A separate piece

It seems like everyone’s doing it.

The New Jersey Division of Investment, The California Public Employees’ Retirement System – hell, the Tennessee Consolidated Retirement System even has two. Over the last two years separately managed accounts dedicated to private equity and private debt strategies have blossomed into a trend du jour, and industry experts say they’re here to stay. 

Limited partners will take advantage of any break on fees or terms they can get, and who can blame them? As the fundraising environment for private debt funds grows more crowded with offerings from traditional private equity firms and other non-traditional lenders, investors have taken the leverage they have built up negotiating increasingly favorable terms over the last few years and applied that to fund managers operating in the debt sector.

This, along with other factors, has led a growing number of LPs to form separately managed accounts, which offer broader exposure to a fund manager’s portfolio of assets at a (typically) lower price. In exchange, fund managers receive a larger quantity of fee-generating capital from a single investor with which they (often) already have strong relationship.

“I think it’s about fees and flexibility. Lower fees, especially for the larger investors, and more flexibility as it relates to the ability to control certain elements of the program,” says David Fann, president and chief executive officer of advisor TorreyCove Capital Partners.

In March, the Tennessee Consolidated Retirement System approved $500 million each to a pair of separately managed strategic lending accounts managed by Beach Point Capital Management and Brigade Capital Management, respectively. At least one of the accounts will have a broad mandate to invest in private debt, direct loans, high-yield, distressed debt and special situations, among other strategies, according to a source familiar with the situation.

Because of the much higher yield in levered loans and strong inflation protection of the  asset class, the strategic lending portfolio will likely focus on loans as its first area of investment, according to minutes from the $34.9 billion retirement system’s investment advisory council’s November minutes. Funding will largely come from the treasury inflation-protected securities (TIP) portfolio.

 Beach Point and Brigade did not respond to requests for comment. Tennessee declined to comment on this story.

 Tennessee’s decision to dedicate $1 billion to debt and other credit strategies is consistent with what sources say is a growing willingness among institutional investors to commit separately managed accounts in the debt sector. However, although Tennessee’s allocation to Beach Point and Brigade looks in line with that market development, the mandate of TCDRS’ programme may differ greatly from those of its peers.

 “All of these accounts will look a little different; all of the arrangements will be bespoke. But I would say that in general, one of the biggest benefits will be a degree of customisation, and that will vary by separate account,” says Mike Koenig, a relationship management principal at Hamilton Lane.

Whereas Tennessee dedicated its strategic lending accounts entirely to debt or high-yield strategies, New Jersey’s separate account with The Blackstone Group included an asset mix that ranges from real estate to traditional private equity to a cross section of credit affiliate GSO’s funds and strategies (GSO Energy, Special Situations, Credit Opportunities).

 Indeed, the largest chunk of New Jersey’s $1.8 billion Blackstone account went to the firm’s then-nascent Tactical Opportunities Fund, which comprises of a number of separately managed accounts that invest across multiple asset classes and leverages the firm’s established private equity, real estate, credit and hedge fund businesses. The goal of that fund is to invest in “time-sensitive or opportunistic ideas across asset classes and geographies”, according to New Jersey documents.

“On the Blackstone thing that we did, on the biggest piece of that, the tactical opportunities fund – on the one hand, we’re doing them a great favour because it really put them on the map and with a very large commitment ensures that will be a successful business for Blackstone,” said Robert Grady, chair of New Jersey’s State Investment Council last month. “On the other hand, they did us a favour in that we have 0 percent management fee on committed capital; there’s only a 1 percent fee on when the capital’s drawn, the carry’s 15 points – not 20. So, you know, I think we got favourable terms for the investor.”

Of course, New Jersey’s size and relative clout within the industry – measured by its ability to commit $1.8 billion to a single manager – was a big reason why the state’s public pensions had been able to negotiate those terms. As it stands now, the management fee breaks that tend to accompany these accounts wouldn’t be able support smaller separate accounts, sources say.

“A lot of the separate accounts have been larger, and the economic benefit has come from their size,” Koenig says. “It’s simple math, you have needed to be a larger investor to do them.”

New Jersey also had the additional benefit of being a longtime investor in Blackstone funds, which enabled them to negotiate lower fee terms that are expected to save the state $120 million over the life of the agreement, according to documents. Several sources indicated that the sort of relationship New Jersey (and now CalPERS) enjoys with Blackstone is rooted in a flexibility that comes with any long-term relationship.

“There’s typically a strength of relationship and trust that has already existed … I think there’s a greater spirit of cooperation, and it’s usually a less contentious negotiation,” says Fann, adding that some separate accounts even include provisions that allow the investor to wind down.

With private market fund managers grumbling about the growing sway LPs hold over the industry, all of this begs the question of why managers would be willing to make these sorts of concessions?

“When we talk to GPs, without fail, they are very excited about their pipelines, they’re excited about potential investment in the market, and there is a breadth to what they can provide to LPs through separate accounts,” says Koenig.

Separate accounts allow fund managers to diversify their business without having to take on investors who may or may not possess the capacity to adequately co-invest.

THL Credit, which manages approximately $3.1 billion in assets, officially established its separate accounts business in 2011 – its series of Greenway funds – to create alternative ways for institutions to invest in its products.

“What we had been doing is bringing in co-investors ad hoc … then in January, 2011 we went programmatic with Greenway I. It was a fund designed to invest very synergistically with the public BDC [business development company],” says Jim Hunt, chief executive officer of THL Credit. “Our structure, as a portfolio company of, and accretive to, the BDC, is designed to align interests, and it’s appropriate for investor who isn’t seeking liquidity, but finds the underlying risk assets attractive and appropriate.”

“It’s good business sense for a manager of a business like a BDC [business development company] to seek diversity in our investments and our assets. That means we don’t want to over-concentrate.”

In particular, Hunt says the firm’s creation of its separate accounts business allows its clients to invest through their public BDC and a separate account, which gives them access to both liquid and illiquid holdings. If LPs continue to show a willingness to create these accounts, the firm should be busy.