When top brass of New Jersey's $72 billion state pension fund met last July in Manhattan with officials of alternative assets titan Blackstone Group LP, they made an intriguing offer: In exchange for handing over a vast sum to Blackstone to deploy across its various investment platforms, New Jersey would get a generous break on fees it paid the manager. Blackstone, sources say, balked at the idea, saying it wouldn't play favorites with investors in its existing product lines. Then the talk took a creative turn: New Jersey had long wanted the flexibility to pounce on fast-arising, short-lived opportunities tied to the markets' vagaries. And Blackstone had been mulling a way to capitalize on enticing investments that were a strategic mismatch for its existing funds.
So why not rig up a separate, bespoke account for New Jersey that would meet both sides' goals, with fee discounts that wouldn't give Blackstone's other clients a reason to gripe? Thus was born a new Blackstone investment platform, called Tactical Opportunities, with New Jersey as its inaugural client.
Signed in February, the $1.8 billion Blackstone-New Jersey pact is only one in a recent spate of similar deals, which are redefining relations between private equity's elite players and their largest investors. In November, Kohlberg Kravis Roberts & Co. LP and Apollo Global Management LLC both lined up $3 billion separate accounts with the Teacher Retirement System of Texas, or TRS. Early last month, Apollo tacked on a $600 million customized account from New York City's pension system. Days later, the California Public Employees' Retirement System, the country's largest pension fund, became Blackstone's second Tactical Opportunities client, pledging $500 million. More arrangements, say industry sources, are in the works.
Though no two of these customized accounts are exactly the same, they share key traits. They're a species apart from the typical one-size-fits-all PE fund, which deploys capital from a host of investors as managers see fit. Some accounts take rifle shots at specific asset categories. Indeed, an earlier generation of separate accounts -- the phenomenon isn't entirely new -- often narrowly targeted things like distressed corporate loans; the sums were smaller, and fees typically weren't discounted.
What's different now is the sway clients have over how their money is spent, the mammoth sums involved and the ability of clients to wield the power of the purse to drive down fees per dollar pledged, although managers may eventually come out ahead because the pledges are supersized.
At the same time, pension funds are availing themselves of a raft of new products the PE giants have hatched since the onset of the financial crisis in a bid to lessen their exposure to the ups and downs of private equity. KKR and Apollo have reinvented themselves, branching into real estate and launching credit and hedge fund offerings. Blackstone, long the most diversified major buyout house, has bolstered its credit business and expanded on all fronts.
Both TRS's arrangements with KKR and Apollo, and New Jersey's with Blackstone, are crafted to exploit the firms' smorgasbord of capabilities.
Says a partner at a large PE firm that has talked with pensions about separate-account pacts, without cutting a deal: "For 30 years, the industry was built on a single core-fund structure with little flexibility. Now, there is more change going on in this area than at any time."
The rollback in traditional fees in these deals is striking. At the same time, elements of them are a boon to managers. It would be simplistic to view one side as the winner.
Take New Jersey-Blackstone. Besides the $750 million Tactical Opportunities account, the pact set up two other customized vehicles, in the areas of energy and corporate debt, according to the pension's website. The three accounts total $1.5 billion, with a further $300 million thrown to existing Blackstone investment vehicles. It represents New Jersey's biggest commitment ever to the firm.
In a possibly precedent-setting reformulation of fees, New Jersey for a start will pay Blackstone 15% of cash profits as an incentive, or "carry," versus the standard 20%. The yearly management fee is 1%, compared to the 1.5% that most large PE funds levy.
But that's not the half of it, for Blackstone will be paid the 1% management fee only on the portion of the money that's actually been invested, not on committed but yet-to-be-invested sums. In the vast majority of PE funds, management fees kick in the moment investors commit, and on the full amount committed.
It's a radical wrinkle that will save New Jersey as much as $10 million a year, the state has estimated. For Blackstone, the deal plumped up a mountain of fee-paying assets that stood at $137 billion at year's end.
Tellingly, the fee formula addresses a major beef leveled by PE investors against the biggest managers -- a complaint the financial crisis stoked. When markets tanked, battering assets and arresting investing activity and profit-taking alike, pension officials chafed at the ample management fees they continued to cough up at a time when their PE portfolios were under water. "The fees created a misalignment of interests," says Michael Harrell, a Debevoise & Plimpton LLP lawyer specializing in private equity. "Investors don't so much mind managers growing rich off their cut of the profits. But they don't want them to grow rich off management fees."
