverse managers is made up entirely of people of color and/or women. This supports the view we advocate to LPs and others – that it is beneficial to have a diverse team.
Do other LPs ever ask for your insights on investing or co-investing with diverse or emerging managers?
Howard: Yes, and what we say is be clear about your strategy, your objectives, and your goals. We think that’s critical because it will help LPs narrow their focus to the market segment that’s most interesting to them. Next, we believe it is important to identify the best way to get exposure to diverse managers. That includes determining if LPs can do it on their own or if they should partner with someone with greater resources to pursue it.
There are a lot of reasons for large asset managers to become more diverse. It helps in hiring and retaining a new generation of talent. Research has shown it leads to better decision making. Do other large asset managers ever ask your advice on how their firms can become more diverse?
Howard: Not surprisingly, they do, as we have a reputation of being a very diverse firm – roughly half of our colleagues are women. Overall, 30% of our U.S. co-workers are people of color. We are happy to share best practices on that point and on being very intentional about internship programs. We work with groups like SEO [Sponsors for Educational Opportunity], Girls Who Invest, and other organizations to proactively provide diverse talent an opportunity to come in, learn the business, and demonstrate their capabilities. We also suggest that firms reach out to diversity organizations when they have job openings – especially at senior levels – to list those opportunities with SEO and Toigo. They both have an extensive alumni base of talented, experienced, diverse professionals.
A lot of investment organizations talk about finding people who are a good “fit.”
Howard: Everyone wants people who are a good fit in terms of the talent and skill they bring to a team, but “fit” is often another way of hiring people who have common backgrounds, similar experiences, have gone to similar schools, and share similar career trajectories – and that’s the opposite of diversity.We subscribe to the view that diverse experiences are important in generating different views, which, in turn, lead to better investment decisions, enhanced risk mitigation, and so on. We also encourage managers to think broadly about who’s qualified for a specific role in private equity. Our experience has been that people who come from different backgrounds – consulting, an operating partner role, other nontraditional paths – can have experiences and skills that will help them succeed in private equity. That’s one reason we think that the largest number of women in our universe is in the venture community.People can enter the venture community after having been a marketing executive, an operator at a company, or an entrepreneur, to name a few examples – and a lot of those people have proven themselves as great investors. That’s a very different path versus the typical path of private equity.
Jones: To borrow a well-known phrase, you have to just do it. There are always easy excuses for going to the same two or three schools where the talent pool is largely homogeneous. Building a diverse team has to be part of your strategy. You just have to get out there and put in the work.
One of the nice benefits of your efforts is that they help attract the next generation of talent. What do you see in that generation that you find interesting? And how do you think the latest generation of talent will evolve in the future?
Jones: Broadly speaking, in the old days, you had to be a good investor. Today, you not only have to be a good investor, but a good fund manager because there are increasing requirements around the back end. I also think diversity is going to play a bigger theme. More people are talking about it – young people, public funds, boards, trustees. Sector specialization will continue to be a theme, too. I’m not sure whether the next generation has a desire to spend three years raising a multi-billion-dollar fund. They may look to raise a smaller fund with a niche strategy. Technology will increasingly be used to source and identify opportunities and analyze data – which companies are growing or not, in which sectors and sub-sectors, in which themes. Finally, I think you’ll see less concentrated economics. Over half of private equity buyout capital in 2019 went to the top 20 firms. The majority of those funds still have the founders in place after more than 20 years, so we’ll see younger talent leaving and setting up their own shop. As a result, the economics are likely to be spread around a little more. It’s just an evolution in the market.
Many of the managers you work with are, as noted, small. How can you help them while their businesses grow?
Howard: Pension plans, insurance companies, corporates, etc. find it difficult to make large commitments to small managers, so they’ll hire firms like ours to invest in these managers as a way to start a long-term relationship. In a way, we look to build a team of managers who are up and coming and exceptional at what they do – an analogy could be the minor league system in baseball. As managers become larger, more established, and receive capital from our clients directly, we transition those managers directly to our clients. That goes back to the idea of how LPs can access diverse managers. If they can only write a $100 million check or $50 million check, but they want to work with diverse managers, it may make sense to partner with us because we can invest in a number of managers on their behalf. We can then transition GPs to have a direct relationship with LPs as they prove their capabilities as a standalone entity.
