Giant Separate Accounts: Falling Short Of A Revolution

It wasn’t that long ago that giant separate accounts were going to revolutionize the relationships between the nation’s largest pension funds, with billions to invest, and the giant—mostly publicly listed—private equity firms that were rapidly transforming into diversified asset managers

In late 2011 the $112 billion Texas Teachers’ Retirement System announced not one, but two $3 billion separate account partnerships, one with Kohlberg Kravis Roberts & Co. and the other with Apollo Global Management. These two partnerships were aimed at leveraging the pension’s huge piles of cash in exchange for favorable fees and terms and—it was strongly emphasized—unique and opportunistic investment opportunities that would take advantage of a whole new style of general partner/limited partner relationship: one that was deeper, more interconnected and more collaborative. It was going to be a relationship that hovered above those with smaller LPs who committed, say, $20 million to an ordinary, commingled private equity fund.

“The goal (of these relationships) is to be dynamic and capture opportunities in the marketplace,” said Richard Hall, the managing director for private equity at Texas Teachers’ in a Buyouts interview in early 2012. “A lot of opportunities…occur for brief windows of time. So you’ve got to be willing to take some uncertainty in these partnerships, so they can invest in something that’s a little bit different, a little bit off the run, and hopefully by doing that, create profits and excess returns.”

KKR, too, emphasized a new kind of relationship with Texas Teachers,’ heralding their “wide latitude for the opportunistic allocation of capital in different market environments.”

But a funny thing happened on the way to the separate account revolution: In the year and a half since Texas Teachers’ and KKR signed their partnership papers, most of the commitments that Texas Teachers’ has made to KKR and Apollo have been to humble, ordinary commingled funds, such as the KKR North American Fund XI LP, a fund available to most of KKR’s investors. Of the $3 billion already committed from the two separate accounts, only $400 million (13 percent) has so far been pledged to special situations or opportunistic vehicles that have Texas Teachers’ uniquely in mind.

Hall, speaking in February 2013 at the SuperReturn private equity conference in Berlin, acknowledged to Buyouts that the majority of the pension’s $2.1 billion in commitments to KKR in the last year and a half were made to commingled funds. But he said a much smaller portion of Apollo’s pledges were made to such funds.  

To be sure, at the time of the initial announcements, it seemed that the pensions themselves were not entirely sure what to expect, since these arrangements were the first of their kind. They were designed to create an ongoing exchange of investment ideas that deepen the communication between GP and LP.  

Not So Separate

Now, details are emerging about how these breakthrough relationships are actually functioning and whether Texas Teachers’ is actually getting what it initially expected. Interestingly, initial expectations that such giant separate accounts would become the industry standard did not pan out: While a couple more separate account deals have been launched, including a $1.8 billion account between the New Jersey Division of Investment and The Blackstone Group, and a $500 million account between the California Public Employees’ Retirement System and Blackstone Group, most of these deals have been few and smaller in scale.

Regular commingled fund investments from the two Texas Teachers’ separate accounts are not given terms that are any better than those given to other LPs, according to Brad Thawley, a private equity investment manager for the pension. For regular commingled private equity funds, “we get the same economics that other LPs get,” he told an audience this month at the SuperInvestor conference in San Francisco.

“The only advantage that we have,” said Thawley, “is that once distributions are made, there is a slightly different carry structure where distributions on the back end flow into a separate vehicle that has different economics.” Those recycling provisions allow for up to half of all distributions to be plowed into another vehicle at a discounted rate, according to Thawley.

So, if these separate accounts offer terms and fees that are similar to what other investors can get for commingled funds, and most investments (so far) have been made to such commingled funds, what then are the advantages of these special accounts to Texas Teachers’?

Rusty Guinn, the director of Texas Teachers’ Strategic Partnership Group, offers one possible answer. In an e-mailed message to Buyouts, he wrote that “the real prize…is developing the kind of trust with our partners that allows us to have truly candid conversations about investment opportunities.”

He also said that the early focus on commingled funds was due mainly to the time-consuming work involved in creating the structures for opportunistic vehicles. “We are in the process of launching the non-commingled (KKR) vehicle that will enable more active and unique opportunistic investments,” said Guinn. In other words, opportunistic investment vehicles took time to launch, but the structures for commingled vehicles were already in place, so those investments were made first.  

Allocation targets for Texas Teachers’ two separate account vehicles are as follows: between 25 percent and 45 percent of the funds will be allocated to traditional private equity, 20 percent to 40 percent of the funds will go to private real estate investments, up to 20 percent will be invested in credit opportunities, and between 15 percent and 35 percent will be invested in opportunistic investments.  

So far, $2.1 billion has already been committed to six KKR vehicles from KKR. Those commitments include $750 million to the KKR Natural Resources Partnership LP, $500 million for KKR North American Fund XI LP, $300 million for the KKR Asian Fund II LP, $250 million to the KKR Mezzanine Partners I LP, $200 million to the KKR Special Situation Fund I LP, and $100 million to the KKR Global Infrastructure Fund LP. That still leaves $900 million left to be committed by 2015, according to Texas Teachers’.

For Apollo, $850 million has been committed across six funds. Those pledges include $200 million to Apollo Strategic Partnership Network (SPN) Lightening Credit Fund LP, $200 million to the Apollo Natural Resources Fund LP, $150 million to the Apollo Global Real Estate U.S. Fund LP, $100 million to the Apollo Global Real Estate Asia Fund LP, $100 million to the Apollo European Principal Finance II LP, and $100 million to Apollo India Credit Fund LP. These commitments still leave $2.2 billion left to be committed by 2016.

Guinn said that Texas Teachers’ has already made “non-commingled proprietary investments in the distressed area” with Apollo. He said he expects the number of these kinds of investments to grow as the two relationships deepen.

Of course, the value of these relationships will be proven or disproven over several years. So far, Texas Teachers’ pension executives have said they are happy with the results, especially when it comes to the deeper level of communication between pension and GP.