In recent years, institutional investors have increasingly turned their attention to co-investments as a strategic avenue for accessing private equity exposure and enhancing returns. With more allocators seeking opportunities to invest in private equity beyond traditional fund structures, we examined how CalSTRS and CalPERS — the two largest US pension funds — have leveraged co-investment programs to achieve significant cost savings and boost the overall profitability of their private equity investments. Additionally, we explored the resource allocation nuances these institutions navigated to incorporate co-investments into their asset allocation frameworks and their forward-looking co-investment priorities.
In a bid to make up for missing out on the exponential growth of private equity from 2008 to 2018 — referred to by former CIO Nicole Musicco as the “lost decade” — CalPERS has been revamping its private markets strategy over the past few years. As of March, the pension increased its private market allocation from 33% to 40%, boosting its private equity allocation from 13% to 17%. This shift is largely driven by the outperformance of private equity in CalPERS’ portfolio, which delivered a 10-year annualized return of 11.4% for the pension as of 2023.
Alongside updated private equity allocation targets, CalPERS has also initiated several strategic shifts, including moving away from mega-funds and large buyout managers and increasing exposure to middle-market firms and venture capital. Notably, with co-investment deals driving top returns in its private equity portfolio, the pension fund has chosen to increase its allocation to these opportunities. In 2023, roughly 47% of the capital CalPERS deployed into private equity was directed into low or no-fee capital structure, and roughly 50% of its annual private equity allocation budget will be earmarked for co-investments moving forward.
These changes are set to yield significant material implications. CalPERS projects that each $1 billion in co-investments saves about $400 million in management fees and carry over the life of the investment. Further, Marcie Frost, the pension’s CEO, anticipates that the new focus on co-investments will position the private equity portfolio to outperform the pension’s public equities portfolio by 150 basis points.
Additionally, co-investments are not only boosting returns but also aiding the pension in addressing liquidity challenges. Anton Orlich, head of the pension’s private equity portfolio, sees the increased PE allocation and emphasis on co-investments as essential steps toward achieving a ‘healthy portfolio.’ Orlich expects that shifting to co-investments will enable the firm to make their PE portfolio ‘self-sustaining.’ Moving from an 85% fund commitment and 15% co-investment structure — with significant unfunded commitments — to a roughly 50/50 split reduces liquidity management challenges and will help the pension achieve a state where co-investment distributions can be recycled into future commitments.
However, the plan’s entire PE portfolio, valued at nearly $70 billion, still has a considerable distance to cover in achieving its co-investment targets. As of December 2023, only 9% of its private equity NAV was allocated in co-investments. Where is the pension focusing its efforts? Co-investments seem to be playing a notable role in its $100 billion climate solutions investment strategy. Between March 2023 and March 2024, CalPERS greenlit over $600 million in climate solutions co-investments.
In 2020, former CalSTRS CIO Chris Ailman conducted a ten-year financial plan to examine the rising costs of asset management, particularly private equity partnerships that follow the traditional ‘2 and 20’ fee structure. The takeaways? The costs were unsustainable, and too much profit potential would be lost. With AUM projected to grow to $348 billion in fiscal years 2028 and 2029, annual investment portfolio costs were forecasted to rise to just under $1.8 billion.
Acknowledging the value of private equity exposure, Ailman implemented a ‘collaborative model’ to help ‘bend the cost curve.’ Inspired by the Canadian pension model, the program seeks to bring investment efforts in-house, collaborate with other institutions to cut costs, and encourage the use of co-investments, joint ventures, SMAs, direct ownership, and revenue sharing.
Today, roughly 62% of CalSTRS’ portfolio is internally managed, with this model driving roughly $1.6 billion in cost savings for the pension since its inception. Much of this success has been driven by the pension’s co-investment portfolio, which has expanded from about 2.5% of the pension’s PE NAV to approximately 20% today, driving over $245 million in savings in 2022. However, as noted by Scott Chan, CalSTRS’ new CIO, establishing a co-investment program has entailed a significant endeavor for the pension.
In a recent Markets Watch interview, Chan discussed key elements that have guided CalSTRS’s approach to developing a co-investment program and offered advice for other institutions interested in pursuing such initiatives. Several highlights include:
“Every year, we produce our cost report, reporting all the costs across the entire investment division. Then we segmented each of the costs, how much were fees, how much was carry, how much was operational, how much was our own staff, how much were consultants. We slice and dice it in any way the board wants it.”Scott Chan, CIO of CalSTRS
“Every year, we produce our cost report, reporting all the costs across the entire investment division. Then we segmented each of the costs, how much were fees, how much was carry, how much was operational, how much was our own staff, how much were consultants. We slice and dice it in any way the board wants it.”
Chan further emphasized the importance of integrating these elements to foster a strong ecosystem for co-investments in today’s environment, highlighting how elevated interest rates heighten the bar for deal viability and require meticulous scrutiny of cash flow stability.
“If you haven’t built the ecosystem, I would caution people about getting into the co-investment space because, essentially, you need a team to select the right investments fundamentally for your organization. We haven’t been in that market cycle, right? We haven’t been in a cycle where it matters because we’ve been in a low-interest rate cycle where everything works, right? I guess what I’m proposing is that the cycle in front of us most likely won’t be one where everything’s going to work.” Scott Chan, CIO of CalSTRS
“If you haven’t built the ecosystem, I would caution people about getting into the co-investment space because, essentially, you need a team to select the right investments fundamentally for your organization. We haven’t been in that market cycle, right? We haven’t been in a cycle where it matters because we’ve been in a low-interest rate cycle where everything works, right? I guess what I’m proposing is that the cycle in front of us most likely won’t be one where everything’s going to work.”
What’s ahead for CalSTRS’ collaborative model? As the pension looks ahead to its next phase of expansion, exploring private credit co-investments and building out more robust capacity for joint ventures are on the docket. Further, Chan discusses ways to better measure and report on the model’s alpha-creation and risk management benefits is top of mind.
CalSTRS and CalPERS are among many pensions seeking private equity exposure to capitalize on portfolio flexibility, cost savings, and enhanced returns. As investors pursue these resource-intensive strategies, technology can provide essential infrastructure for managing co-investment exposures, collecting qualitative and quantitative data, and modeling valuations.
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