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Pension fund opens coffers: $506M could be boon for venture capitalists

August 22, 2005

The Public Employees' Retirement Fund, Indiana's largest pension system, is preparing to unleash half a billion dollars into venture capital, real estate and other privateequity investments. And the fund's managers aim to put the bulk of it to work inside state lines.

Hoosier venture capitalists are salivating at the prospect. T h a t 's t h e equivalent of nearly seven BioCrossroads Indiana Future Funds.

"If there are excellent opportunities to invest in Indiana, we ought to be looking harder at doing it," said Chuck Schalliol, director of the Indiana Office of Management and Budget.

"Here's a way we can take dollars, many of which came from taxpayers to begin with, and use them in a prudent way to create Hoosier j o b s . Wow, what a win."

Since taking office in January, Gov. Mitch Daniels, a Republican, has appointed a new leader for the $12 billion fund. He's also overhauled PERF's board of directors.

The top item on the board's investment agenda is to diversify $506 million into private equity, which includes a range of investments, such as venture capital and leveraged buyout funds.

Entrepreneurial leaders applaud the plan, saying Indiana venture firms that land state money will be able to leverage it to attract millions of additional dollars from out of state, boosting the funds available to fuel promising young Hoosier companies. They say it also will raise the profile of Indiana as a good place to invest.

"It sends a signal to venture capitalists around the country that Indiana is serious about this process," said Indiana Venture Center President Steve Beck. "I think it changes the whole perspective on the marketplace in Indiana."

Those involved in the effort say the foremost duty of the PERF board will continue to be achieving high financial returns while shielding the fund from undue risk. And they note that PERF already occasionally invested in local private equity-most notably in Indiana Future Fund.

The difference is the new management believes it's possible to regularly make gains for pensioners while simultaneously achieving economic development for the state.

But the path is mined with potential danger, warned Bill Styring, an independent economic consultant with locally based Styring & Associates. No matter how good their intentions, PERF's managers will face pressure to lean toward Indiana investments inferior to others available on the market, he said.

And they won't be in office forever.

"There's an old aphorism in economics: You make yourself no better off and possibly worse off by limiting your opportunity set," Styring said. "Before we take the plunge, we ought to step back and consider the downside, too."

Pension performance

Hoosier public pensions, including PERF and the Indiana State Teachers' Retirement Fund, have spent the last decade diversifying their assets. For more than a century, they had been constitutionally barred from chancy investments, including stocks. The ban dated back to Indiana's earliest days, when a failed bet on the Wabash and Erie Canal nearly bankrupted the state.

While the restriction reduced risk, it also limited the upside. For most of the pension's history, member contributions into low-risk bonds provided steady-butlackluster gains.

Once the law changed in 1996, PERF began shifting assets into stocks, and the payoff has been enormous. At the start of the diversification in mid-1998, PERF held assets worth $8.3 billion. Since then, its holdings have grown almost 50 percent, to $12.4 billion.

Today, the pension's portfolio still includes a large number of bonds and other fixed-income investments. But it also includes stocks of every size and stripe, from small-caps to international equities. Carefully screened top-tier investment firms from around the world manage the money for PERF in each class.

And if their performance falls short, PERF isn't afraid to fire them. Board minutes show PERF spent much of the first half of 2005 breaking off ties to Baltimore-based mid-cap manager Brown Capital Management after it concluded its returns were subpar.

In recent years, PERF began inching its way into private equity, the investment class with both the highest risks and highest potential returns. Though it aimed to put 5 percent of its assets into that class, so far it's committed only $116 million. To reach 5 percent, it must invest another $506 million.

Some of the $116 million already has had a huge local impact. PERF agreed to put up to $20 million into BioCrossroads' Indiana Future Fund, a commitment that helped attract additional dollars from institutional investors. PERF ended up providing 20 percent of the $73 million total, or $14.5 million.

To date, PERF has made just four other private equity investments. Only one recipient, locally based real estate financier House Investments, is in Indiana. House received an $11.5 million commitment.

PERF invested $10 million in Arch Venture Partners and $30 million in Merit Mezzanine, both in Chicago. Another $50 million went to Lindsay Goldberg & Bessemer LP, headquartered in New York.

Before he took charge of the state Office of Management and Budget, Schalliol oversaw Eli Lilly and Co.'s venture capital arm. He also was an architect of the Indiana Future Fund, and served a stint as BioCrossroads' CEO. Under Daniels, PERF now reports to OMB.

"We can do a much better job of investing some of our Indiana people's money into Indiana and still do prudent things," Schalliol said. "We've not done a good job with either pension fund doing that in the past."

New management

In recent years, most of the attention PERF received was unflattering. A series of stories in The Indianapolis Star, for instance, revealed personnel problems that allowed a convicted identity thief to gain access to pensioners' information. The scandal dogged Gov. Joe Kernan, a Democrat, in last year's election.

