Building out a new allocation to private markets for a perilously underfunded pension fund with only a four-person investment team and scant back-office support is not for the faint hearted. But David Kushner, chief investment officer of City of Austin Employees Retirement System (COAERS), in the role since May last year, couldn’t be more at home.

He’s about to launch a new private markets portfolio that will begin with a 2-3 per cent allocation to private credit that will ultimately account for 10 per cent of COAERS $3 billion assets under management. Private equity will follow in the next 18-24 months.

The move into private markets is not just the consequence of COAERS hiring a new CIO renowned for his private markets experience. It’s also tied to new funding rules to address COAERS 56 per cent funded ratio. As every savvy pension fund CIO knows, funding and investment strategy must go hand in hand. Even with the best returns in the world, it’s impossible to invest your way out of a bad funding policy.

Over the past two years, COAERS has collaborated with its plan sponsor, the City of Austin, to develop a legislative proposal to improve the system’s long-term financial health and sustainability. The legislation was approved last May during the 88th Texas legislative session and requires larger contributions from the City that will help close the gap between COAERS liabilities and assets.

“It was hard to recommend taking on illiquidity risk with a legacy funding policy. You can’t put in place 20-year investments when you need cash to pay benefits,” says Kushner in an interview with Top1000funds.com.

COAERS has just completed asset liability and asset allocation studies, stress testing how much illiquidity the fund can take with the new contribution policy in place and exploring the illiquidity risk/ return of new allocations to private credit and private equity.

“The studies have given us comfort that we can take on more illiquidity,” says Kushner who believes his seasoned perspective on everything from the perils of high inflation to liquidity management gives an edge in today’s challenging markets. His experience of managing liquidity risk goes back to before the GFC but during those tumultuous months balancing paying benefits (what he calls his number one job) without disrupting the investment programme was bought sharply into focus.

Back then Kushner was half-way through a 10-year stint as CIO of San Francisco Employees’ Retirement Association. His comments at the time on the unprecedented opportunity for long-term investors, famously attracted the wrath of the endowment and foundation community.

Many of this liquidity-pressed cohort urged their GPs not to make capital calls. But Kushner was vocal about ringing all 80 GPs in SFERS’ portfolio, arguing that as a fiduciary to the fund he expected them to make capital calls. “To say that foundations wanted my head on a platter for taking advantage of their distress was an understatement,” he recalls.

The advantages of being evergreen

His longevity in the industry is also informing another element of strategy. COAERS’ new private credit allocation will only invest in evergreen structures to safeguard against worrying trends in direct lending that risk leaving investors out of pocket.

As market conditions tighten, large private equity firms are increasingly arranging complex refinancing transactions that transfer the best assets in a company to different vehicles leaving existing lenders without a claim on the more profitable assets, even if they are lending high in the capital stack.

“Some of the big private equity firms are handing the keys of companies back to lenders and arranging debtor in possession financing for the better assets,” he says. “Diligence on credit managers to ensure that the covenants in place actually provide protections for investors, even though they may believe they are high in the capital stack is really important.”

Evergreen structures allow investors to conduct more detailed due diligence on the covenants and corporate loan documents in the portfolio, he continues. “You can do a more detailed due diligence on evergreen than you can on blind pool, drawdown funds. An investor can see the covenants on existing loans as a check to ensure the GP does what they say they do.”

For example, the higher cost of borrowing is also making him wary of leverage in direct lending and private equity. “Are GPs lending to over-leveraged companies and are they putting leverage on that leverage?” he asks. “Direct lending is an example of where this can happen involving managers adding more leverage on companies that are already levered. All too often no one asks these questions and that is scary.”

Evergreen structures also hold important operational benefits for an investor moving into the asset class for the first time like COAERS and lacking the accounting resources, custody requirements and analytical capabilities private markets require.