To be clear, that scenario is more about size than investment expertise, correct?
Howard: Many emerging managers are exceptional the day they start their firms. It’s like a world-class heart surgeon who is part of a practice with 50 other doctors, and then leaves and sets up shop with just one other surgeon. That person is no less a world-class heart surgeon because they’re at a two-doctor practice.
Jones: If you’re a woman or a person of color walking into our office raising $500 million, you’ve been exceptional throughout your career. A commonality we’ve found is that diverse managers have had to be exceptional at almost every level to put themselves in a position to raise that kind of money credibly. There’s still plenty of wood to chop, too. Less than 2% of capital is handled by managers who are not white men, which means more than 98% is not being invested with diverse managers, including white women. We’re trying to do our part.
Howard: Investors canvas the entire world for return opportunities, and many diverse managers who are proven who have great track records are overlooked.0 It’s not because of a lack of skill and expertise. It’s just that the institutional marketplace doesn’t necessarily see the same opportunities investing with these managers that we do. We think diverse manager track records demonstrate that other LPs miss out on opportunities and return potential if they’re not investing in this segment of the market.0
0Past performance is not necessarily indicative of future results. No assurance can be given that any investment will achieve its objectives or avoid losses.
1 Due diligence processes seek to mitigate, but cannot eliminate risk, nor do they imply low risk.
1 Why Pension Stabilization is a Critical Strategy – and Not a Return to 1999
Most pension plans across the U.S. are still following the same incremental de-risking plan they adopted in the years immediately after the global financial crisis. Specifically, replacing return-seeking assets such as equity with long-duration fixed income that seeks to match the liability. In re-evaluating these glide path strategies in the current environment, it appears that most plans have de-risked far enough to avoid serious risks and to continue would simply increase costs and inefficiency with no discernable benefit, says Jared Gross, Managing Director and Head of Institutional Portfolio Strategy for JP Morgan Asset Management. II recently asked Gross to describe the course correction he’s urging pensions to make before they face the consequences of an outdated investment approach.
You have had a ringside seat at the evolution of pension strategy over the past 20 years. How far has it come since then?
Jared Gross: Prior to early 2000s, plan sponsors were focused on generating high returns with a traditionally diversified asset allocation – mainly stocks and core bonds. In many respects, this approach was appropriate given the rules in place at the time. Accounting and regulatory standards were mild, with only a limited pass-through from funding changes to required contributions or the financial statements. Pension investors generally didn’t consider liabilities when allocating assets. After all, a long period of strong returns had left most plans in a surplus position.
This era ended with the tech bust in the early 2000s, and the decline in interest rates that rapidly followed. The fallout led to a massive downturn in the funding of defined benefit plans; most went from being overfunded before 2000 to significantly underfunded just a year or two later. That was the first wake-up call. No one really had to confront the asset-liability mismatch in pensions before. Not too many years later, the global financial crisis delivered another blow, and sponsors began responding by starting to de-risk their asset allocations, closing and freezing defined benefit plans, and moving employees to defined contribution plans that offered the promise of more predictability.
How have you seen that de-risking process evolve?
I think we have seen two broad phases of pension de-risking with liability driven investments, and I believe we are about to enter a third.
The first phase, which I refer to as LDI 1.0, involved moving from shorter to longer duration bonds during the period immediately following the global financial crisis. With LDI portfolios offering high levels of yield, this was an unusual opportunity to reduce risk while also increasing return. Within a few years, most plan sponsors had moved their fixed income to a long-duration benchmark, often starting with the Long Government Credit Index.
Since then, we have seen a long process of patient de-risking that I refer to as LDI 2.0 or the “Glidepath Era,” in which plans have just been waiting for incremental improvements in funding before shifting capital from return-seeking strategies to LDI strategies. They’ve developed increasingly customized hedging strategies, many of which involve custom fixed income benchmarks, derivative overlays, and completion management. While the complexity of these hedging strategies has increased, their diversification has not. Most plans have reached a point where the exposure to investment grade corporate credit is the largest risk in the asset allocation.
