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Institutional investor profile: Kevin Kester, Director of Alternative Investments, Colorado PERA

Kester on changing return expectations, on the importance of integrity, on the difficulties of emerging markets and on what it takes to get a re-up from Colorado.

With $27bn under management, Colorado PERA provides retirement and other benefits to Colorado's public employees. It has been investing in private equity since 1982 fairly consistently and decided to formalise its programme of fund investing by creating an alternative investment division. Colorado now invests in all areas of private equity and across all geographic regions. It has recently set up its Targeted Opportunities Program, advised by Alignment Capital Group, to help it identify smaller funds. Colorado has a target allocation of eight per cent to private equity and is currently running at around ten per cent. Kester joined Colorado's real estate group in 1997 and was promoted to his current position in 2000. He previously worked in the real estate mutual fund industry.

Why do you invest in private equity?
‘Our primary reason for investing in private equity is for returns. But we also believe that there is some degree of diversification - our experience shows that private equity is not perfectly correlated to the public markets.'

Have your return expectations changed over time?
‘In some respects, it depends on who you ask. When we do our asset allocation modelling, we make assumptions about private equity in terms of expected returns, standard deviation and correlation. If you looked at those, our expectations are relatively low - around 11 per cent. If you then looked at what we're benchmarked against, you'd see that we're expecting four to five basis points above the S&P500. But if you asked me what we look for when we go out and underwrite groups, we're looking for net returns in the mid to high teens minimum. We won't invest in a group unless we believe we can get a minimum of two times our capital. If we're looking at a secondary fund or a distressed fund, we may be looking at a lower multiple, but a higher IRR. In those cases, we'd be looking at net 20 per cent returns. There isn't one perfect answer to what our return expectations are.

‘Our expectations have come down recently, however. A few years back, we were looking for net returns in the 20s; now we feel that if we earn 18 or 19 per cent, we feel pretty good about that. But in order to achieve those returns, we believe that we have to be targeting higher than that because of the inherent volatility in this asset class.'

What type of investments do you look for?
‘In our main programme, we tend to look at all areas in private equity, with the exception right now of mezzanine. So we look at the different stages of venture capital, different buy-out, strategies, distressed, secondaries, etc. We also look around the world. We are predominantly invested in the US and Europe, but we do invest in Asia and we have historically invested in Latin America. We try to find the best opportunities in any given area, while wanting to be in each category.

‘We define our programme along five sub-sectors. On the buy-out side, we have large buy-outs and buy-out (other). On venture capital, we have early stage and later stage, which includes development and expansion capital. We also have a special situations pool. Those are our five pools of capital and our approach is to seek investments every year in each of those areas. We manage the amount of capital invested in each area based on the opportunities and on how we want our programme to be composed over the long term. In any given year, we are looking for the top one or two opportunities in each of those areas.

‘We also have a separate programme, the Targeted Opportunities Program, from which we seek to invest in smaller funds, those raising $250m or below. We have appointed Alignment Capital Group to advise us on a non-discretionary basis on these investments. The rationale for this is that, as a relatively large investor, we have a lot of capital to deploy and we don't always have time to seek out and conduct due diligence on the smaller funds. This allows us access to funds raising smaller amounts of capital that we believe have the potential for outperformance. So far, the programme is running well.'

Are you looking to scale back your exposure to private equity to bring it into your eight per cent target allocation?
‘We have an eight per cent target to private equity. But we also have a three to 12 per cent range. That is a huge range because it takes into account the fact that this asset class is very difficult to rebalance and it is very hard to predict cash flows. Plus, it is a small asset class in our overall portfolio and so our relative levels of exposure can change quite dramatically, depending on what is happening in our other investments.

‘We are only slightly over our target allocation. But all that means is that we are now investing with an eye to come in line with that target over time. We may put out a little less capital, but we haven't stopped investing by any means. We don't want to have vintage year gaps. We also feel that if we don't invest consistently, we will find that we are down to five per cent or less because that is just the way that the cash flows work in private equity, especially when you have a fairly mature portfolio, such as ours.

‘Our goal is to find a steady flow, a tight range of capital that we can invest every year. That allows us to plan and allocate our internal resources well. This fits in with our philosophy that we are not trying to time the market, but are trying to invest consistently with solid partners in all the key areas.'

How do you source opportunities?
‘Except for our Targeted Opportunities Program, we do not use a gatekeeper or consultant. We have four investment professionals, including me, and two support staff. We source our investment opportunities the good, old-fashioned way. We pound the pavement, we talk to people, we use our networks, we use placement agents to help with deal flow. We have capital and people know that we invest year in, year out, so we are approached by a lot of groups. It's a combination of all those sources. We have a pretty robust database of deal flow opportunities that helps us screen groups and invest in the right funds for us.

‘We take the approach that, all things being equal, our bias is to re-up with groups. We like to maintain relationships and we don't like the number of GPs in our portfolio to become unmanageable. Having said that, every re-up has to stand on its own two feet. We compare them to similar opportunities in the market and if we feel that there is a better fund out there, then we will go with that. We don't simply re-up automatically.

‘We have a large portfolio and a lot of it was built in the 1990s. The current team inherited that in 2000. We have identified a number of groups that haven't performed as well as expected and we wouldn't consider them top tier groups in their category. Around a quarter of our relationships may turn over and we have already started that process.'

Are you seeking to reduce the number of GP relationships in your portfolio over the long term?
‘We are always very conscious of the number of GP relationships we have. This is partly to do with the complexity of managing so many investments, but also because it is possible to be over-diversified. You can dilute the excellent returns you receive from some groups if you maintain relationships with less well performing groups.

