Memo To: The Board of Trustees SDCERA Cc: From: Brian White, CIO Satya Kumar, CFA Steve Voss Date: April 19, 2011 Re: Salient Partners Due Diligence Overview In November 2010, Integrity Capital, LLC (Integrity), which serves as SDCERA s Portfolio Strategist, was acquired by Salient Partners, LLC (Salient), a Houston-based investment management firm. As part of the acquisition, Integrity s founder, Lee Partridge, was named the CIO of Salient Partners. The SDCERA Board requested Hewitt EnnisKnupp conduct a due diligence meeting with Salient to better assess Salient s capabilities and identify and evaluate areas where SDCERA can better leverage Salient s resources 1. As part of the work that is currently underway relating to the structure of SDCERA s investment organization, consideration is being given to have Salient be responsible for selection, monitoring and oversight of all investments across the publicly-traded asset classes within SDCERA s portfolio. This would include traditional stock and bond strategies as well as hedge fund investments, which, combined represent 77% of SDCERA s total allocation as per the approved strategic asset allocation. In turn, SDCERA s internal investment department would be responsible for all private market investments (such as real estate, private equity, infrastructure, and natural resources). 1 We note that Integrity Capital may already be permitted under its existing contract with SDCERA to use Salient, and/or third-parties, to perform some or all of the functions discussed in this memorandum. We defer to SDCERA s counsel on that issue. We do not intend to suggest in this memorandum that additional Board action is required to authorize Integrity s use of Salient with respect to any specific function. Hewitt EnnisKnupp, Inc. 10 South Riverside Plaza, Suite 1600 Chicago, Il 60606 t 312.715.1700 f 312.715.1952 www.hewittennisknupp.com
Page 2 With the recent addition of Mr. Partridge as CIO and the institutional framework and processes that he brings to the firm, coupled with Salient s existing resources, we view Salient as capably suited to serve SDCERA with the management of its portfolio. We are also supportive of the changes that Mr. Partridge has initiated since his arrival at Salient. Given the changes that are underway as the firm enhances it due diligence processes and procedures and moves towards a more technology-based platform, it is important to pay close attention to the stability of key resources and ensure that changes being implemented take full effect. Under a separate document titled Structure of Investment Organization, which will be presented and discussed at the Board meeting on April 21, 2011, we have provided a detailed outline on a proposed structure for SDCERA s investment organization. The structure follows from discussions with the Board at its retreat in March 2011 and addresses the roles and responsibilities of various parties responsible for the management and oversight of SDCERA s portfolio. Overall, we believe that Salient, under Mr. Partridge s leadership, and in conjunction with the internal and external resources as identified, is capable of performing its role as outlined in that presentation. Specifically, this includes: Overseeing SDCERA s tactical asset allocation and directing the organization s futures trading agent with respect to tactical targets and rebalancing programs, within the constraints set forth in the Statement of Investment Policy (IPS) Recommending hedge funds, separate account managers and other commingled funds that require Board approvals as per the IPS Selecting all investment vehicles that are permitted under the IPS, including, but not limited to, commingled fund investments that offer at least monthly liquidity and are specifically permitted under SDCERA s IPS. Organizational Overview Salient Partners, which is based in Houston, was founded as a family office-focused investment management firm in late-2002 by Andrew Linbeck, Jeremy Radcliffe, and Haag Shearman. In 2003, Salient merged with Pinnacle Management and Trust Company. In January 2010, Salient concluded a capitalization transaction through the sale of 38% of its ownership to Summit Partners, a Bostonbased private equity firm. The remaining ownership is distributed among Salient s professionals.