Today, however, we need to reconsider the glide path approach for two reasons. First, higher funding levels and lower volatility asset allocations have reduced pension risk to a very low level already. And second, the rules that govern mandatory plan contributions have been dialed back to the point that contribution risk is minimal, if not nonexistent. It is very hard to see the value in further concentration in long-duration bonds.
If you don’t see plans continuing to de-risk, then what actions do you see them taking?
Given this backdrop, plan sponsors need a course correction. They’ve already done an enormous amount of de-risking – consider that volatility is dramatically reduced even in plans that are only 50% hedged. Pushing further down the glide path rapidly becomes inefficient. That “last mile” is very expensive; giving up significant returns to reduce volatility only slightly makes it an extremely costly form of hedging. If the risk of large mandatory contributions was a serious concern, this behavior might be justified, but it is not.
This brings us to an inflection point in pension strategy. What I think of as LDI 3.0, or as we describe it to our clients, “Pension Stabilization”, is a more balanced approach than traditional LDI. It aims for a long-term blend of modest excess return and low volatility – but not the lowest possible volatility. It’s definitely not a journey back to 1999 when plans were seeking high returns and ran 12-15% annualized funding volatility. A stabilization strategy begins when a plan approaches full funding and adopts a sensibly de-risked and diversified asset allocation, allowing for the gradual improvement in funding across time while preserving numerous positive financial benefits for the sponsor. I expect that many sponsors will see the appeal of taking this “off-ramp” from an outdated glide path.
Why is it so difficult to completely hedge the risks in a traditional pension plan?
Simply put, it’s impossible to perfectly hedge pension liabilities with financial assets. For starters, you can’t hedge the actuarial risks around participant behavior and people living longer. The sponsor must bear these costs through increased returns or contributions.
Additionally, the fixed income portfolios that are used to hedge liabilities will experience downgrades and defaults. The liabilities won’t change, but there will be performance drag across time. A more diversified stabilization strategy can still out-earn the liabilities over the long run and that drag from credit losses will just be noise. But when assets are concentrated in fixed income, the drag becomes more difficult to outrun. This is the critical flaw in most hibernation strategies. An LDI portfolio comprised of long-duration corporate bonds and Treasuries will slowly burn through its excess capital.
How might pensions approach additional de-risking now?
We really need to get away from the notion that, as the hedge portfolio grows in size it should become more and more concentrated in corporate credit. The exact opposite is true. Hedge portfolios need to become more diversified. Treasuries certainly have a role to play, though their lack of yield is a concern. Long-duration, securitized fixed income and high yield bonds are also useful options, but the list doesn’t end there. It’s instructive to observe the investing behavior of life insurance companies, who are managing the risks of annuity portfolios that are quite similar to pension liabilities; these firms are large holders of securitized assets, crossover portfolios that incorporate high yield bonds, structured credit and mezzanine debt.
The other path to de-risking begins in the return-seeking portfolio. Investors today have access to a far more diverse set of low-to-moderate volatility alternative asset classes that can deliver stable excess performance versus liabilities without the high volatility and low correlation of equities. Many of these asset classes are also capable of delivering a high level of distributable income, which is a valuable resource for a benefit-paying institution.
Defined benefit plans are continuing to decrease as defined contribution plans become more common. Do you see a future for DB plans?
I hope so. The historical volatility of defined benefit pensions and the uncertainty surrounding contributions convinced many sponsors that they were too risky to maintain. This is simply untrue. A well-funded and prudently managed DB plan has powerful benefits that a DC plan simply cannot replicate. When we consider the recovery in DB plan funding and the evolution of pension asset allocation over the past 20 years, there should be a conversation in corporate America about preserving what remains of the DB system. While I am not convinced we will see closed plans reopen or new plans created, it’s worth considering. In a period of rising wages and highly competitive labor markets, the original purpose of defined benefit plans comes back into focus: proving a tax-advantaged, investment-driven vehicle for delivering competitive benefits to employees.
