Texas Municipal Retirement System Is Betting On Smaller, Emerging Managers | Christopher Schelling, Director Of PE | Q&A
Christopher Schelling is the director of private equity at the Texas Municipal Retirement System (TMRS). Since joining TMRS, he designed the IPS for private equity, hired consultants and staff, sourced over 500 general partners and committed $1.4 billion across 30 limited partnerships.
In this interview, Schelling discusses how smaller, emerging managers helped TMRS beat their return benchmark; why machine learning might not be as effective for TMRS' decision-making process; and why public pensions need to change and innovate to be successful.
Christopher Schelling was named on Trusted Insight's 2018 Top 30 Private Equity, Venture Capital Investors. He graciously spoke with us on May 2nd, 2018.
Trusted Insight: Since joining, the Texas Municipal Retirement System beat its 1-,3- and 5-year return benchmark. To what do you attribute that success?
Christopher Schelling: We’ve done a couple of things. We have focused on smaller funds and earlier stage funds, because the research shows that emerging managers and smaller managers tend to outperform historically. On a forward-looking basis, the evidence also suggests that that's a better place to be right now. Multiples in the lower middle market are 8.5x instead of 10 or 11x, and that's going to show up directly in returns. We haven't made a huge bet there but that's where we've kind of leaned.
"Our board has given us the approval to do more international and a dedicated European fund or two, so we're beginning to research that market."
Within private equity, smaller and earlier stage managers are where that dispersion of return is wider. If you have any evidence of skill in manager selection you want to be in those places where the dispersion is wider. That’s where we’re focusing, and I think we've done a decent job picking managers.
We've also come into some seasoned primaries, where we were able to underwrite an existing portfolio. We were fortunate enough to get some NAV uplift from some of the portfolio companies in there. A bit of luck helps out too.
Trusted Insight: TMRS wants to build up/construct a portfolio of $1.2 billion of private equity investments. What influenced this move and how will you approach it?
Christopher Schelling: We’re a $28 billion plan. Our target net asset value is about 1.4 billion, and that's just the asset allocation target of five percent for private equity. The goal is for it to be the highest return generating asset class in the portfolio. It's a simple and unambiguous goal.
In the last three years, I allocated or committed that entire $1.4 billion. We'll continue to pace to get our NAV up to where it needs to be, but I think we're on a good trajectory. I don't know if there's anything unique or revolutionary about it, it's just a mix of buyout, growth equity, venture and some special situations.
We've been heavily domestic focused and a conservative organization. We go slow, but we go forward. Our board has given us the approval to do more international and a dedicated European fund or two, so we're beginning to research that market.
Trusted Insight: What industry or sectors in the private equity space do you find most intriguing right now?
Christopher Schelling: Our average fund commitment is $50 million, but despite that, we've done quite a bit in growth equity space. A majority of that is in information technology and even within that, the majority is software. We've done a lot in smaller funds.
We like GPs where they are the first institutional investor in what are founder-led bootstrapped companies that have been very capital efficient and have gotten to significant revenue. These are mission-critical, enterprise software that really creates so much operating efficiencies they're so sticky that they can't go anywhere. They have really high growth rates. Think of it as venture-like upside with buyout-like downside. We spend more time in that space than venture.
Multiples in that market segment are certainly no longer cheap. It's heated up quite a bit. Last year, 40 percent of private equity transactions were in the IT sector and multiples are often 12-16x. We're slowing our pace of committing there. We might not have room for new managers, but it’s certainly still performing well.
On the other end, the credit cycle is long in the tooth. People have been saying that for some time, but there will be a correction at some point and spreads will move wider. How can we participate in a distressed cycle and generate equity-like rates of return without having our returns eroded if that cycle doesn't emerge?
We're looking at managers who can come up with fund structures where there are no fees unless something happens or capital is deployed only contingent upon the cycle emerging. We also look at managers who can do other things like participating in turn around buyouts or messy corporate carve-outs, but can also source distress for control opportunities from the debt markets, if that does emerge. That's one area where we spent a lot more time this year than we did last year.
Trusted Insight: What are your thoughts on machine learning and artificial intelligence? And how do you see that technology impacting institutional investing?
Christopher Schelling: As far as adoption by institutional investors, it's more of a longer-term cycle than a shorter-term one. Given our constraints around budget and implementing technological things to help us do our job it's very hard for me to see how it’ll be broadly adopted quickly amongst a big set of institutional investors.
"In private equity, the team, philosophy, strategy, culture and market dynamics, matter a lot more than just math."
In terms of long-term asset allocation, I don't know how helpful it is because those are very long-term assumptions that move very slowly. Our decisions take anywhere between months to a year. In terms of immediate impact, you're clearly seeing them in high-frequency trading, quantitative hedge funds, and that's the only real alpha out there at the moment. Right now, the shorter time frame, the more powerful those things are. Conversely, I don’t know how valuable it is the longer your time frame.
