ERS EMERGING MANAGER PROGRAM REPORT TO THE 82ND TEXAS LEGISLATURE

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1 ERS EMERGING MANAGER PROGRAM REPORT TO THE 82ND TEXAS LEGISLATURE May 2011 Employees Retirement System of Texas

2 2 ERS Emerging Manager Program

3 Table of Contents Background...1 ERS Assets and Advisors...1 Current Emerging Managers...2 Methods...3 Results...5 Fiscal Year 2012 Initiatives...6 Conclusion...6 Appendix A Managers of Emerging Managers Appendix B Emerging Manager Relationship Data Disaggregated By Gender...11 Appendix C Emerging Manager Relationship Data Disaggregated By Race...12 ERS Emerging Manager Program 3

Background Legislation passed by the 81st Legislature required the Employees Retirement System of Texas (ERS) to make a good faith effort to acquire financial services from emerging managers and

Emerging managers are defined in the statute as private professional investment managers with less than $2 billion in assets who provide consulting, investment advising, brokerage services, hedge

4 Background Legislation passed by the 81st Legislature required the Employees Retirement System of Texas (ERS) to make a good faith effort to acquire financial services from emerging managers and report on the methods and results to the 82nd Legislature. Emerging managers are defined in the statute as private professional investment managers with less than $2 billion in assets who provide consulting, investment advising, brokerage services, hedge fund management, private equity management, and real estate investment. This report includes an overview of the Emerging Manager Program and provides data on ERS relationships with emerging managers by race, gender, and fund size. During fiscal year 2010, ERS established an Emerging Manager Program to provide increased opportunities to qualified emerging managers. As of April 30, 2011, ERS has about 10% of its externally advised assets either committed to or advised by emerging managers and will continue to seek relationships with emerging managers that align with ERS investment program, policies, and fiduciary responsibilities. Figure 1: ERS Total Plan Assets as of April 30, 2011 ERS' Total Plan Assets $23.7 billion 77% Internally Managed 23% External Advisors Figure 2: ERS External Advisors as of April 30, 2011 ERS External Advisors by Asset Class $5.4 billion 5% 10% 79% 6% The ERS Emerging Manager Program focuses on identifying and developing emerging managers through the following approaches: In January 2010, ERS developed a dedicated website to encourage emerging managers to begin a direct dialogue with ERS. ERS hired four Managers of Emerging Managers to increase outreach to the emerging manager community. ERS staff regularly attends industry conferences to meet emerging managers. ERS investment plan consultant, Hewitt EnnisKnupp (HEK), assists in identifying emerging managers for consideration. Public Equity Fixed Income Private Equity Private Real Estate ERS Assets and Advisors ERS had total plan assets of $23.7 billion as of April 30, As shown in Figure 1, 77% of plan assets are managed internally and 23% are externally advised. The majority of the externally advised assets are within the public equity asset class as highlighted in Figure 2. Under Texas law and the Texas Constitution, ERS must maintain discretionary authority for all investment decisions. ERS utilizes external advisors to provide non-discretionary investment advice and guidance. ERS manages the majority of assets internally because it is cost-effective and prudent for the Trust. ERS Emerging Manager Program 1

5 Current Emerging Managers Of the $5.4 billion that is externally advised, $553 million (10%) has been invested or committed within the Emerging Manager Program. As shown in Figure 3, $378 million is advised by emerging managers (either directly or through portfolios implemented by Managers of Emerging Managers). ERS has committed an additional $175 million to private equity and private real estate by emerging managers. Figure 3: Emerging Manager Program as of April 30, 2011 The ERS investment program also has opportunities for emerging firms to provide brokerage services. ERS currently has four brokerage/investment research relationships with emerging managers. These firms are: Bley Investment Group, Inc. (Women Owned/Certified HUB) BOE Securities, Inc. (African-American Owned) Cabrera Capital Markets, LLC (Hispanic Owned) M. Ramsey King Securities, Inc. (Women Owned) Emerging Manager Program $553 million Fixed Income $256 million Public Equity $122 million Private Equity $50 million Private Real Estate $50 million International Private Equity $75 million 2 Fountain $256 million 1 Leading Edge* $58 million 1 Credit Suisse* $50 million 2 Morgan Creek* $50 million 2 Legato* $64 million 1 1 Invested 2 Committed * Manager of Emerging Managers A recent ERS success story of an emerging manager that has worked with ERS through its Emerging Manager Program is Herndon Capital Management that now works directly with ERS. Herndon, which is 45% minority-owned, began as an emerging manager through Leading Edge Investment Advisors and Legato Capital Management. As of February 2011, Herndon has graduated to a direct, established advisor relationship with ERS for a large cap value mandate. 2 ERS Emerging Manager Program