What is the next evolution in pension plan strategy?
I would love to see pension stabilization evolve to become the standard model. I’m encouraged because I do see many well-funded plans adopting elements of this approach. Consultants are getting behind this trend as well, although some continue to view the pieces independently rather than as a holistic framework that can challenge the glide path/hibernation/termination model.
I think we may be close to the high-water mark for traditional LDI strategies. With current interest rates and credit spreads, managers know that a dollar put into a traditional LDI strategy today is almost never going to outperform liabilities going forward. Conditions may change, but from where we stand today, it’s hard to envision those LDI frameworks remaining static. There are just too many better ways develop a risk-efficient pension strategy outside of them.
What do you see as the advantage for plan sponsors in the way JP Morgan collaborates with them on pension stabilization?
JP Morgan has a 150-year history of serving as a fiduciary to our clients; I can’t overstate the importance of that legacy to the present-day JP Morgan Asset Management. We also have the broadest cross-section of investment strategies of any manager in the business, each of which is built around the premise that highly skilled, independent investment teams can deliver specialized strategies while drawing on the collective resources of the broader organization. Unlike some firms that implictly guide clients to the particular strategy in which they specialize, we want clients to make the best possible strategic decision because we are confident that we will find a way to partner with them in implementing it.
With respect to pension stabilization, the merits of the approach speak for themselves. As clients look to implement this type of program, they will need to reconsider their exposures to traditional hedging and return-generating assets as well as new forms of diversifiers. For hedge portfolios, we’ve been at the forefront of long-duration securitized investing and have a long history of success in high yield and mezzanine debt. Within the realm of alternative diversifiers, we tend to highlight the powerful income generation and diversification benefits of core real assets – with a very strong platform across real estate, infrastructure, and transportation.
JP Morgan also has a long history of working with institutional clients in discretionary management and delegated solutions. Pension plans may not have the internal resources and operational flexibility to execute a sophisticated asset allocation that takes advantage of the full investment opportunity set. A number of sponsors are currently using our delegated platform and its full spectrum of assets to outperform liabilities in a risk-aware manner, and we think this business model will continue to grow.
The current path to hibernation and termination is a dead end. Specialized LDI managers aren’t going to give plan sponsors the unbiased advice that they need. Diverse, forward-thinking managers and consultants can help redirect clients to change course with full-spectrum strategies that maintain positive returns while still managing volatility. We want plans to get fully funded and stay fully funded. Pension stabilization can achieve both and help ensure their pensions are once again able to be a source of value.
2 Diverse Manager Case Study
GCM Grosvenor is a strategic LP to managers and catalyzes GP fundraising. In doing so, the firm seeks creative and meaningful ways to support the fundraising efforts of small, diverse, and emerging private equity managers by providing investment capital, resources, and expertise. Here’s a case study of how GCM Grosvenor acted as a strategic investor and formed a partnership that benefited its clients, the manager, and the firm.
The Manager: The investment manager (the “manager”) is a certified Minority and Women-Owned Business, founded over a decade ago. One of company’s co-founders has more than 25 years of experience in the commercial real estate industry, having invested in and loaned CRE assets on behalf of large pension funds and institutional investors. The manager has invested over $4 billion in CRE debt and structured equity.
The Partnership: GCM Grosvenor partnered with the manager to help launch its commingled fund business and create potential upside for GCM Grosvenor and its clients via promote-sharing with the manager, while seeking to invest in a lower-risk investment strategy that looks to provide downside mitigation.
The Win: The partnership provided the manager with capital to make investments that ultimately served as seed assets for its initial commingled fund; investors appreciated the ability to buy into a partial seed portfolio.
How the Partnership Evolved
- 2012: One of the company’s co-founders meets with GCM Grosvenor team. The manager is considered an established emerging manager, having raised more than $400 million in pre-fund assets.
- 2013: GCM Grosvenor recommends changes to pitch materials.