As far as investing in companies that are producing those products and services, we do have some through our growth portfolio. It's important to identify general partners that have deep networks and relationships in those sectors and are actually able to understand both the technology and competitive market dynamics.
Trusted Insight: How does your educational background in psychology, paired with finance, influence your approach to the markets?
Christopher Schelling: It's very helpful and almost more helpful on a day-to-day basis than the finance background. When I think about what finance actually is, it's not like physics or chemistry, which are bounded by closed-end solutions. In finance, it's never a certainty; it's always about probabilities because it’s about trying to predict the markets.
In terms of private markets, I think of assets as a spectrum from super liquid, super short, super competitive and super low cost, to illiquid, very long term, not as competitive and a lot higher cost. On one end, you're buying products and at the other end, you're closer to just hiring people.
In private equity, the team, philosophy, strategy, culture and market dynamics, matter a lot more than just math. For me, it's very important to understand the team, the motivation and interest, and what they are trying to accomplish. That's really flowed through to our diligence process, where one of the things that we incorporate is a personality test.
Trusted Insight: Could you elaborate on the personality test? Is this something that you’ve implemented recently or has it always been in place?
Christopher Schelling: We implemented it about a year and a half ago. It's essentially a 45-minute online test, where three to five critical personnel at our managers are asked to complete it. They can do it in stages so they can take their time. It goes through a series of personality characteristics and asks them many questions about how they operate. That really gives us a more accurate insight into what their motivations are, how they work together, how they make decisions, and what their strengths and weaknesses are as a team. It highlights things like decisiveness, energy level, agreeableness, manageability and sociability.
That allows us to see how two key partners would work together. Is one really decisive and the other is not? Is one a lot more sociable than the other? If we see that with hard numbers rather than our subjective judgement, we may have a better feel for why someone is the head of an investment committee and why the other person is, for instance, head of business development. I believe it's been very helpful.
Trusted Insight: Before joining Texas, you were a deputy CIO at Kentucky Retirement Systems. What attracted you to the realm of public pensions as opposed to any other branch of institutional investing?
Christopher Schelling: There's a few, but one of the big ones is the chance to be involved in solving a large social challenge. The problem is the aging of society, underfunding of retirement plans and under-saving for a big chunk of our population who's unprepared for retirement. Along with increasing life spans, all these are going to result in increasing healthcare and retirement costs. Increasing lifespan is an unmitigated good, but not being able to fund those increasing life spans is going to be a big challenge. Doing something where you can actually help to make people's lives better instead of just making more money for a corporation, that's attractive.
Also, at U.S. public pensions, you might not make private sector compensation or even Canadian pension compensation, but you have the opportunity to step into a big job with big responsibility. You’ll be able to make an impact since you're committing lots of money. You’ll get to meet senior people across the industry immediately, people like Bill Ackman, Henry Kravis, etc. Learning how they have invested and made highly significant investment decisions are both attractive.
Trusted Insight: Can you elaborate on your experience as an adjunct professor of alternative investments at the University of Kentucky, and would you consider teaching again?
Christopher Schelling: Yes, frankly, it was a lot of fun. I was there when University of Kentucky (UK) won the NCAA championship, and it was great watching Anthony Davis play.
Being back in that university environment, I felt that I had valuable lessons to share with the students. I shared my direct, real-world experience as an allocator and gave them a view of what it's actually like. That's kind of how the class was designed. I made it very applied and invited speakers from the industry as well, which were mostly senior people from hedge funds, private equity funds and infrastructure funds. "Here's what our company does, here's what my career is like, here's what my job is like."
On the other side, it was a chance to get in front of 75 students about three times a week. It helped me become a better public speaker, frankly. Looking back on it, it was a lot of fun and I have some of those students who are now in the industry. They'll reach out to me every so often; one of them is at Morgan Stanley. It's a strange feeling having someone I taught in the industry and to think I've made a little impact on their career.
The challenge, in Austin unlike Lexington, is that I don't know if I have a skill set that is much different than a lot of other peers in town. The University of Texas is a big school, and they've got a lot of big name adjuncts. They have many people with applied experience. At UK, I think my class was differentiated, and I brought a new perspective there. If an opportunity arises at an institution where they think I could be valuable for their students, then yeah, I would definitely consider it again.
Trusted Insight: Is there anything that you’d like to add about yourself, TMRS or private equity or pension investing broadly?
Christopher Schelling: One of the challenges of being a U.S. public pension is that our organizations are highly bureaucratic. We have a governance structure that prevents us from making big mistakes in the short run, but make it difficult to innovate in the long run.
In the current financial landscape, you need to innovate and change in order to be successful. Whether it's hedge funds, private equity, etc., you have to change sometime down the road particularly in alternatives.
As an industry, public pensions look at what Harvard did 20 years ago, what the state of Oregon did 20 years ago, and often try to replicate that today. Well, that doesn't work. It is incumbent upon investment professionals, executive directors and boards of trustees to realize that they've got to change. If we do the same thing as was done 20 years ago, we're going to have an unacceptable result many years down the road.
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