With evergreen structures COAERS can perform analysis on the individual managers and investments in the existing portfolio. It can build resources slowly and identify what to do internally or externally. “We can get into the market and then buy some time to identify the resources we need and have the right conversations with the board.”

He also likes the liquidity and flexibility of an evergreen structure which allows investors to increase their allocations over time or reduce if they need to, without having to select new funds or deal with capital calls or subscriptions.

In most evergreen structures, capital is locked up for two-to-three years after which withdrawal requests on a periodic basis kick-in. “Around 10 – 20 per cent of the NAV should mature at every withdrawal date if the fund has been in existence for a while and properly managed by the GP,” he says. “Investors can either say when they need the cash back or just let it go and not have to re-up on that part of the portfolio every three years.”

In contrast, in drawdown vehicles it can take three years for a fund to be fully invested, by which time investors will have to go back out and find another fund. “Even if they invest with the same sponsor, they have to re-up and underwrite,” he says.

Kushner says he’s already swamped by manager proposals and will only select two or three in this wave. He will weed out the bulk by ditching proposals that don’t’ meet criteria around the investment strategy, terms, returns, lock up requirements and favourable comparisons with drawdown funds.

Decisions around manager selection and fund size must also factor in COAERS small size which brings both opportunities and challenges in private markets. The biggest opportunity comes from being nimble and the ability to move allocations quickly, but COAERS can only make small, $20-30 million investments which means it can only mandate to smaller GPs where it can scale investment successfully.

Recruitment firm Egon Zehnder has been appointed to commence a global executive search for the next chief executive of the Australian Retirement Trust following the resignation of Bernard Reilly two years after the pension’s formation by the merger of Sunsuper and QSuper. The former State Street executive has urged Australian and international peers to consider throwing their hats in the ring for a job he says he enjoyed “almost every minute” of.

On the day mega-merger of Australian pensions Sunsuper and QSuper completed in February 2022, floods in their home state of Queensland reached their apex and Russia invaded Ukraine.

It was symbolic of the frenetic schedule and complex national and geopolitical problems Bernard Reilly would face throughout his subsequent 18 months as inaugural CEO of the new Australian Retirement Trust.

Reilly, who has announced he will step down from the role in February next year, admits the job was a challenging one.

“The last four years have been pretty big – COVID, mergers, integrations. These jobs are all-consuming and you never really switch off,” says Reilly, who lives in Sydney with his family – 733 kilometres (455 miles) from the fund’s headquarters in the Queensland capital of Brisbane.

While he concedes there were hurdles – including closing a major deal during the nation’s controversial lockdowns during the pandemic and the political and media scrutiny that comes with being a leader in its unique compulsory defined contributions system – he doesn’t want those to deter ambitious, values-based peers in the industry from stepping into his shoes at the A$260 billion ($166 billion) fund.

“This is an amazing job,” he tells Top1000funds.com. “I enjoyed almost every minute of it. I’m stepping away because it’s the right time for me. But for the right person there is an amazing platform to continue to grow Australian Retirement Trust to benefit our members.

“We are around the 20th largest pension fund in the world. And I think that’s an amazing platform to think about what we can do in the Australian context, but also when you think about the role that we play in the assets that we manage globally.”

The comments come as recruitment firm Egon Zehnder has been appointed by the ART board to conduct a global executive search for Reilly’s replacement.

Under his tenure, the fund has inked employer mandates with two of Australia’s largest listed companies, groceries giant Woolworths and the Commonwealth Bank, and says it continues to experience organic growth from members switching of their own volition.

Asked to name some of his achievements in the role, other than completion and integration of the two Queensland-based legacy funds, Reilly pointed to the fund’s work in preparing members for retirement and investment in building relationships with external investment advisers.

ART chair Andrew Fraser, a former treasurer of the state of Queensland, praised the outgoing CEO in a statement. “Bern has expertly guided Australian Retirement Trust to deliver merger benefits to our more than 2.3 million members,” he said. “But I think the thing Bern should be proudest of, and a true testament to his leadership capabilities, is the culture he has helped grow across our organisation.”

