CalSTRS’ Ailman: Owning real estate managers has ‘real cost savings’

For California State Teachers’ Retirement System, reducing investment costs will be a key component in its ability to achieve its 7 percent long-term return target, says Christopher Ailman, chief investment officer of the $246 billion US pension fund.

On the public side, the pension fund could cut costs by managing more assets internally, he said. The greater potential cost savings, however, is in CalSTRS’ real estate, private equity and infrastructure portfolio, where Ailman said costs could approach $2 billion a year in 10 years if it continues to be primarily managed by external managers, with limited co-investments and direct stakes in operating companies.

“Our goal is to bend that curve,” he said during a board meeting held last week.

In Ailman’s view, if CalSTRS can take the same investments and reduce costs by 20-50 basis points, that will end up generating one-fifth to one-half of a percent of added return.

Carried interest and performance fees are the biggest source of costs for the pension giant. Other cost drivers include employee and travel-related costs and service contracts awarded to traditional asset managers for global equity and fixed-income investments.

“The real cost savings – it is almost an 8:1 or 10:1 cost ratio – is by owning asset managers as we do in real estate, by doing a lot more in co-investments and better fee structures in private equity, and being more creative by moving away from separate accounts and [instead] owning asset managers in infrastructure,” Ailman said.

In real estate for example, CalSTRS owns stakes in three to four operating companies, with the remaining investments made via external managers. According to Ailman, having direct ownership in operating companies helps in generating additional revenue.

“We own the company; they then get hired by other public pension plans, and we are able to capture that as revenue. We get from fee to flat to a revenue standpoint. And by year five to eight, that cost curve really starts to break because we start to see revenue.”

Owning more asset managers is one of the strategies under CalSTRS’ collaborative model. Others include doing more co-investments and increasing its overall investment capabilities.

Successfully reducing costs, however, would require addressing two challenges, as Ailman highlighted, especially given the current remote working environment. One pertains to succession planning in real estate and the second is how CalSTRS can successfully hire and build talent, including its co-investment team in private equity.

Over the past few years, CalSTRS has shifted its real estate portfolio towards controlled investments wherein there is some degree of direct control over investment decision-making. As of Q3 2018 – the most recent performance data available – 79 percent of its real estate portfolio represented controlled investments, including co-investments, up from 46 percent in 2010. Its total real estate net asset value stood at $30.4 billion, of which around 63 percent comprised direct investments in separate accounts and joint ventures. The remaining 37 percent was allocated to funds and other investment vehicles.

Public pension plans across the globe are experimenting with different ways to meet their long-term portfolio return figures after the covid-19 outbreak brought investment activity to a halt and real estate valuations were hit. CalPERS, for example, has chosen to leverage its portfolio to meet the 7 percent return rate. As PERE’s sister publication Private Equity International reported recently, CalPERS intends to leverage 20 percent of the current fund or close to $80 billion over the next three years to achieve the “7 Percent Solution.”