To patch up PERF's problems, Daniels hired David Adams, 44, a former IT consultant who also built two companies of his own. One sold cars over eBay. The other managed residential real estate. As PERF's executive director, Adams has launched initiatives aimed at improving customer service and internal controls.

Adams' investment philosophy matches Schalliol's. Returns are the primary obligation. But finding them in Indiana is a close second. To help finish PERF's diversification into private equity, Adams plans to hire an internal director of alternative investments and as many as half a dozen consulting firms.

By devoting more resources to scouring the Indiana market, Adams said, PERF will be able to fairly compare local prospects against those elsewhere. He notes that Indiana's neighboring states already use some of their pension dollars this way.

"It's something the fund is going to get more aggressive about getting into than in the past," Adams said. "But this is something you need to do your due diligence on and take a very strategic approach to."

In June, Daniels replaced all but one of PERF's board members. Its new directors are Ken Cochran, president of Fishers and Noblesville sewer company Hamilton Southeastern Utilities Inc.; Kathy Ettensohn, a CPA and vice president of Evansville-based Harding Shymanski & Co.; and Matthew Murphy III, director of finance and administration for locally based Mays Chemical Co.

City Securities Corp. Senior Vice President Robert Welch is the sole holdover on the board. Schalliol also holds a seat. The last slot remains open.

Newcomer Cochran said he's confident PERF can do a better job investing funds in Indiana than it did in the past.

"The general idea is to try and make wise and fiducially proper investments in Indiana entities. It sounds like a great idea to me, if we can get it done eventually," he said. "The No. 1 goal of the commission is still going to be to safeguard the members' funds. So we're going to have to be very careful how we do it."

Teachers' turnover

Management at the Teachers' Retirement Fund also is in flux. Robert Newland, TRF's longtime chief investment officer, has served as interim executive director since William Christopher retired in April. In June, Daniels appointed an entirely new TRF board, Newland said.

"Usually, the new administration works them in slowly as their terms come to completion," Newland said. "I've been here 22 years, and this is the first time I've seen a change in one fell swoop."

As it diversified into stocks, TRF also has done well. In mid-1998, its assets totaled $4.2 billion. Today, they're worth $7.1 billion.

Unless the new directors choose to increase TRF's 5-percent goal for privateequity investments, the fund already has maxed out its investments in the area. Because individual teachers decide how to allocate some of the money, TRF actively manages just $4 billion, and it's already committed $210 million to private equity.

Of that, just $7 million went to local private equity managers: $5 million to the Indiana Future Fund; and $1 million each to Centerfield Capital Partners and Hammond Kennedy Whitney & Co.

But in a few years, TRF's previous private equity investments will ripen and be sold. At that point, the fund will have to reinvest its profits. And if TRF continues to perform well in the overall market, a 5-percent slice of its assets will represent millions more than it does today.

Private equity potential

Venture capital is just one type of private equity. But local venture capitalists, who've long pressed for a chance to raise public pension money, hope to see a substantial portion of PERF's $506 million flow into their field.

"There needs to be a market test associated with the deployment of public pension funds," Centerfield Managing Direc- tor Tom Hiatt said. "[But] as long as the funds are allocated carefully and judiciously, they will have a tremendous effect on the state."

Perhaps just as important as PERF's money is the credibility it lends to the private equity firms receiving it. In the past, when Indiana-based venture capitalists went on the prowl for investors in other states, they always faced the same elephant-in-the-room question: If you're so worthy, why won't the largest institutions in your own back yard take a chance?

"A base of support within your own community is expected. It's a lot easier to talk to people if your own local investors have shown confidence in you," said John Aplin, managing general partner of CID Equity Partners, the state's largest venture capital firm. "It provides credibility as well as some reciprocity."

In other states, each pension dollar historically attracts four to five more from other institutional investors, said Indiana Venture Center's Beck.

By that math, Beck said, if half of PERF's private-equity money remains in state, it could leverage $1 billion. And he said that in states like California or Minnesota, where this sort of investing has been done for years, the returns have been "very, very good."

Institutional risk

But Styring, the independent economic consultant, has reservations. He noted that Hoosiers in the 1830s were convinced building canals was the best way to further economic development, only to see the arrival of railroads revolutionize transportation in America.

He said plenty of other seemingly surefire investments in the years since have proved similarly wrong-headed. If a venture capitalist in 1999 had invested PERF's dollars into a promising but unproven local IT firm, Styring said, chances are that money would now be gone.

"I'm a stick-in-the-mud when it comes to this," he said.

Styring calls himself a supporter of Daniels. But he noted that someday the governor and his associates will leave office. They may promise to withstand the pressure to unfairly favor local prospects. But can they be certain their successors won't one day use public pension money to underwrite an economic development boondoggle?

"Once you get away from a perfect fiduciary duty, a whole lot of things will come into play, no matter how good the people are," Styring said. "I will probably watch this and the IBJ will watch it for the next couple of years. But there will be a time when nobody will be watching it. That's when we have another Wabash and Erie Canal."
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