From this October $71.9 billion Pennsylvania Public School Employees’ Retirement System, PSERS, will reduce net leverage, add fixed income allocations, and continue to shave costs off its external investment management fees.

The fund is targeting an annual $130 million reduction in fees by “prudently” lowering the private markets target allocation to 30 per cent (it is currently 36 per cent) and taking the absolute return target allocation down to zero from current levels of 4 per cent of assets.

The trimming and shifting of the portfolio comes after the fund decided to adjust its strategic asset allocation in response to significant ongoing market changes.

Typically the board reassesses the SAA every three years (it last adjusted its SAA in 2021) but may consider adjustments during the interim should material changes occur to the underlying economic and capital market assumptions. In a recent board meeting, members heard how the latest decision reflects the fund’s strength and flexibility to adjust to an ever-evolving market environment.

“PSERS has successfully applied a modest amount of leverage over the years to improve diversification and enhance long-term return expectations,” CIO Ben Cotton said in the meeting. “However material changes to underlying return expectations make it practical to reassess our present targets.”

Rising interest rates have made the cost of leverage higher and by extension, the benefits of such leverage less certain, explained Cotton who oversees 65 internal investment professionals and staff.

“Reducing net leverage and making the planned reductions to private markets and absolute return allocations also allows us to simplify the overall asset allocation and reduce risk,” he said. “At the same time, we can preserve the fund’s diversification and liquidity while still maintaining sufficient long-term return expectations to hopefully meet or surpass our 7 per cent annual assumed rate of return.”

The absolute return allocation has targeted returns with a low correlation to public financial markets and strategies have included event driven, relative value, tactical trading and long short equity.

Cutting management fees

PSERS commitment to cut fees follows a concerted strategy to reduce management fees in recent years. According to its annual report, investment expenses decreased by $92.7 million from $618.1 million in FY 2021 to $525.4 million in FY 2022. As a percentage of total benefits and expenses, investment expenses have decreased from a high of 8.2 per cent in FY 2013 to 6.2 per cent in FY 2022.

PSERS is renowned among public pension fund peers for its fee transparency. It requests management fee information from each of its limited partnerships and collective trust fund investments, even if it is not specifically disclosed in the fund’s standard reports or identified in capital call requests.

This information includes base and performance fees obtained from either the fund’s administrator statement, capital account statement, or financial statements and is then used to report all relevant management fees in PSERS’ financial statements.

PSERS – one of America’s oldest pension funds, founded in 1917 although it only had assets under management of $6 billion in the early 80s –  has a 40 per cent long term target asset allocation of equity that includes a 12 per cent allocation to private equity. Public equity consists of small, mid large cap US equity (12 per cent) non US equity (16 per cent). PSERS invests around 33 per cent of the portfolio in fixed income, divided between investment grade, public and private credit and US inflation protection

Real assets comprise 29 per cent of the portfolio and includes public and private real estate and infrastructure, commodities and gold.

The United Kingdom’s £32 billion Pension Protection Fund (PPF) is marketing its credentials to act as consolidator for the country’s thousands of  DB corporate retirement funds.

The government wants the £1.5 trillion sector to invest more in economic growth at home and put money into alternative assets like infrastructure and private equity rather than invest in these schemes’ favourite asset – liability-matching fixed income that safely secures member outcomes.

The PPF’s push for an expanded role to act as a consolidator comes in response to the government’s call for evidence on how DB pension schemes, and the PPF, could support greater productive investment in the UK. Growing pressure to cajole these risk-averse pension funds to invest more in illiquid assets is an increasingly fraught debate. Many closed DB pension funds are well funded and don’t need to take this added risk to deliver on returns.

The PPF is the latest large pension scheme to burnish its ability to manage these DB funds. Under its new name Brightwell, BT Pension Scheme Management, the executive arm of the £47 billion ($59.8 billion) BT Pension Scheme (BTPS) is already offering its pension management capabilities to other defined benefit pension schemes – like the £1 billion DB arm of the EE Pension Scheme.