6 Methods ERS has initiated several approaches to identify and develop emerging managers. ERS External Advisor Website In January 2010, ERS developed a dedicated website 1 to encourage emerging managers to begin a direct dialogue with ERS. The ERS External Advisor Website details helpful information and has a portal for interested firms to register with ERS. To finalize the registration process, firms complete a short questionnaire (ERS External Advisor Questionnaire) with pertinent information about services and strategies. There are currently five unique forms on the website (Public Equity, Hedge Funds, Private Equity, Private Real Estate and Brokerage) and each is broken up into five different sections (Firm, Management, Strategy, Fees and Attachments) with about 20 questions. The last part of the questionnaire is related to the firm s status as an emerging manager. If the firm is a qualified emerging manager, it must report staff and ownership information by gender, race and ethnicity. The information submitted through the website is compiled in a database and directed to appropriate ERS staff or external Manager of Emerging Managers for follow up. Once registration is complete, the firm will receive automatic updates for relevant ERS bidding opportunities and communication. This website has enabled ERS to create a robust database that is a primary source for ERS searches for financial service providers. Enhancements to the site in 2010 allowed firms to submit marketing and performance materials electronically; expanded registration from a public equity-focus to include additional service providers for brokerage, hedge fund, private equity and private real estate firms; provided 24/7 access for firms to update firm/strategy information; and included features that help ERS monitor and search for firms through improved reporting functionality. ERS bidding opportunities are also posted on various existing state resources, including the Electronic State Business Daily (ESBD), also known as the Texas Marketplace, an online database for locating procurement opportunities posted by all state government entities. All bidding opportunities issued by ERS for external advisory services will be in the form of a Request for Qualification or Request for Proposal (RFQ/RFP) posted on the ESBD 2 and the ERS website. These bidding opportunities are open to the public and there is no invitation needed to participate. A simple registration by firms on the Centralized Masters Business List 3 or ERS External Advisor Website will ensure automatic notice of any bidding opportunities. Managers of Emerging Managers ERS hired four Managers of Emerging Managers to increase outreach to the emerging manager community. These managers have the resources, experience, relationships, and industry knowledge to identify and evaluate emerging managers for ERS. Historically, emerging managers have faced barriers in gaining access to significant assets under management because of limited track records, perceived operational and business risks, and small asset bases. Managers of Emerging Managers act as an intermediary and extension of ERS staff to discover and cultivate these emerging managers for the ERS Emerging Manager Program. Please see Appendix A for detailed information on each of the four Managers of Emerging Managers hired by ERS. These Managers of Emerging Managers are able to help firms overcome historical barriers by: Identifying and introducing ERS to emerging managers to increase ERS universe of viable firms, Constructing a portfolio of emerging managers using an array of evaluation and monitoring tools, Performing full qualitative and quantitative analyses on an ongoing basis to help ERS prudently monitor its investments with emerging managers, Focusing efforts on emerging managers that have not been hired by ERS to mentor and help them grow for future consideration, Encouraging graduation to a direct, established relationship with ERS, Initiating and sponsoring outreach activities to the emerging manager community, and Keeping abreast of developments within the emerging manager investment space. 1 See 2 See esbd.cpa.state.tx.us 3 See ERS Emerging Manager Program 3