The New Jersey-Blackstone structure helps right that imbalance. But fees are only part of the story.
Another unusual twist is that Blackstone will have the right to plow up to $250 million of the profits the Tactical Opportunities vehicle generates into new investments of its choice during the initial three-year investment period. While the investment period is short -- most PE funds are supposed to deploy all the money by the fifth or sixth years -- New Jersey can stretch the time horizon to 12 years. And from year three onward, it can opt to recycle whatever gains it wishes, year after year. "New Jersey really views this as a long-term commitment," says a person familiar with the pension fund's thinking. "They trust Blackstone, and they wanted to be able to recycle the capital and compound the returns."
In an interview, New Jersey chief investment officer Tim Walsh says the state had spurned earlier chances to do a kindred deal because "I don't like giving somebody money for 10 or 20 years and not have much control over it." But Blackstone's manifold capabilities sparked his fancy. "We could bargain with a firm that in our opinion was first quartile in the big four areas -- hedge funds, commodities, real estate and private equity -- and they were willing to negotiate a good alignment of interest both on capital and fees," he says.
Even before the new pact, Blackstone was New Jersey's largest alternative asset manager, running $1 billion in commitments for the pension fund.
Regulatory developments and market shocks also factored into the decision. Says Walsh: "The opportunity set has gotten a lot better in the last year or so because of Dodd-Frank [rules], the end of banks' proprietary desks, problems that European banks are having."
Of the three New Jersey-Blackstone separate accounts, Tactical Opportunities stands out for its depth, scale and the ambitions Blackstone has pinned on it. It's not just an account; it's a full-fledged investment platform that insiders have nicknamed Tac Ops.
David Blitzer, a top Blackstone partner who led the firm's European PE activities from 2002 until late last year, now runs the new unit full-time. The basic plan, he and others say, is for Blackstone to use its vast market intelligence to unearth deals that don't fit its usual mold. Tac Ops will assemble a grab bag of small buyouts, debt sloughed off by European banks, subprime and prime mortgages, mezzanine paper and short-duration structured investments. It will aim for 15% to 20% annual returns, a shade less than most PE funds' return targets.
"We felt there was a real lack of capital pursuing these kind of special situations because banks and hedge funds had pulled back," Blitzer says.
"We often came across promising transactions that did not fit the private equity or real estate or credit funds. Often this was due "to lack of capital, liquidity or the wrong duration profile. It was a missed opportunity," he adds.
The level of client care is extraordinary. So, too, is the pension fund's input on investment decisions.
Blitzer's staff eventually will number about 15, hired from within Blackstone and without. He talks once a week or more to Bryan Martin, a senior pension official for New Jersey's Division of Investment, about the opportunities he sees and to gauge the client's priorities. The Tac Ops team meets once a month with Martin and other pension honchos.
While Blackstone can bid on fast-breaking deals without first consulting New Jersey, it doesn't have complete investing authority, as it does in the firm's flagship PE fund. New Jersey has a voice in setting overall strategy, according to sources, and it can veto deals that would cause it to be overweight in specific sectors. But it lacks the right to cherry-pick investments, and Blackstone effectively calls the shots.
Blitzer, meanwhile, isn't mustering his forces to cater to merely one client. From the start, Blackstone envisaged Tac Ops as a new investment platform, not unlike its energy, PE or hedge fund businesses, with New Jersey as its anchor client. "New Jersey knew it was seeding a new business," says a well-placed source.
CalPERS's recent $500 million pledge to a separate Tac Ops account hiked commitments to $1.25 billion. According to California state documents, Blackstone hopes to corral $3 billion to $5 billion, but Blitzer denies there's a set target.
It stands to reason that managing several nominally bespoke accounts under the Tac Ops banner might prove tricky. Will the platform's tilt toward New Jersey's tastes pose problems for CalPERS? Must CalPERS bend to New Jersey's agenda? Will it have an open communications line with the manager?
Blitzer declines to go into specifics but says the logistics will be ironed out. Each pension has some leeway in the sectors it targets, he says. At the same time, his group will seek out deals that meet all clients' needs. "The idea is that everyone will be on the same page," he says.
Less is known about the deals TRS has made with KKR and Apollo than has been revealed about New Jersey-Blackstone. None of the parties has released or discussed details.