Perhaps Brightwell’s most compelling service comes in its promise of a coherent, single approach to pension management. Under the Brightwell umbrella schemes can replace a noisy cohort of actuarial, investment, fiduciary and covenant advisors, plus multiple asset managers, with a single operation.

A step change

The PPF explains that persuading DB funds to invest in riskier long-term assets, and accepting more volatility, is at odds with many of these funds de-risking strategies and will require a step change.

These schemes typically seek insurer buy-outs, it continues in its response to the government. They buy gilts and corporate bonds to reduce balance sheet volatility to get to this endgame as soon as possible.

Most pension funds are sufficiently well funded and do not need to generate the higher returns offered by an equity stake in productive finance assets. Improved scheme funding in recent years, driven by higher interest rates, will further accelerate the trend for closed, corporate, DB schemes to de-risk, it states. Arguments echoed by others on these pages like Railpen’s head of investment strategy and research, John Greaves.

The PPF says it has the experience and expertise to run a consolidated fund. This would create scale, and combined with professional asset management, lead to greater allocations in productive finance while providing security for members.

“The PPF is well placed to run such a Fund,” says Oliver Morley, PPF chief executive. “Consolidation must be an integral part of the solution.”

The PPF outlines how a Public Sector Consolidator solution could be designed, structured and set up. It argues that its own investment approach and asset allocation acts as a blueprint for what could be achieved.

Around 30 per cent of the portfolio is invested in alternative assets comprising private equity, private credit, infrastructure and timberland/agriculture, over two thirds of which are in the UK.  The PPF has 18-year experience consolidating over 1,000 DB schemes, it says.

“Running a Public Sector Consolidator would be a natural evolution of the PPF’s existing capabilities. Through our investment approach the PPF already provides a blueprint for how the government’s objectives can be delivered at scale. We’re a major buyer of UK gilts, invest heavily in productive assets and, by investing for growth over the long term, we’ve delivered greater security for our members,”  adds Morley.

Alongside consolidation, and an overhaul in the structure of the DB market, other step changes would also be essential. Schemes will have to embrace long term investments, diversification, interest rate/inflation risk management, scale and professional management.

The PPF also argues that unleashing this money for investment would involve “severing the link” between the sponsoring employer and its pension plan, which currently encourages most schemes to minimise risk.

The UK’s Universities Superannuation Scheme has produced new climate scenarios that are more informative for investors by focusing on shorter-term scenarios and switching the focus from temperature pathways to the complex interplay of physical and human factors.

The £75.5 billion fund aims to develop a long-term investment outlook informed by the scenarios and draw out investment implications for capital markets expectations, top-down portfolio construction, and country/sector preferences.

USS commissioned the University of Exeter earlier this year to apply a new approach to scenarios to support its investment and risk management decision making. The result of that collaboration is a report released today No Time To Lose – New Scenario Narratives for Action on Climate Change, which introduces four new climate scenarios that look at shorter-term and more realistic time horizons to inform investment decision making.

The new scenarios are more meaningful for investors because they switch the focus away from global average temperature pathways and towards the complex interplay between physical factors such as extreme weather events and human factors such as disruptions in geopolitics, economics, financial markets, and technology.

The focus is on operationalising net zero commitments and the need to have shorter term and bespoke scenarios to achieve that.

“This paradigm shift towards shorter horizons and business applications requires scenarios that focus less on the climate itself and more on the vicissitudes of politics, markets and extreme weather events. Global warming is not a major uncertainty over the next few years, but extreme weather events are rising rapidly, even if location and timing are uncertain,” the report says.

The report highlights that existing scenarios understate both the economic damage of climate change and the potential benefits of action, failing to capture key aspects of the real world, and so restrict their usefulness for investment decision-making. It also recognises that the mainstream economic models being used for climate risk scenarios are not up to this task.