7 ERS has made a deliberate decision to use multiple firms to manage the ERS Emerging Manager Program because of the benefits each firm s varied resources provide to ERS. In public equity, for example, Legato Capital Management and Leading Edge Investment Advisors each have their own online portals 4 to register and evaluate emerging manager firms. In the asset classes of private equity and private real estate, ERS has contracted with two separate firms to deploy commitments of $50 million each for an aggregate of $100 million to be invested with domestic emerging managers. Each fund is managed by a Manager of Emerging Managers with the experience and resources to attract the best emerging manager firms for each of these funds. Figure 4 shows emerging managers currently working with ERS to advise on public equities as of April 30, Figure 4: Emerging Manager Program Public Equity (MWBE Ownership Noted) as of April 30, 2011 Emerging Manager Program Public Equity $122 million Each of the Managers of Emerging Managers for private equity and private real estate may invest with five to 10 emerging managers. According to their respective investment mandates, these emerging managers will deploy capital to multiple underlying private companies or real estate properties. Typically funds like these would require five or more years to deploy the entire fund s commitment; however, ERS made a strategic decision to task each of the Managers of Emerging Managers in private equity and private real estate to invest all commitments within three years for a more timely implementation of the program. Leading Edge $58 million (Asian) Mar Vista (African American) Markston Herndon (African American) Nicholas (Women) Lombardia (Hispanic) Legato $64 million (African American) ClariVest Cornerstone Herndon (African American) Mar Vista (African American) Phocas Signia Stephens TWIN Industry Conferences ERS staff regularly attend industry conferences to meet emerging managers. ERS Managers of Emerging Managers attend and sponsor conferences to attract and mentor emerging managers. Industry conferences bring institutional investors and emerging managers together to discuss best practices. Examples of these conferences include Opal Financial Group Emerging Manager Summit; New America Alliance/NAA Pension Forum; Latino Deal Makers; Council for Urban Professionals; Marathon Club; Women s Private Equity Summit; Private Equity Women s Investor Network; Association of Asian American Investment Managers; and National Association of Securities Professionals. Credit Suisse Customized Fund Investment Group (CFIG), the ERS Private Equity Manager of Emerging Managers, is sponsoring the Credit Suisse Private Equity Small and Emerging Manager Conference scheduled in Charlotte, North Carolina for September In January 2012, ERS and Morgan Creek Capital Management, the ERS Private Real Estate Manager of Emerging Managers, are hosting the Inaugural Real Estate Emerging Managers Summit in Austin, Texas. 4 See Legato s online portal at and Leading Edge s online portal at 4 Consultant ERS plan consultant, Hewitt EnnisKnupp (HEK), uses several methods to develop relationships with emerging managers. In addition to the evestment Alliance database, HEK uses an internal Emerging Manager Research Team to identify Minority and Women Owned Business Enterprise (MWBE) firms as well as smaller firms. On average, HEK meets with nearly 100 emerging managers annually across all asset classes, public and private. ERS leverages the relationships made by HEK to expand the universe of emerging managers tracked and evaluated in the ERS External Advisor Database. ERS Emerging Manager Program