Page 3 In addition to the November 2010 acquisition of Integrity Capital, in 2011, Salient acquired RDG Capital, LLC (RDG) a Houston-based MLP manager. As part of this acquisition, all investment professionals at RDG joined Salient and RDG offers its MLP product under the Salient umbrella the Salient MLP Fund. Salient has over 100 employees and is led by its four co-founders: John Blaisdell, Andrew Linbeck, Haag Sherman, and Jeremy Radcliffe, in addition to Lee Partridge, who serves as the CIO. Given recent acquisitions and a reorganization of its talent, Haag Sherman, who served as CIO prior to Mr. Partridge s arrival has taken over as the CEO, replacing Mr. Blaisdell in this capacity. Mr. Blaisdell continues to serve on the firm s Investment Committee. Salient indicates that it currently has $18.0 billion in assets under advisement and management and its client base is divided as follows: Institutions: $9.0 billion (of which SDCERA represents 85%) Individuals and families (high net worth): $3.5 billion Financial Intermediaries: $5.6 billion Currently, nearly 90% of Salient s overall revenues are derived from its private/high net worth client base. While the SDCERA relationship accounts for a significant portion of Salient s assets (under advisement), it represents less than 1% of Salient s overall revenues. In addition to advisory services provided to both individual and institutional investors, Salient offers a suite of investment products managed both internally and in partnership/joint venture with external entities. The table on the following page lists the firm s investment offerings managed both internally and in joint venture with external entities. Excluding assets relating to SDCERA (~$7.7 bn) and assets managed in joint venture with external entities, Salient oversees approximately $4.0 bn in assets, representing both advisory and investment management relationship (including products that it manages). Salient s management appear to have a reasonable amount of their personal wealth invested in products that they offer.
Page 4 Product AUM ($) Description The Endowment Fund $5.6 billion Joint venture relationship with Morgan Creek Capital Managed by Mark Yusko, the CIO of Morgan Creek with Mssrs. Blaisdell, Linbeck, and Sherman serving on the Investment Committee Fund-of-funds vehicle with an endowment portfolio orientation; provides access to a diversified portfolio across major asset classes, with a bias towards alternative investments Salient conducts operational due diligence on investments and administers the fund MLPs (The Salient MLP $250 million Internally managed active MLP product Fund) Managed by Greg Reed and Ted Gardner formerly with RDG Capital, which was acquired by Salient in 2011 SRI Multi-Strategy Hedge $400 million Joint venture with the Sid Bass organization Fund Salient manages a parallel portfolio to that run by the Sid Bass organization, with Salient implementing the social screening / restrictions Salient Absolute Return $120 million Internally managed fund of funds Fund Product launched in 2009 REITS $75 million Internally managed active REIT portfolio Timber $350 million Joint venture relationship with the Molpus Woodlands Group representing two-closed end funds that are closed to new investments Large Cap Stocks $300 million Internally managed active large cap stock strategy There are plans afoot on a number of fronts with regard to product and distribution expansion, including getting the Absolute Return Fund onto the Morgan Stanley High Net Worth platform and considering a public offering of a closed-end MLP offering in late-2011.
Page 5 Salient currently derives a significant portion of its revenues from its high net worth client base. With the arrival of Mr. Partrdige, Salient is making a concerted push to institutionalize its capabilities and offerings. There are several changes afoot, including the addition of several new members to the investment team and the acquisition of two firms (Integrity and RDG Capital). While significant, these represent positive changes / additions as the firm focuses on building out their capabilities along more institutional lines. Product creation and distribution remain high on Salient s priorities. In light of the substantial changes underway, we would not view product creation and distribution as a high priority at this time. People Salient has over 100 members on its team, which includes investment professionals, operations, client services and support staff. There has been a good deal of change in the roles and responsibilities of key professionals within the organization over the past year, in addition to several new hires on the investment team over the past year. Mr. Partridge replaced Mr. Sherman as CIO. Mr. Sherman replaced Mr. Blaisdell as CEO (Mr. Blaisdell remains at the firm). With the acquisition of RDG Capital, LLC, Salient added four investment professionals and one trader to the investment team. Paul Bachtold, who serves as Chief Compliance Office, joined Salient from the legacy Barclays Global Investors (BGI) organization less than a year ago. Bill Enszer joined the organization within the last year, replacing Jeremy Radcliffe as the portfolio manager for the Salient Absolute Return Fund. Mr. Radcliffe now serves as Salient s Chief Investment Strategist. One of Salient s goals is to develop a more institutional focus. Along these lines, Mr. Partridge would like professionals to have a specialized focus as opposed to being generalists. We anticipate potential changes in the roles and responsibilities of the professionals as the new CIO settles into his new role and completes an assessment of needs, available talent, and determines how best to utilize resources. We were reasonably impressed with the quality of individuals across Salient. How the team integrates and evolves remains to be seen in light of potential changes that the new CIO may make, as well as how the investment professionals relate to and engage with the new CIO and his approach.