What's been revealed is that, like the New Jersey pact, the separate $3 billion arrangements are 10 years or more in length and include profit recycling. The money will go into a spectrum of investment platforms the two firms steer. Fee discounts are said to be hefty. TRS, industry sources say, pitched similar deals to other firms and was turned down. Blackstone chairman Stephen Schwarzman told Bloomberg Television in November that his firm passed on the offer because "for us ... it didn't make much sense."
Fee breaks killed the deal, people familiar with the matter say. Specifically, TRS wanted to peg the "carry" it would have paid Blackstone to the average blended return of all the asset baskets in which it had put money with the manager. Say, for instance, the real estate basket delivered a $100 million gross return, which normally would entitle Blackstone to a $20 million incentive payment. If the PE basket did no better than break even, the performance in PE would have slashed millions from the incentive payment.
"That was a concession Blackstone refused to make," a source says.
Whether Apollo and KKR acceded to that concession isn't clear. Both firms and TRS declined to comment about fees. Blackstone wouldn't elaborate on Schwarzman's comments.
Notwithstanding the breaks clients are now commanding, the massive size of commitments sown across an array of products could pay rich dividends to the managers. And not just by helping them bulk up. Equally important, these custom arrangements advance a bedrock goal of every buyout giant: product diversification.
A run of PE firms going public from 2007 to 2012 has sped the diversification drive, because public-market investors prize diversity and are leery of firms whose fortunes are yoked to leveraged buyouts. New Jersey's and TRS's deals will help Blackstone, KKR and Apollo -- all three of whose shares trade publicly -- to expand.
"I'd say that's part of the agenda with those deals," says Barry Gonder, managing partner at Grove Street Advisors LLC of Wellesley, Mass., a pioneer in fashioning custom PE accounts for institutions.
"Bringing in big accounts boosts assets under management. And that'll probably have a positive impact on their stock prices," he adds.
Again, custom accounts aren't new. But since they first arose a dozen or so years ago, they have evolved in nature and scope.
In the late '90s, when CalPERS found itself left out of Silicon Valley's venture capital-fueled technology boom because of its intimidating size, the pension fund tapped Grove Street Advisors to manage a dedicated VC vehicle.
Unlike traditional, nondiscretionary gatekeepers that were essentially fee-based consultants, Grove Street had a discretionary mandate to build a fund-of-funds portfolio with brand-name venture capitalists and charge a carry based on the funds' performance. CalPERS also asked Grove Street to oversee direct investments and "seed" new private equity firms.
That arrangement, which Grove Street replicated under different mandates from a few other large clients, upended the notion of a passive limited partner by granting CalPERS a more active role. Under the terms, CalPERS had the ability to change the investment pace and strategy midstream, increase scale, shift geographic focus, have direct relationships with investment managers and exercise informal veto rights.
Sole managed accounts with financial sponsors had antecedents in fact in CalPERS' arrangements with one of its largest managers, Apollo. CalPERS committed $800 million to Apollo Special Opportunities Managed Account, launched in 2007, and $1 billion to a credit opportunities fund in 2008. The funds, as the names implied, presumably aimed to capitalize on credit market turbulence. (CalPERS declined to comment on these sole managed accounts.)
The Apollo Special Opportunities pool, now fully drawn, is showing a less than stellar internal rate of return, at 4.3%, than the credit fund, with a 14.1% IRR as of Sept. 30.
In 2008 TRS and the South Carolina Retirement System launched programs, calling them strategic partnerships. The Texas fund, with a $108 billion portfolio as of February, used this as a model for its current programs with KKR and Apollo. At the time, it said it needed a more diversified investment strategy. It picked BlackRock Inc., J.P. Morgan Chase & Co., investment units of Lehman Brothers Inc. (now Neuberger Berman Group LLC) and Morgan Stanley to manage $1 billion each for a three-year period initially. The money went into publicly traded securities.
TRS did not disclose the terms of these contracts. But it reportedly paid each manager a minimum annual fee of 0.2% of assets, rising up to 0.85% if it outperformed benchmarks. The program appears to be successful, returning nearly 15% during the 12 months ended Aug. 31. In July, the system added Barclays Capital to the list of strategic partners, committing $500 million.
South Carolina had similar objectives, though it gave its managers -- Goldman, Sachs & Co., Boston investment manager Mariner Investment Group Inc., Morgan Stanley and Los Angeles-based TCW/Palmetto State Partners LLC, now part of Crescent Capital Group LP -- a broader mandate across credit, hedge funds, private equity, real estate, real asset funds and direct co-investments in public and private securities.