8 Results As of April 30, 2011, ERS has $378 million invested with emerging managers and commitments to invest an additional $175 million in private equity and private real estate for a total of $553 million allocated to the Emerging Manager Program. As of December 31, 2010, ERS had invested 7,760 hours and $211,900 on these approaches since the inception of the Emerging Manager Program in September The hours and dollars dedicated to the Emerging Manager Program by ERS staff include the time and money committed to the ERS External Advisor Website; the evaluation, selection, and contract negotiations of Managers of Emerging Managers; industry conferences; staff meetings with emerging managers and operational development of the program. A breakdown of the different financial service categories in which ERS actively works with emerging managers follows: Investment Advising ERS entered into a contract with Fountain Capital Management in 1999 for high yield fixed income advisory services. African-American private equity fund for a portfolio company with more than 200 employees based in Texas. CFIG opened an office in Austin, Texas to work with Texasbased emerging managers, as well as emerging managers nationwide. CFIG is sponsoring the Credit Suisse Private Equity Small and Emerging Manager Conference scheduled in Charlotte, North Carolina for September Additionally, ERS has created a separate fund in 2011 for emerging managers in international private equity with $75 million to be deployed over three years. Private Real Estate ERS hired a Manager of Emerging Managers for Private Real Estate Morgan Creek Capital Management (Morgan Creek). The contract was executed in December 2010 and funding for the $50 million commitment will be deployed over three years. In 2010, ERS hired two Managers of Emerging Managers for Public Equities Leading Edge Investment Advisors and Legato Capital Management at which time both firms met the criteria of an emerging manager and are minority-owned. Herndon Capital Management is an emerging manager through Leading Edge Investment Advisors and Legato Capital Management. Herndon has graduated to a direct, established advisor relationship with ERS for a large cap value mandate. The firm is 45% minority-owned. Brokerage Services/Investment Research Broker/Dealer commissions paid to emerging firms in 2010 were $46,163 and represent approximately 1.2% of domestic commissions generated. ERS has four brokerage/investment research relationships with emerging managers. These firms are Bley Investment Group, Inc. (Women Owned/Certified HUB); BOE Securities, Inc. (African-American Owned); Cabrera Capital Markets, LLC (Hispanic Owned); and M. Ramsey King Securities, Inc. (Women Owned). Private Equity ERS hired a Manager of Emerging Managers for Private Equity CFIG. The contract was executed in December 2010 and funding for the $50 million commitment will be deployed over three years. The first $1 million of the $50 million commitment managed by CFIG was invested in a co-investment opportunity with an Morgan Creek is in final negotiations to deploy the first $5 million of the $50 million commitment to a fund focused on real estate and real estate-related investments primarily in Texas. The fund is managed by an emerging manager that is 40% Hispanic-owned. In January 2012, ERS and Morgan Creek are hosting the Inaugural Real Estate Emerging Managers Summit in Austin, Texas. ERS External Advisor Website/Database 69 emerging managers have responded to the ERS External Advisor Questionnaire through the ERS External Advisor Website. Appendix B and Appendix C provide detailed data on the emerging manager relationships in the ERS External Advisor Database by gender and race for those firms that have responded. These data are based on staffing levels. ERS enhanced the questionnaire to capture both staffing and ownership data. The data are limited because the information has only been collected since early 2010 and some firms did not respond with this information. For comparison, data on gender and race for the ERS Investments Division has been included. ERS is currently unable to comprehensively report data due to limited responses by prospective financial service firms. ERS has modified the ERS External Advisor Questionnaire to encourage more comprehensive responses in the future and will monitor the process to determine best practices for obtaining the data. ERS Emerging Manager Program 5

9 Questionnaires for hedge funds, private equity, and private real estate were recently added to the ERS External Advisor Website and therefore the database is relatively small. ERS expects this to change as continued enhancements are made to the website. ERS is collecting data on hedge fund firms for future use since the hedge fund program has not been implemented. Fiscal Year 2012 Initiatives ERS goal is to gain diversification and investment opportunities across all asset classes through further development and expansion of the ERS Emerging Manager Program. To meet this goal, ERS has set the following initiatives for fiscal year 2012: Continue to develop and enhance the ERS External Advisor Website to encourage emerging managers to have a direct dialogue with ERS, Forward all relevant materials on emerging managers to appropriate ERS staff and to contracted Managers of Emerging Managers to increase outreach to the emerging manager community, Continue to incorporate emerging managers in all investment searches, Increase ERS visibility and participation at industry conferences to expand ERS network of emerging managers, Host the Inaugural Real Estate Emerging Managers Summit with Morgan Creek in Austin, Develop emerging manager relationships throughout the industry by sharing information with other public and private funds, and Partner with organizations that promote diversity in the investment industry. Conclusion ERS is committed to the continued expansion and growth of its Emerging Manager Program consistent with ERS investment program, policies, and fiduciary responsibilities. These early efforts have enabled ERS to create a foundation from which to attract a diverse group of financial service providers that includes qualified emerging managers. ERS continues to focus staff and other resources on expanding the program, and expects to meet the goals set forth by the Texas Legislature. Contact Information Ann S. Fuelberg Executive Director ann.fuelberg@ers.state.tx.us Jacqueline M. Johnson, CFA Deputy Executive Director of Investments jacqueline.johnson@ers.state.tx.us Tom Tull, CFA Director of Strategic Research tom.tull@ers.state.tx.us ERS Emerging Manager Program