- 2014: GCM Grosvenor facilitates industry relationships and encourages future development of track record.
- 2016: GCM Grosvenor and the manager form a joint venture partnership with GCM Grosvenor providing $55 million in seed capital.
- 2016 to 2018: GCM Grosvenor participates in reference calls with new investors on the manager’s behalf. GCM Grosvenor consults and advises on the manager’s capital raising strategy and key investor relations hire.
- 2017: Funds hold first close with more than $180 million in commitments.
- 2019: Fund holds final close with more than $410 million raised.
2 Pension Funding Has Stabilized
In the interview above, JP Morgan’s Jared Gross questions whether pension funds still need to aggressively de-risk given that funded status has generally improved since LDI strategies first became a go-to for such plans. And, indeed, despite the Covid pandemic, funded status is looking better these days.
According to “The State Funding Pension Funding Gap: Plans Have Stabilized in Wake of Pandemic,” a whitepaper by The Pew Charitable Trusts, the gap between the cost of pension benefits that U.S. states have promised their workers and what they have set aside to pay for them dropped in 2021 to its lowest level in more than a decade.
Pew estimates that state retirement systems are now over 80% funded for the first time since 2008. Such progress would be significant in any year, but the improvement in fiscal 2021 occurred during a recession in which many analysts predicted that revenue losses related to the COVID-19 pandemic would increase retirement fund shortfalls. Instead, Pew found an increase in assets of over $500 billion in state retirement plans, fueled by market investment returns of more than 25 percent in fiscal 2021 (the highest annual returns for public funds in over 30 years) and substantial increases in contributions from taxpayers and public employees to pension funds.
Upward trend for U.S. states
These contribution increases, which came after years of states shortchanging their systems, are part of an upward trend over the past 10 years. Pew research shows that contributions have increased an average of 8% each year over the past decade, boosting assets and paying down debt. In the four states with the most financially troubled pension systems – Illinois, Kentucky, Pennsylvania, and New Jersey – contributions increased by an average of 16% a year over the same period.
Nearly every state has also enacted benefit reforms to lower costs, including cutting benefits for newly hired public workers. Officials in many states have also become more disciplined about managing pension finances, using tools such as stress testing to determine how twists and turns in the economy might affect pension funds. As a result, Pew found that for the first time this century, states are expected to have collectively met the minimum pension contribution standard. This means that even before the market rally during the pandemic, payments into state pension funds were sufficient to cover current benefits and reduce pension debt, a milestone called positive amortization. The improvement in pension funding levels also has led to the highest aggregate funding ratio since the 2007-09 recession. Based on data from the fiscal year that ended June 30 in most states, Pew estimates that the funded ratio – the dollars held in pension funds compared to dollars promised in retiree benefits – has risen above 80%, a level higher than any point since the 2007-09 recession. As a result, Pew projects that state retirement systems will have less than $1 trillion in accumulated pension debt for the first time since 2014.
The significant improvement in plans’ fiscal position is due in large part to dramatic increases in employer contributions to state pension funds in the past decade, which boosted assets by more than $200 billion. Since 2010, annual contributions to state pensions have increased by 8% annually, twice the rate of revenue growth. And for the 10 lowest-funded states, the yearly growth in employer contributions averaged 15% over this period. As a result, after decades of underfunding and market losses from risky investment strategies, for the first time this century states are expected to have collectively achieved positive amortization in 2020 – meaning that payments into state pension funds were sufficient to pay for current benefits as well as reduce pension debt.
Corporates well-funded, too
According to Milliman’s 2021 Corporate Pension Funding Study, despite a decline of 67 basis points in discount rates, the private single-employer defined benefit plans of the Milliman 100 companies continued to make funded ration improvements in 2020 due to their greater than expected investment gains of 13.4%. The Milliman 100 companies sponsor the 100 largest defined benefit plans among U.S. public companies.
The year-end 2020 funded ration for the Milliman 100 companies settled at 88.4%, up from 87.5% in 2019. According to Milliman, such improvement is remarkable given that it estimated the funded ration had fallen to approximately 81% at the end of July 2020.