Mirko Cardinale, head of investment strategy and advice at USS Investment Management, says the fund wants to lead in the development of this new approach that is focused on understanding how real-world dynamics could play out.

“The work with the University of Exeter has been extremely valuable in representing an important milestone for the development of a new approach to climate scenario analysis,” he says.

“We aim to lead in the development of this new approach that is less focused on precise estimation and more on understanding how real-world dynamics could play out in a complex world where climate risks cannot be looked at in isolation from political, economic, and technological factors. Moving forward, we intend to develop a long-term investment outlook informed by the scenarios and draw out investment implications for capital markets expectations, top-down portfolio construction, and country/sector preferences.”

USS’s Mirko Cardindale and University of Exeter Visiting Fellow Mike Clark will speak at the Sustainability in Practice event at Oxford University from November 6-8. For the program and more information click here.

Since Alison Romano joined the $33 billion San Francisco Employees Retirement System (SFERS) in the middle of last year, she has spent most of her time working with the team to ensure the fund’s celebrated long-term performance continues in the face of today’s shifting market environment.

Romano joined SFERS after a 13-year stint at Florida’s State Board of Administration and tells Top1000funds.com that she began by approaching her new dual role as both CIO and CEO by focusing on SFERS core principles. This meant outlining SFERS objectives, and how the team should design a repeatable process to meet those objectives. Alongside better-defined objectives, she’s enhanced the investment policy statement, liquidity needs and risk guardrails for each asset class, and talked a great deal on portfolio construction.

“With a refined framework in place, we can better evaluate the return/risk profile of strategy types and individual strategies and, in doing so, put capital to work in a way that is aligned with our objectives. We continue to evaluate our geographic tilts and exposures toward growth and innovation,” she says.

SFERS sophisticated and experienced investment team, who oversee an active public market allocation, top-performing private market exposure and exposure to growth themes such as technology, constantly evaluate new opportunities, debating where to trim or change the allocation.

Currently, a key focus is the fund’s exposure to China in the public equity allocation in light of what she calls “elevated risk.” In recent years, SFERS has sought to increase excess returns in public equity by investing with specialised managers with competitive advantages that has included those with expertise in China. Although exposure to China has added value over the benchmark in the last 3-5 years, concerns have grown with respect to China equities given economic conditions and COVID-19 policies.

As for equity opportunities, she’s assessing value and global mandates to complement existing strategies.

In fixed income, the team added multi-sector credit managers in 2022 and is now researching strategies in the higher yielding multi-sector credit space.

“Across every asset class, I want to make sure with each investment or tilt, we evaluate the risk/return profile in today’s environment and consider all the objectives of the strategy, from return, liquidity, diversification, downside protection, and more,” she says.

Private markets expertise

Other areas she is focused include private credit where SFERS is building out the target allocation to 10 per cent from current levels of 6.5 per cent. With a eye on relative value and risk-adjusted returns, she is looking at de-risking where possible through strategies like lower leverage, higher seniority in a capital structure, or lower jurisdictional risk while also keeping a look out for credit opportunities and distressed opportunities that may be attractive.

SFERS has been actively investing in private markets for years and has notable exposure across private equity, real assets, as well as private credit.

“We are long-term investors, and in long duration assets, maintaining discipline in pacing is important.  That said, we may lean-in or out of certain exposures or look for managers with certain expertise based on our market outlook, the risk/return dynamics, and the positioning of the overall portfolio,” she says.

For example, whereas in the recent past multiple expansion was a key driver of private equity returns, today operational improvement is increasingly important.  SFERS is particularly seeking GPs that have the expertise to facilitate operational change in both good and challenging economic environments.

Reflecting further on private equity, she notes that the prolonged period of low rates, easy monetary policy, strong economic growth and secular trends in technology that created tailwinds prior to 2022 have now changed.

