TRS REPORT
Springfield, IL
June 20, 2013
Dennis Murfin
** Indicates needs Board approval. This report is in two parts. The first part is written by me and the second by Don Davis.
AUDIT COMMITTEE
Janice Reedus, Chairperson, joined the meeting on the phone so Bob Lyons Vice Chairperson, opened the meeting. The first item after roll call, public comments and approval of the minutes of the May 20, 2013 Audit Committee meeting was the IT General Assessment Report. Some managers were using software for selecting securities which did not meet standards – these firms have since changed their practices satisfying the auditors. The next item was the Employer Services Audit Update, the same item that had caused so much concern at the last board meeting. From the phone Janice Reedus reported she was having trouble hearing Stacy Smith so Stacy Smith, Senior Auditor, moved to beside Executive Director Ingram to share his microphone. The outside auditing firm and TRS staff had finally come to agreement. CMS selects the outside auditing firm for all the state systems. The plan of action was presented to the Board in the form of a Resolution in three parts: 1.) all procedures are to be audited by a level 2 employee or above; 2.) analysis of any action to be monitored by a second auditor; and 3.) documentation parameters would be reset. These actions would be reported at the annual meeting (August). Bob Lyons, vice chairperson, expressed his disappointment that this report had taken so long to be resolved and had to require so much board involvement. Audit Committee concluded at 8:22 AM.
INVESTMENT COMMITTEE
Board Members Present: Molly Phalen, Jan Cleveland, Cinda Klickna, Marcia Campbell, Cynthia O’Neill, Bob Lyons, Mike Busby, Sharon Leggett, and Sonia Walwyn, Enrique Vasquez. Attending by phone: Janice Reedus.
Public Comments: Public Comments of five minutes each were made by the UNITE HERE union representative and three union members accompanying him. They had returned, claiming Walton Street was not abiding by the neutrality agreement with TRS. Walton Street controls/owns several casinos including River Casino in Pittsburgh, PA which Unite Here is attempting to unionize. Their statements claimed intimidation and unfair firing of two union organizing committee members plus the filing of some 50 unfair labor practices against River Casino pending before the NLR Board.
Another person made a public comment concerning rumors that OakStreet Capital was reported to be ready to sell the 5 major papers they held (LA Times, Chicago Tribune, and three others) to the Koch brothers. The Koch brothers were rumored to have expressed their intent to use the papers as a platform advancing their own extreme views.
After the Public Comments, the Investment Committee immediately proceeded to the reply by Walton Street Capital to TRS’ request of its neutrality in labor issues at River Casino. Mr. Bloom, Chairman of Walton Street, made the main presentation flanked by his corporate counsel, another executive of Walton Street, and a representative of Rush Street Gaming. He contended strong support of union rights. Supporting his contention he cited a Statement of Policy of his organization granting unions rights to organize. He identified River Casino as being in Fund VI in which TRS is an investor. He is the chief owner of Rush Street Gaming – the firm that used union workers to construct River Casino. Janice Reedus interrupted his presentation, apologizing that she had to terminate her phone connection to the meeting at this time (9:10 AM). Mr. Bloom continued, stating there were 800 employees at River Casino of which two hundred are management. The group from Walton Street claimed increased training had been given, additional lawyers had been hired, and there had been requests for more oversight of their problems to the management at River Casino.
During the presentation, several board members made statements to the Walton Street Group expressing their concerns. Those making specific concerns known were Jan Cleveland, Bob Lyons, Cinda Klickna, Marcia Campbell, and Enrique Vasquez. Outside Fiduciary Counsel from Cavanagh & O’Hara brought forth an issue concerning one of the lawyer staff of a firm Walton Street had hired. This lawyer was known for a reputation of union busting. Mr. Bloom claimed not knowing this lawyer and to be trusting of his dealing with other lawyers form that firm. He reiterated his support of employees being able to unionize. He further stated that Unite Here was an overly aggressive union that had a reputation for harassment. At this time (9:40 AM) the Investment Committee ended the presentation and took a 10-minute break.