Overall, according to the report, 19 plans among the Milliman 100 companies had a funded ratio of at least 100%, compared to 14 plans from its 2020 pension survey.
3 How Investment Programs Can Become More Diverse
What are the key factors in investing with diverse managers? Are the sourcing and investment processes the same compared to more established managers? What might be gained, and what are the risks? The GCM Grosvenor team that focuses on investing with diverse private equity managers was established in 2007 and has focused on sourcing, sharing best practices, and allocating capital to diverse private equity managers. During this time, they have helped numerous corporate and public pension plans and other institutional investors build diverse manager programs from the ground up.
Thing You Should Know #1: There is Increasing Interest in Investing with Diverse Managers.
- There is ample evidence that investing with diverse managers is good business. Surveys, studies, and GCM Grosvenor research and experience support diverse managers’ ability to produce attractive risk-adjusted returns and the potential to generate alpha. 0 One recent study conducted by the National Association of Investment Companies (NAIC) notes that its universe of diverse manager funds reliably outperformed relevant benchmarks over long time horizons.1 The study attributes performance primarily to smaller fund sizes, differentiated deal flow, and managers’ investments in first-time funds.
- People of color manage less than 1.5% of the $69 trillion AUM in the asset management industry.2
- Many endowments, foundations, and pension funds (and the entities that govern them) continue to highlight the importance of equal access to capital in their investment programs. Some investors are influenced by external sources like regulatory requirements. Others may be influenced by C-suites, boards, and trustees who realize the diversity of their investment management falls short of the progress they have made toward diversity in other parts of their businesses.
- There has also been a new wave of interest among investors who have been sparked by the increased focus on racial justice in the U.S. and globally. These investors tend to emphasize underrepresented minorities, such as African Americans and Hispanics. Given the current dialogue, limited partners, corporations, foundations, and others are exploring how they can leverage their influence and investments to ensure equal access to capital.
- The population of diverse manager talent is much deeper than in prior years. People of color and women have risen to more senior levels of established firms, giving them the experience and track records to launch their own funds. The number of funds launched by diverse private equity managers has increased significantly since 2008.
Thing You Should Know #2: There are Skills and Traits Common to Those Who Have Successfully Achieved More Diversity in Their Investment Programs.
Investors who have seen success by including diverse, small, and emerging managers in their portfolio have a thorough knowledge of the diverse manager universe. They frequently meet with managers and are proactive in sourcing talent rather than relying solely on placement agents or general partners (GPs) that approach them. Doing so helps build their reputations as investors that are accessible to diverse managers. GCM Grosvenor has an “open-door” approach toward meeting diverse managers, which has allowed it to see hundreds of opportunities and commit more than $1 billion to diverse private equity managers in 2020.
In the GCM Grosvenor team’s experience, successful LPs immerse themselves in the diverse manager community and actively participate in relevant industry organizations. Firsthand observation indicates that being involved with associations of diverse professionals can create new relationships and strengthen existing ones. GCM Grosvenor typically sponsors or attends more than 25 industry conferences per year and hosts two premier industry events that spotlight diverse and emerging managers. Fostering a community in the diverse manager space remains important during the current global pandemic. The firm’s hosted events have shifted to virtual settings and it remains committed to sponsoring and attending other virtual industry events.
Established investors in this space also can consider managers with complex stories or shorter track records. These LPs are prepared to invest early in funds that may be smaller and less well-known and can often move quickly to execute co-investments with managers.
Finally, LPs in this space often have diversity on their boards and investment teams. This isn’t necessarily a requirement, but there’s an element of “walking the walk” in doing so.
Thing You Should Know #3: Even When Short of Resources, LPs Can Still Invest with Diverse Managers.
Investors can supplement their efforts by working with an advisor or consultant at varying levels of engagement. Some LPs in the early stages of diverse investing may require advisors for help with sourcing, due diligence, and implementation. Others may play a more active role by participating in deal flow calls to get an advisor’s views on managers, or invest alongside the advisor in its commitment to a particular manager.