‘Over time, our bias is going to be towards having fewer relationships. We currently have around 45. I don't think that is too many, but I wouldn't like that number to grow much and indeed, it may be preferable to shrink it a little. Inevitably, in a mature portfolio, you will have relationships that you don't maintain in subsequent funds while adding new groups at the same time. So over the short-term, we'll probably end up with a few more than we currently have, but some of these will be inactive.'

What do you look for in a private equity firm?
‘We look for the obvious qualities, but one thing that is very important to us is that people act with integrity. This isn't something easy to identify or to define. We like to back people with the right attitude and personality. I don't particularly like this phrase, but it's the only one that fits - we are looking for people with a fiduciary mindset. We want to commit to people who really do understand that they are investing other people's money - they have a sense of duty, care and loyalty. We provide the retirement benefits for teachers, police officers, etc. These are people who have served society and they have put their faith in us to provide them with a stable retirement. It's important that their money gets managed prudently and effectively.

‘Of course, we want to be with high performing funds. But if there is a great group out there that treats its LPs poorly, we may well pass on their fund. We have to be able to trust the people we invest with. You can't document every possible outcome or eventuality in an agreement and that makes it so important to be with people that act with integrity.

‘The last few years has really opened our eyes to the importance of this. Within our own portfolio, we saw GPs act in totally different ways. Some stepped up to the plate and did the right thing, regardless of what the agreement said - they fulfilled their clawback liabilities, they decided not take distributions, or they lowered their management fees. But we also saw the true colours of some of our partners come out - they acted only in their own interest and not in that of the LPs.

‘Our goal is to invest with people who are good performers and who are good actors in the industry.'

What is the biggest mistake you have made?
‘I'd say there are two mistakes: one that I made and one that the programme made before my time.

‘One of the biggest mistakes that I made was to bet on Latin America - Argentina in particular - while the region was in a recession. At the time, I thought we were taking a contrarian stance and that the economy was about to come out of recession. If you followed historical patterns, they suggested that that should have happened. It didn't. Things simply got worse. That was unsuccessful.

‘A mistake that our programme made in the mid to late 1990s was to commit huge amounts of capital to some very large buy-out funds. Some of these have performed very poorly and many suffered heavily from strategy drift. I don't think that the commitments themselves were mistakes, it was more the amount of capital we invested in each fund relative to the size of our programme. We were too heavily weighted in this area.

‘We learned from all those experiences in terms of what we do well and what we don't do well and how we can do a better job of picking partners that aren't going to get distracted. I think we also learned a lot about emerging markets. I just don't think that areas without developed capital markets can perform well over the medium term. I don't think you can bet on event-driven stories in private equity. In the mid-1990s, it was the tiger economies of Asia and now it is the accession countries, etc. These macro-stories will probably drive higher growth, but I don't think you get paid for taking the risk. These types of opportunity may be great for a distressed fund or a hedge fund to take advantage of because you can get in and out quickly. Private equity is long term and you can't do that. If at any point during your ten or so years you have a hiccup (which is likely) then you will see your returns affected pretty badly.'

What is the biggest issue in the industry?
‘I think that the biggest issue is alignment of interest between GPs and LPs. You still see situations in which limited partners lose money while GPs still do OK. If you look at a typical limited partnership agreement today, in which the GP contributes one per cent of capital, and you look at the fees, including deal fees, etc. It's easy to see that there is a certain amount of profit that can be generated from those fees. If you start to add it all up, you are likely to start asking the question: is the general partner taking any risk? They are indemnified by the limited partnership agreement, which is underwritten by a group of AAA-rated institutions. Their management fees more than pay for their commitment to the fund and the excess of these and the deal fees allow them to pay themselves very comfortable salaries and pretty large bonuses. If a fund just returns 1x, you have to ask how the GPs have fared in this.

‘Compare this to the public markets. Shareholders are always pointing the finger at the boards of public companies that are able to pay themselves large amounts even if they destroy shareholder value. I think the same holds true for private equity firms and their LPs. That is why I think it is so important that LPs don't just keep on handing money to GPs that don't perform. The industry will not go through the shake-out it needs if LPs continue to support groups that haven't performed. LPs need to be more disciplined. I place a lot of the blame for the issues that the industry is currently facing squarely at the door of LPs. We funded a lot of these groups and we signed agreements that were egregious. We have nobody to blame but ourselves for that.

‘I still get GPs coming cap in hand who are shocked that I won't re-up with them, even when they have performed poorly. If you do the analysis of many of the large US funds raised in the mid to late 1990s, you would have been better off investing in Treasuries. That is a pretty sad statement.'

How do you think that the market will develop in the future?
‘There are two opposing forces. One is that there will be a lot more money coming into this asset class. At some point in the next decade we will again hit the peaks of fundraising that we saw in 1999/2000. Most institutions are not lowering their allocations to private equity. There are also a lot of groups that have never invested in the asset class but are currently thinking about it. I still see this as a growth industry. The other force is that there is a lot of concern that there is too much capital going into private equity. People are beginning to question whether, with all this additional new capital flowing in, you are going to be able to achieve high returns. The point about this is that people are talking about a mass shake-out of the industry, a purging of the poor performers. But I would ask the question: when is this going to happen if there is so much capital is pouring into the market?

‘I don't have a crystal ball. I just think the industry will mature, just like any other industry or financial instrument.'

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