10 Appendix A Managers of Emerging Managers As of April 30, 2011 Leading Edge Investment Advisors Asset Class Public Equity Contract Executed August 2010 Assets Managed for ERS $58 million Ownership Minority Owned/Asian Staffing 13 employees Female (5) and Male (8) African American (2), Asian (7), Hispanic/Latino (1), White (3) Number of Emerging Managers Tracked 1,776 firms 4,505 active products Meetings with Emerging Managers 227 (Since December 2010) Number of Emerging Managers Hired Has hired 5 emerging managers for the ERS portfolio to date: 2 are African-American owned 1 is Hispanic owned 1 is Women owned Strengths Leading Edge investment professionals pioneered the first fund of emerging managers in History of identifying exceptional managers in the earliest stages of their development, and funding many of those managers with first allocations. The firm is dedicated to working with emerging managers to reduce business, investment, operational and reputation risks. Outreach to Emerging Managers The firm conducts an annual symposium featuring investment industry experts that counsel managers on a variety of issues, including, but not limited to: business management and development, branding, SEC audits, back office technology, marketing and raising capital. Hosted or presented at 6 conferences (The Association of Asian American Investment Managers, Opal Financial Group, National Association of Securities Professionals, California Public Employees Retirement System, California State Teachers Retirement System). Attended an additional 3 conferences (Opal Financial Group, National Association of Securities Professionals, New America Alliance). Education Enrichment Activities for Emerging Managers (Myth or Reality The Asian Glass Ceiling and Taking the Leap to Start Your Own Fund). ERS Emerging Manager Program 7

11 Appendix A (continued) Managers of Emerging Managers As of April 30, 2011 Legato Capital Management Asset Class Public Equity Contract Executed August 2010 Assets Managed for ERS $64 million Ownership Minority Owned/African American Staffing 10 employees Female (4) and Male (6) African American (1), Asian (4), White (5) Number of Emerging Managers Tracked 1,227 firms 229 women or minority owned firms Meetings with Emerging Managers 390 (Since December 2010) Number of Emerging Managers Hired Has hired 8 emerging managers for the ERS portfolio to date: 2 are African-American owned Strengths Dedicated to identifying and assisting in the development and strengthening of emerging manager firms. Tracks movements of talented investment professionals who may start a new firm. Outreach to Emerging Managers At the end of 2010, investment managers that are majority owned by women and/or minorities represented over 40% of Legato s assets under management. Hosted or presented at three conferences (SJCERA Annual Round Table, National Association of Securities Professionals, Critical Value Advisors). Attended an additional 10 conferences (Commonfund, Council of Institutional Investors, Institutional Investor, California Public Utilities commission/joint Hearing of the Senate on Diversity, State Association of County Retirement Systems, MWBE Investment Symposium). 8 ERS Emerging Manager Program

12 Appendix A (continued) Managers of Emerging Managers As of April 30, 2011 Credit Suisse Customized Fund Investment Group Asset Class Private Equity Contract Executed December 2010 Assets Managed for ERS $50 million investment over three years Number of Emerging Managers Tracked 1,400 funds 209 firms in its Minority Manager Universe : African American (55), Asian (15), Hispanic (26), Female (65) Number of Emerging Managers Hired Has made one co-investment on ERS behalf: The co-investor is an African-American manager. The underlying company is a Texas-based business with 243 employees in Texas. Strengths The Credit Suisse Customized Fund Investment Group (CFIG) is a chief organizer/participant with prominent organization focused on the women and minority investing space. CFIG professionals organize, sponsor and support women and minority focused organizations and frequently participate as speakers and panelists at key events. Considered one of the first stops for emerging managers attempting to raise a fund. The group has an open door policy and is known to provide advice, guidance and mentorship to first time fund managers and those inexperienced in raising private equity funds. Because of CFIG s leadership role in the emerging manager space, the group and its professionals continue to receive recognitions and awards for their exceptional service and commitment to developing opportunities for women and minority talent. The founder of CFIG, Kelly Williams, is one of the most recognized names in emerging manager investing and is a leader in the community. Outreach to Emerging Managers CFIG has opened an office in Austin to interface locally with Texas-based emerging managers as well as emerging managers nationwide. Credit Suisse Small & Emerging Private Equity Manager Conference is one of the principal conferences to provide emerging firms with valuable exposure to large limited partnerships. Plan Sponsor and Emerging Manager Conference is an annual gathering that focuses on discovering new talent and investing within the emerging manager arena. New America Alliance (NAA) is an organization of American Latino business leaders committed to leading the process of Latino empowerment and wealth building. CFIG has served as a Gold Sponsor of the NAA Pension Forum and several CFIG staff members have contributed to the annual event by planning and/or speaking. Other organizations and events include: Council of Urban Professionals, The Toigo Foundation, Sponsor for Educational Opportunity, Women s Private Equity Summit, Harvard Business School Latino Alumni Association, Private Equity Women s Investor Network, Hispanic Scholarship Fund, Marathon Club, National Association of Investment Companies, Latino Deal Makers, Association of Asian American Investment Managers, Executive Leadership Council, National Association of Securities Professionals. ERS Emerging Manager Program 9