Page 6 Investment Philosophy: Asset Allocation, Portfolio Construction, and Risk Management The overall investment philosophy is largely driven by the CIO, Lee Partridge, who brings strong and clear beliefs that have been honed over the years in previous roles. The overall thematic approach today is broadly similar to what had been in place at Salient historically, with the new CIO introducing a significantly greater quantitative rigor to the process across asset allocation, portfolio construction and risk management. Salient s top-down investment approach focuses across three broad areas: Low cost implementation: Passive, replication of exposures for market return/beta or for exposures where skill is not a driver of return Quantitative research: Quantitative orientation to the portfolio construction, monitoring, and risk management with an emphasis on factor analysis Skill identification: Sourcing, due diligence, and ongoing monitoring of skill-based (alpha generating) strategies Salient argues that a few factors determine much of capital market and investor portfolio returns: economic growth, price inflation, and volatility. Based on these drivers of return, they define three investment regimes: Growth Oriented, Stable Value and Real Return. The chart below, which reflects the investment strategy for the Salient Absolute Return Fund, best illustrates this categorization. (Source: Salient)
Page 7 Salient makes the now-common observation that the majority of institutional portfolios are dominated by equity risk. Modest amounts of diversification into less-correlated alternative asset categories have little impact on this aspect of a portfolio s risk profile. Consequently, most portfolios will outperform in the Global Equity regime and underperform in the other two. A more effectively diversified portfolio will consist of three buckets, corresponding to the three investment regimes. The approach is similar to that espoused by risk-parity strategies, with some differences: the overall risk budget is tied more closely to the natural volatility of the underlying asset classes, less emphasis is placed on diversifying away from equity/growth risk, and illiquid investments and hedge fund betas are more fully integrated. An interesting feature of the philosophy is the development of a matrix in which portfolios are identified across both regime orientation (Growth-Oriented, Stable Value, Real Return) and implementation style (Passive, Active, Private). Notably, this results in certain types of investments (such as, private equity and real estate) classified as implementation styles rather than as separate asset classes. Diversification is achieved by allocating across regimes; the purpose of the implementation decision is capture of active management and liquidity premiums; allocation across implementation styles is not viewed as diversifying. Obtaining beta exposures efficiently (as opposed to diversifying through expensive active management) is a key element of the process. At the same time, some systematic risk premiums (betas) are best accessed through hedge funds, which combine systematic and unsystematic (active) risks. Close attention is paid to identifying normal and stressed markets; correlations are expected to vary materially in stressed markets, and certain asset categories are viewed as protection against tail risk. Overall, the investment process has a highly quantitative focus. Risk management is inherent in the overall asset allocation and portfolio management process. Salient s overall risk management approach follows a quantitative discipline. Most of Salient s exposure within active, publicly traded securities represent hedge fund strategies, which may not be fully transparent and/or for which real time holdings information may not be available. Salient relies on extensive regression-based factor modeling to measure and manage risk on a real time basis (monthly or quarterly). While Salient currently has a suite of internally-developed risk management tools, Mr. Partridge is looking to develop capabilities further based on experience gained and along the lines of capabilities developed in prior positions. In this regard, Salient has identified an individual who is currently completing a Doctorate degree in Economics to join the team in June 2011 to focus on this effort.