GCM Grosvenor has partnered with investors of varying size and resource levels to be complementary to their existing efforts in the space. For example, they partnered with one large U.S. institution by introducing them to managers, providing training, supplementing their team, and helping develop their emerging manager conference. On the smaller side of the spectrum, the firm has worked with investors to access oversubscribed and hard-to-access diverse managers.
The LP must hold its advisor accountable by asking the right questions:
- How many diverse managers did the advisor meet with last year?
- How much capital did it allocate in the past three years?
- Is the advisor acting on behalf of all its clients, or just those that request diversity?
- How diverse is the team itself?
- Which diversity-focused conferences did senior members of the firm attend?
- How many within the organization spend the majority of their time focused on investing with diverse managers?
- What is the advisor’s view on investing with first-time funds?
- Is the advisor adequately evaluating the manager’s performance? 0
Answers to these questions may help an LP assess whether the advisor is fulfilling its fiduciary responsibilities by executing broad and inclusive searches.
Thing You Should Know #4: LPs Can Apply Parts of Their Usual Investment Process to Source and Evaluate Diverse Managers. But There are Some Big Differences, Too.
Diverse managers are not an asset class based on ethnicity or gender. A buyout manager is a buyout manager and is evaluated by investors on the same criteria – alignment, track record, how long the team has worked together, strategy, and potential competitive advantage – and nothing should be compromised. LPs are looking for benchmarked performance and, just because it’s a diverse manager, the standards for underwriting don’t change. 0
That said, there may be nuances in sourcing – how and where investors are finding diverse managers. LPs must be able to sort through complexity to identify and evaluate managers that may lack a long history or typical track record. But that’s a common theme in emerging manager investing broadly. It’s about rolling up your sleeves and doing the work to understand the deals a manager has done and vetting its performance.
Thing You Should Know #5: Diverse Managers Do Not Add Risk.
There isn’t anything unique about the investment risks associated with diverse managers. In general, alternative investments are subject to risks such as strategy risks, manager risks, market risks, and operational risks. Still, investors with diverse managers are often exposed to a different type of risk: perception risk. Some investors and consultants believe there is additional risk in seeking investments with people that are somehow different from them. That is a misperception. Meeting with and evaluating a diverse team is an opportunity, not a risk.
Thing You Should Know #6: LPs Can Help Keep a Fluid Pipeline of Talented Diverse Managers.
When it comes to maintaining a pipeline, LPs should hold themselves and their advisors accountable. It is not about meeting quotas, but LPs may benefit from being more “intentional” in asking themselves questions like: Are we invested with diverse managers who have generated exceptional performance? If not, why not? How many diverse managers have we met with this quarter? And if we’ve not met with many, why not? Who’s in the pipeline? It is critical that an investor, its staff, and advisor leave no stone unturned to find the very best opportunities.
It’s also important that LPs stay connected to the feeding organizations that supply talent, as there is a need for established managers to have their own diversity of staff and promote growth among diverse professionals. Considering that only 20% of employees at alternative investment firms are women, and just 12% occupy senior roles,3 investors should help drive change and influence managers by inquiring about their diversity initiatives and stressing the importance of having an inclusive culture.
GCM Grosvenor hedge funds data as of July 1, 2020. Private equity and real assets commitments as of March 31, 2020.
Investments in alternatives are speculative and involve substantial risk, including strategy risks, manager risks, market risks, and structural/operational risks, and may result in the possible loss of your entire investment. Past performance is not necessarily indicative of future results. The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by GCM Grosvenor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Certain information included herein may have been provided by parties not affiliated with GCM Grosvenor. GCM Grosvenor has not independently verified such information and makes no representation or warranty as to its accuracy or completeness.
0Past performance is not necessarily indicative of future results. No assurance can be given that any investment will achieve its objectives or avoid losses.
1 NAIC, “Examining the Returns,” 2019. Full report athttp://naicpe.com/wp-content/uploads/2020/03/2019-NAIC-ExaminingTheResults-FINAL.pdf
2 Bella Research Group and John S. and James L. Knight Foundation
3 Source: Preqin.