Of course long-term opportunity persists, and private equity continues to have an important role in the asset allocation. But at the moment her particular focus is on growth as a theme, expressed in part through SFERS notable exposure to venture capital.

The portfolio also has an overweight to technology and an increased focus on healthcare, she says. “While our themes will drive portfolio weighting over time, we will remain opportunistic in pursuing top-tier managers across strategies and geographies.”

“We continue to evaluate exposure outside of the US, buyouts, and lower middle-market,” she continues.  As for secondaries, whether SFERS is buying or selling assets, it will apply a similar lens as any investment decision – what is the risk/return trade-off, the opportunity costs, the liquidity needs, and impact on the overall fund.”

With respect to real assets, the team hunts for areas supported by population demographic and migratory trends and assets with strong long-term market fundamentals, including areas like industrials and the digital and energy transition.

A review of absolute returns

This year she has also undertaken a thorough review of the $3.5 billion absolute return portfolio, taking into account the role of the asset class in the total plan. Once again, this process took her back to defining SFERS’ key objectives for the allocation.

In this case those goals are preserving capital relative to global equities during equity market downturns while outperforming global fixed income over a full cycle; producing returns that are independent of the performance of the equity and fixed income markets and providing a secondary source of liquidity.

After defining the objectives, the team then categorised different absolute return strategies as core/diversifiers, risk mitigators, return drivers, and high beta.

“We will continue to emphasise core strategies, such as multi-strat, market neutral, or quantitative.  These will be complemented with risk mitigators like systematic macro and opportunistic return drivers.  We are leaning away from strategies driven by equity or credit beta,” she explains.

This coming year SFERS plans to complete a full asset liability study. Part of the process will include considering current capital market assumptions, liquidity needs today and into the future, a multifaceted view of risk and the fund’s current funding status of 96 per cent.

Perhaps most pertinent is liquidity, particularly in the context of the forecast increase in liabilities – projected to grow considerably faster than the 7.2 per cent discount rate – exposure to private markets, and the slowing of fundraising and distributions.

“We continue to focus acutely on liquidity so that we can manage cash flows and retain the flexibility to be nimble when opportunities present themselves.”

SFERS targets a 7.2 per cent actuarial rate of return over a full market cycle (subject to liquidity needs and other risk considerations) and assets are divided between a target 60 per cent exposure to growth assets (public and private equity), 20 per cent to diversifying assets (real assets and absolute return), and 23 per cent to income/capital preservation that comprises fixed income and private credit. SFERS has the option to employ leverage up to 5 per cent.

Building the team

Romano’s role as both CEO and CIO take her responsibilities beyond just investment. She oversees a team of 125 “talented and hardworking individuals” that includes the 25-person investment team. Her focus is on fostering a strong culture so that SFERS can attract and retain talent across all areas of business, from investments to benefits administration and beyond.

“I aim to create an environment in which our mission, goals, and priorities are clear so that everyone knows how their responsibilities and efforts relate directly to the mission.  I strive to reinforce a culture in which individuals and teams acknowledge successes, learn from mistakes, support active problem-solving, and take ownership at every level of the organisation.”

The key to achieving this type of culture is strong communication, particularly when navigating a hybrid work structure. And this often means listening rather than speaking, she explains.

“There are many things I’ve learned over the course of my career that impact how I work, communicate, and lead.  Leaders are often expected to be the first to speak, the first to suggest the answers.  However, good leadership comes from listening, from asking good questions of the experts on the team, and from creating an environment in which good ideas can be heard and debated.”

“This is also an environment in which I, as a leader, can make well-informed decisions about risks and opportunities. Hopefully, when I lean into the Socratic elements of this management approach, I can empower the team to develop their own solutions and buy into the approach. Of course, communication is two-way, and I am responsible for engaging with the team, sharing information, and providing context for decisions. ”

Alison Romano is a speaker at the Fiduciary Investors Symposium on campus at Stanford University from September 19-21.  Click here for the program.