Goldman received a $1.5 billion commitment; Morgan Stanley, $1 billion; TCW and Mariner, $750 million each; and Apollo, up to $750 million. Each firm was required to ante up a "meaningful" amount of capital. No other contractual terms have been disclosed. (A spokesman did not return repeated calls for comment.) Last year, Crescent Capital reportedly received a $750 million re-up.
Over the past four years, the South Carolina Retirement System says, it has coursed money through these partnerships into high-yield fixed-income, PE fund allocations and direct investments. As of mid-2011, the strategic partnerships accounted for 50.7% of its private equity allocations, across buyouts, venture, secondary, mezzanine, co-investments, diversified funds-of-funds and related assets; direct fund investments accounted for the rest.
To date, the PE portfolio appears to be doing just fine, with annualized returns of 20.2% as of June 30. For all strategic partners, the annualized return for the same period averaged about 13%.
The stream of new-style megabuck, big-discount, multiplatform deals certainly will increase. But experts do not foresee a flood of these bespoke arrangements.
For starters, nearly all the thousands of small and middle-market alternatives managers do but one thing, whether PE or credit or real estate. Too, the circle of big firms boasting an array of products is small: Besides Blackstone, Apollo and KKR, just Carlyle Group, TPG Capital, Bain Capital LLC and, to a lesser extent, Oaktree Capital Management LP are likely candidates for such deals. And steep up-front discounts on management fees, like the one Blackstone took on Tac Ops' yet-to-be-invested dollars, are a luxury that most midmarket firms can't afford.
A good many public pension funds, even some of the biggest, are handcuffed on making new commitments. That's because the post-crisis slowdown in PE asset sales has left them overexposed to PE and other alternatives. "We couldn't write a big check like that even if we wanted to," says Jay Fewel, senior equity investment officer for the $73 billion Oregon State Treasury, a big-dollar backer of KKR dating back to 1980. "We're overallocated on private equity." By contrast, TRS had started to ramp up in PE only recently, which gave it latitude to forge its deals with KKR and Apollo.
The deals also have their critics.
"They come at a cost" to the pension funds, argues Monte Brem, CEO of StepStone Group LLC, a San Diego investment firm that, like Grove Street, packages custom accounts for clients. The accounts take stakes in a smattering of PE, secondary and mezzanine funds.
"The managers are great in certain areas. But they are not so great, or have no track record, in others," he says. "It is like [the pension funds] are trying to force capital into a cheap fee structure. But cutting fees is not the primary way to make money in this asset class. Picking the best managers in different strategies is."
Both KKR and Apollo have set up real estate units in just the past two years. Other initiatives that they and other big players have launched lately have had varying degrees of success.
Still, the shift of big pledges to proven, top-line players seems poised to accelerate. Leading pension funds are looking to drop weaker performers, large and small, from their PE rosters to elevate returns in the category. Tighter budgets too have spurred the culling, even as pensions bestow more money on favored managers. "It makes sense to rationalize the number of relationships and allocate more capital to those you have a strong conviction about," says a former state pension official. "It allows you to be more efficient investing with a small staff."
Walsh says that New Jersey initiated the deal with Blackstone mainly to exploit investment opportunities that it "had no other way" to access. In theory the pension fund, with 20 investment professionals in Trenton, N.J., could have hired 10 different hedge funds, but it would not have been able to extract better fees, he says.
In CalPERS's case, says one source, much of the impetus was fee-related. At the height of the pay-to-play scandal that snared former CalPERS officials, industry executives and intermediaries, the California pension fund bargained for lower fees on Apollo's managed accounts. "The fund tends to be cyclical on the issue," the source says. "Lately, they've been adamant. If you want to get money out of them, it's a process."
The pension fund, which has continued to pare private equity and venture capital holdings since 2005, is said to be putting much greater weight now on sole managed accounts. (CalPERS declined to comment for this story.)
Next in line might be the $154 billion California State Teachers' Retirement System. In February its investment committee recommended that its authority be revised to make room for separately managed accounts for many of the aforementioned benefits. In June it proposed that accounts must not exceed $500 million for an existing general partner relationship, or $250 million for a new GP, to mirror its set rules for investing in commingled PE funds. A decision is expected in July, a spokesman says.
While as yet none of the sovereign wealth funds -- gargantuan capital pools that invest on behalf of foreign governments -- that are active in PE have negotiated a custom deal, some inevitably will, PE executives say. "What you've seen so far is just the tip of the iceberg," says a partner at a well-known PE manager. "There's a lot going on under the water right now, lots of discussions."