Upon resuming, the Investment Committee heard from Carlson Capital L.P. in their Black Diamond Thematic Fund. This approach is an Absolute Return program employing a “thematic” long/short strategy. The main presenter was Richard Maraviglia, Portfolio Manager of Equity Long/Short. Mr. Maraviglia joined Carlson Capital in 2010 with nearly twenty years of investment experience. Before joining Carlson, he was a Portfolio Manager at SDF Capital, a New York-based family office for close to three years. Prior to that, he spent two years at SAC Capital as the Macro Strategist/Research Trader. Previously, Mr. Maraviglia was a Vice President in Institutional Equity at Morgan Stanley and head of Global Hedge Fund Sales at Prudential Securities. Mr. Maraviglia receives a B.A. 1st Class Honors Degree with Distinction in Economics and Modern languages from Leeds University.
Black Diamond Thematic’s strategy uses a very liquid, high velocity trading process. Black Diamond Thematic’s investment team currently consists of 7 professionals – Richard Maraviglia, Portfolio Manager; Matt Barkoff, Director of Research for Thematic team; 4 dedicated analysts; and a Trader in London and additional access to the Firm’s sector-focused equity traders. Their research indicates that on the macro level the hot part of the market has shifted from long Emerging Markets to long Domestic and short Emerging. The theme of Supply-Demand is one of the themes they study. When supply and demand increase/decrease together there is no opportunity. However, opportunity develops when supply and demand diverge. They utilize fundamental analysis to pick common stocks, long and short, to optimally express themes. Short positions are meant to be alpha generators – not just a hedge. They use actively trade positions within themes to exploit volatility. The disciplined risk management plan has Magnetar entering themes early to avoid crowded situations. By trading early in themes, they are offered the ability to take profits while selling to other market participants who discover/enter theme late. Since inception (November 1, 2011), the Thematic Fund has generated an attractive, absolute return profile:
· 20.44% annualized net returns.
· 1.16% Alpha (monthly) versus the S&P 500 TR Index
· 0.27 Beta and 0.25 Correlation to the S&P 500 TR Index
· 1.96 Sharpe Ratio and 84 percent profitable months.
The Investment Committee recommended a $50 million mandate to Carlson Capital’s Black Diamond Thematic strategy.**
The second Absolute Return presenter was Magnetar Capital for their Constellation IV Fund. Magnetar’s Fixed Income program is more conservative than the previous presenter but provides durable, double digit returns. They provide structured solutions to financial institutions by financing the trade of credit to meet capital regulatory requirements. Magnetar was founded in 2005 and is run by three managing partners: Alec Litowitz, Ross Laser and David Snyderman – all registered investment advisers. The firm is headquartered in Evanston, IL with satellite offices in New York, London, and Beijing. Their fixed income program covers mortgages, corporate credit, convertible bonds as well as structured solutions. Financial crisis has caused capital shortfall at money center banks. First, they had substantial write-offs in 2007-09. Then regulatory changes increased bank’s capital requirements. Banks found themselves billions short of required capital for their existing franchises. Capital shortfall impeded bank’s growth because available capital must be deployed to meet regulatory requirements first, but growing core businesses requirements demanded capital too. Magnetar has found solutions for this high demand for long-dated capital. Competing requirements of stability (new governmental requirements) and growth have caused the banks to search for new sources of long-dated capital. The supply of such capital is insufficient. Traditional capital providers are similarly constrained and other forms of Tier 1 capital are either too dilutive or expensive. Thus Magnetar is in position to provide the needed long-term capital thus reducing the regulatory capital requirement of the new business to the bank. The Investment Committee recommended the Board grant a mandate of up to $150 million to Magnetar Capital’s Constellation IV Fund.**
TRS’ Private Equity Consultant, TorreyCove Capital Partners, presentation included a Private Equity Portfolio Review and a Tactical Plan for 2014 and Beyond. Last year (2012) was a very active year with $1.1 billion in new fund commitments and $99.4 million in co-investments. Distributions totaled 22.8% of beginning-of-year fair market value. Contributed capital exceeded distributions by $72 million. TRS returns underperformed the benchmark (Russell 3000 + 300 bps) for the one, three, and ten-year periods. As TorreyCove explained, this reflected the fact that public equity performed well. Generally Private Equity underperforms during
up-markets and outperforms during down-markets. When the TRS portfolio performance was compared to the performance of the Thomas Reuters benchmark (the pooled returns of all US Private Equity Funds) the TRS portfolio outperformed the benchmark for all time periods.
