We caught up with Ashley Baum, director of the special opportunities programme at Teacher Retirement System of Texas, the sixth-largest US pension plan and 25th largest in the world.
TRS manages about $165 billion in assets on behalf of 1.6 million teachers, bus drivers, custodians and other employees in the US state’s public school system. Baum runs a team of eight people focused on special opportunities, which is the opportunistic sleeve of the trust. She says it has no set allocation or policy and its focus is on anything that does not fit within a pre-defined asset class.
The team spends a lot of time in the private and illiquid credit market because it does not fit anywhere else within the trust’s strategy. The team also maintains co-investment relationships with hedge funds and public market managers.
Could you explain your tactical approach to investing?
It’s a legacy that goes back to 2007 when we were a pretty normal, slow and sleepy US pension plan and we had a new chief investment officer come in by the name of Britt Harris. He did what all CIOs do, which is launch an asset liability study and really take a good look at the plan. What he found was that effectively we had a lower payout requirement than most foundations and endowments. What we ended up doing was adopting an asset allocation that I would describe as endowment-lite, which was very heavy on private assets, emerging markets and the illiquidity premium.
When we describe our asset allocation we really think of it in long-term time horizons. There are three so-called regimes that the trust focuses on. One includes the majority of our assets and is what we call the global equity regime – all forms of equity including hedge funds, private equity and public equities. Then we have two hedges for times when we’re not in a perfect, Goldilocks-type scenario – one is a recession portfolio and one is an inflationary portfolio. Although you haven’t seen an inflationary scenario in the US, we still feel it’s really important to have that portfolio.
And where does that leave your approach to credit?
What we’ve found is that credit never outperforms in any of those environments. We think credit is a really strong tool for the toolkit but it does not have a strategic allocation. So, we are a little bit different in that regard. We have a large treasury portfolio as part of our recessionary hedge but no credit otherwise. Every time anyone in the trust invests in credit, we’re doing it against non-credit benchmarks and it’s for tactical, not strategic, purposes.
How has the balance of your exposure changed over time?
We made a very large tactical credit play in 2008-09 when we reallocated about $8 billion at the height of the GFC into high-yield, leveraged loan obligations and commercial mortgage-backed securities. We invested heavily at that time because we felt the dislocation was so extreme, and we got all of our capital back by around 2011. In 2015-16 we made another call in favour of credit, when we believed the US equity markets were at an extreme inflection point from a valuation standpoint and felt it was unlikely to continue. What’s happened in the last few years shows we aren’t right about that yet, but the trust asked our team to go and build this portfolio of tactical credit.
The way to do that when you’re trying to get capital out quickly is you have to prioritise scale. What the portfolio currently reflects is a large allocation to direct lending, not necessarily because we feel direct lending is the most unique asset class but because we felt we could identify strong partners and they could get capital out for us within a one-year or two-year period. We’ve tended to pick large managers with a lot of resources that we felt could get our capital deployed. We did not want to be sitting in four- or five-year investment period vehicles.
What we have added, which we’re excited about, is asset-based lending which is a broad area covering everything from real estate assets to structured solutions – which comprises combinations of debt and equity but secured by assets. We find these are really niche opportunities. We also look at agricultural lending and something else we see quite a bit are ‘fix and flip’ loans. If you think about those opportunities from our standpoint, we really need to be able to write a $200 million cheque to make it worth our time as we have very limited resources. So, we have to look to managers to be our partners because we can’t access those opportunities without them.
We’re also a very big believer in regulatory capital transactions, where we feel we’re a perfect partner, and we examine anything related to areas where we may have a tax benefit by the unique nature of TRS. So, for example – and this is where my team’s opportunistic specialism is key – we’ve found we don’t pay taxes on oil and gas royalties in the state of Texas and that’s one area my team has been spending some time on. Warehousing is also a very great asset for us, so we’re looking for partners there.
From the co-investment side we’ve done appraisal rights, asset-based securitisation facilities, we have been investors in distressed debt and rescue financing situations, and we’ve been involved in several activist campaigns. Right now we are underwriting some of the SPACs as part of the SPAC mania that’s going on, but we think there’s a really interesting way to play that. So, my team’s all over the board. It’s a very eclectic approach.
How are you planning for the distressed cycle?
It would be dangerous to predict when the distressed cycle will start. But what we do believe is that it is definitely coming. If you look at the raw economics and where defaults have picked up, it has been a strange market. In March we were very prepared and we put some capital into very high-quality companies even in the investment grade space where we felt there was panic in the market. We’re very concerned, as many people are, about the potential for fallen angels, given the quality of BBB paper and what’s been going on in that space. We’ve also been very focused on the long-term knock-on effects of covid-19 and how many companies can survive. Many of them have had liquidity infusions and we have participated in several of those through our partners.
Our approach is ‘you can never time distressed’, so we have a couple of managers where we give them some pretty broad leeway and they tell us when they think it’s time for distressed and we have seen them starting to deploy recently. Everyone is waiting for liquidity to run out and the Fed and other central banks to be a little less accommodating. We’ll be ready to look at those as co-investments. But those that have been brought to us so far, we don’t feel like we’re getting paid for the risk. We think it’s probably six to 12 months before we really see anything other than the directly impacted and highly levered companies that can’t survive the direct covid-19 hit.
How does your team go about assessing opportunities?
We can do public assets, private assets, equity and debt. It’s a complete multi-strategy portfolio and all we are doing is finding a compelling opportunity that the trust would otherwise miss. Our job is to raise our hands and say we should be investing in a given area.
About half of our assets are in illiquid credit, which we define as a large tactical area – for us it’s about a $4.5 billion to $5 billion portfolio. The other half are accordion-style capital where we have co-investment relationships that are pretty established and managers will call us with particular opportunities. My team is looking at individual security analysis, individual property analysis and then deciding whether TRS should write a cheque for between $50 million and $200 million into that specific opportunity.
The majority of time is spent on co-investments, and looking for strategies that should deliver around 10 percent. We’re also looking for things we can underwrite where we feel we understand the downside and which refer back to the fact all the credit my team is doing and all the relationships they are forming are tactical. A lot of managers have that conversation with LPs about what the goals of the strategy are and whether you’re taking capital away from another area. In private credit, most allocators I speak with are taking that either out of their private equity bucket as a hedge or safer asset, or it’s coming out of their public fixed-income bucket and they’re trading off illiquidity for additional return premium.
Our asset allocation committee decides what they are going to sell and that leads to a great question I always ask my managers: “You have a great opportunity that you’re pitching us. What do I sell? How do I fund you?” That’s the other side of the co-investment we have to think about, which is we’re taking some pretty idiosyncratic risk climbing into these investments, whether a tactical credit fund or a specific investment. What am I selling?
What would be your prediction of the future of private debt?
My crystal ball shows there will continue to be high demand as long as we continue to have this very low interest rate environment. The need for yield and income are just incredibly high. I do think the industry is still too immature to really know what will happen in a downturn. So, how it performs in this downturn is critical for its long-term success.
We manage approximately $2 billion in direct lending. When the market fell in March across the board we had a 20-30 percent hit on our direct lending portfolio. We were quite surprised, because theoretically there’s still equity value and you can get into questions about how much impairment on the debt should be going into the valuation. Anyway, the values did go down and the public markets recovered.
The industry needs to be careful about what it is. It bills itself as a higher income but less volatile opportunity set for investors, but if it’s tagging public markets on the way down it needs to tag them on the way back up. Performance versus public market indices, or even versus a private equity index, is not looking so good. The past two quarters have been pretty interesting. I think what we see is going to be really important for how people think about the asset class and what bucket it fits in.