13 Appendix A (continued) Managers of Emerging Managers As of April 30, 2011 Morgan Creek Capital Management Asset Class Private Real Estate Contract Executed December 2010 Assets Managed for ERS $50 million investment over three years Number of Emerging Managers Tracked 668 funds 59 women or minority owned funds: African American (24), Asian (5), Hispanic (14), Female (14), Other (2) 49 women or minority owned firms: African American (17), Asian (5), Hispanic (8), Female (17), Other (2) Meetings with Emerging Managers 107 Number of Emerging Managers Hired Has not made any investments on ERS behalf: There are currently 17 funds in the pipeline for review. Due diligence has begun on a fund that is Texas-based and 40% Hispanic-owned. Strengths The firm has supported several MWBE funds since inception. Specifically, Morgan Creek has supported five emerging managers that were minority or women-owned businesses in fundraising and has one additional MWBE fund that is pending final funding. Outreach to Emerging Managers One of the directors, Larissa Herczeg, has been focused on the MWBE space for the past two years and has developed one of the more comprehensive MWBE pipelines in the real estate asset class. She tracks a universe of MWBE funds and, prior to joining Morgan Creek, held meetings with in excess of 35 MWBE real estate managers. In addition, she has been a leader in the MWBE real estate space, co-founding Women in Real Estate. Participates in conferences focused on emerging managers and in organizations such as Real Estate Executive Council and New America Alliance. In January 2012, ERS and Morgan Creek Capital Management, the ERS Private Real Estate Manager of Emerging Managers, are hosting the Inaugural Real Estate Emerging Managers Summit in Austin. 10 ERS Emerging Manager Program

14 Appendix B ERS External Advisor Database Emerging Manager Relationship Data Disaggregated By Gender (Staffing Only) Percentage of Employees Male Female Brokerage Services - ERS Established Relationships (Emerging Managers) Public Equity - ERS External Advisor Database (Emerging Managers) Hedge Funds - ERS External Advisor Database (Emerging Managers) 71% 29% 58% 42% 70% 30% ERS Investments Division Staff 68% 32% ERS Emerging Manager Program 11

15 Appendix C ERS External Advisor Database Emerging Manager Relationship Data Disaggregated By Race (Staffing Only) White Asian Black or African American Percentage of Employees Hispanic or Latino Native American Native Hawaiian or Other Pacific Islander Other Brokerage Services - ERS Established Relationships (Emerging Managers) Public Equity - ERS External Advisor Database (Emerging Managers) Hedge Funds - ERS External Advisor Database (Emerging Managers) 53% 4% 14% 28% 1% 0% 0% 80% 8% 6% 6% 0% 0% 0% 87% 5% 0% 3% 2% 1% 3% ERS Investments Division Staff 79% 14% 2% 5% 0% 0% 0% 12 ERS Emerging Manager Program

Policemen s Annuity and Benefit Fund of Chicago

Policemen s Annuity and Benefit Fund of Chicago Minority and Female Investment Hearing Questionnaire Senate Pensions & Investments Committee 1. What is the percentage of minority and women representation on the Board of Trustees of your fund ( the Fund