TorreyCove reviewed the following categories of fundraising activities of Private Equity for the period 2006-present: Total Committed Capital NOT Called (Overhang); Leverage Activity by Type; Venture Market Activity; and Venture & Buyout-Backed IPOs. They reviewed TRS’ portfolio pacing toward the 12% allocation goal. TRS’ program is expected to become consistently cash flow positive in the near future based on projected investment levels. One comment of significance was “As US Economy recovers, and as US Interest Rates rise, they may negatively impact Europe and through Europe the rest of the world, thus slowing or stopping global growth.”
Next, TorreyCove reviewed 2013 program initiatives. In the 2013 tactical plan, TorreyCove recommended the development of a process to consider the purchase of funds in the secondary market. Additionally, TorreyCove recommended that TRS consider the sale of certain existing funds to optimize the portfolio and take advantage of the “seller’s market” in the secondary space. Subsequently, TRS has developed a process document for reviewing the purchase of secondary opportunities and the board recently approved three firms to help advise on the sale of funds currently in the portfolio. TRS staff and TorreyCove have each identified funds within the portfolio that could be considered good candidates for sale. Such funds are generally with legacy managers, have not generated a return over recent years which meets TRS’ target returns, and do not show promise of generating such returns in the future. TRS should consider delegation of certain investment decisions. TorreyCove recommended preliminary discussions about the investment approval process as it is possible that in the next several years the review of every fund by the board will become a bottleneck as the number of relationships in the portfolio grows. This is not an immediate concern as the board has capacity to review 18-24 funds per year, and the busiest year to date has included the review of 15 funds. TorreyCove also recommended continuing development of the global portfolio. During fiscal 2013, TRS deployed $255 million, or 28% of total capital committed, in investments focused outside of the US. This total is comprised of one fund commitment focused on Europe, one fund dedicated to Asia, and a co-investment in a Brazilian telecommunications business.
TorreyCove’s tactical initiatives for fiscal 2014 and beyond are as follows: TRS should continue Exploration of Secondary Market Purchases and Sales.
· As a structural advantage in purchasing fund interests on the secondary market, TRS is often provided with a right of first refusal when a limited partnership interest in a fund in which TRS is also invested comes up for sale. An active relationship with a private equity firm also allows TRS to gain knowledge of a fund’s value and path to liquidity, enabling an educated bid for a limited partnership interest.
· Also, TRS has a significant number of fund commitments which have slowed in their value creation and which are with managers who are no longer considered core relationships.
· A secondary sale would monetize a portion of this value and could be crafted to include all or just a portion of the legacy funds.
· The cash could be redeployed to higher yielding co-investments, diversification enhancing non-US funds, or other TRS needs.
· TRS recently approved three sell-side advisors and is currently reviewing its portfolio to identify those funds best suited for sale. TorreyCove believes this process should continue with the goal of consummating a transaction during the third quarter of 2013 to capture the opportunity presented by the current market environment.
TRS should continue development of its global portfolio.
· TRS continues to be underexposed to non-US funds, particularly those focused on European markets.
TRS should increase Small- and Mid-Market Buyout Exposures
· TRS should make additional commitments to small and lower middle market managers or pursue additional co-investments in this segment to enhance overall portfolio diversification and achieve a more balanced corporate finance portfolio.
· Private equity funds in the small and mid-market segments have an ability to drive growth more easily than large companies either through organic growth or acquisition, and while the organizational resources often do not match those of larger firms, market opportunities lead to equally attractive returns.
TRS Board should consider delegation of certain investment decisions.
· As the private equity portfolio continues to expand its relationships, the time needed for each manager to present to the Board and for the Board to vote on each investment may become a limiting factor in portfolio development.
· TorreyCove believes the Board currently has maximum capacity to review 24 investments per year if four funds are presented at each of the six board meetings. While there appears to be bandwidth presently – TorreyCove expects between 7 and 18 funds per year over the next two years - it is prudent to identify the possibility of such a bottle neck in future years and to be aware of potential option for alleviating such a problem should it occur.