Page 8 This individual is currently serving in a consultant capacity until he joins Salient full time in June. Mr. Partridge has indicated that until Salient s internal capabilities are further enhanced, specifically as it relates to SDCERA, he will also rely on risk reporting both from Albourne and Hewitt EnnisKnupp to supplement existing internal capabilities. In summary, Salient s asset allocation approach is well thought out and consistent with views emerging in much of the investment community regarding diversification across economic regimes. The concept of a spectrum of implementation styles being more important than asset class identity within the three portfolios is an interesting one. Salient has the necessary components and a suitable approach to portfolio asset allocation and portfolio construction. With respect to risk management, Salient has access to sound analytics to evaluate and monitor portfolio risk. The CIO exhibits a deep understanding on risk management and integration of risk management into the portfolio construction and management process. External Manager Selection and Monitoring The processes in place to identify, select, and monitor external investment managers on an ongoing basis are very similar to those employed by an institutional investment consultant or a fund-of-fund. The process that results in a manager being approved for use typically begins with quantitative analysis on the manager s performance followed by more detailed due diligence and screening on the managers, including an operational due diligence, contacts with third-parties and vendors. Shortlisted managers are brought forward first to the Valuation Committee and subsequently to the Investment Committee for approval. The Valuation Committee focuses on aspects of valuation, accounting, and transparency, while the Investment Committee focuses on the investment opportunity as a whole, including the thesis, suitability of strategy, and the strategy s fit within stated goals. There is a fairly significant quantitative discipline in evaluating and assessing managers. The manager research function is handled by analysts and portfolio managers within Salient. There are five professionals that focus on external manager research. These individuals report to Mr. Radcliffe, Salient s Chief Investment Strategist. The process for monitoring external managers is still evolving as evidenced by the recent separation of the investment due diligence and operational due diligence (ODD) responsibilities. In the past, members of the investment team covered both the investment and operational aspects of external manager due diligence. The separation of functions is in keeping with Mr. Partridge s desire to have professionals focus on a specialization. As a result, two professionals who currently serve on the investment team and focus their attention on both investment and operational due diligence will now focus exclusively on operational due diligence, reporting to Philip Mason.
Page 9 Salient does not yet have fully built out capabilities across the private market asset class spectrum such as real estate, private equity, natural resource and infrastructure. This is not a concern as it relates to SDCERA.Under the proposed structure for SDCERA s investment organization that is under consideration, the retention and monitoring of private market investment will remain with SDCERA s internal Investment Team. Further given that Salient seeks to invest a majority of marketable asset classes passively, the emphasis of the manager research function is on seeking managers across skill-based strategy spectrum (or in other words, hedge funds). Salient has historically focused their efforts on the smaller, more niche hedge funds/managers, but have also had access to and invested in marquee, blue chip hedge funds. Under Mr. Partridge s leadership, Salient is developing a more quantitatively-oriented discipline to evaluate and assess external investment management firms. Salient utilizes both industry-standard, external and internally-developed, proprietary tools to support its ongoing due diligence efforts. For instance, with respect to analytics, they currently use an industry-standard application, PerTrac, which they have customized using excel to support their analytical needs. Additionally, they have developed an internal database-oriented tool to document and access due diligence on any of their investment managers. The tool has all the necessary functionality to support their due diligence efforts, but is currently in the process of being populated. The frequency of monitoring external managers varies from quarterly to semi-annually depending on exposure to a given manager managers to whom Salient has significant exposure are classified as high touch and contact is made at least quarterly. The remaining managers, classified as low touch are contacted at least semi-annually. Onsite meetings once the initial investment has been made are determined using a risk-based approach. Salient s manager research professionals are involved across a very broad range of asset classes and a variety of implementation choices. Salient does not have a fully built out private market capability. This is not a concern specifically as it relates to SDCERA. Based on the proposed structure of the investment organization that is currently under consideration, SDCERA s internal Investment Team will be fully responsible for the private market portfolio. Given Salient s philosophy to replicate market exposures passively and focus manager selection on skill-based sectors, most of the investments across the public security spectrum will be in the hedge fund arena. Salient has historically focused its research on smaller, niche hedge funds, but has also had access to and invested across the large, name-brand hedge funds.
Page 10 Mr. Partridge has introduced a more quantitatively oriented discipline in evaluating and assessing managers/strategies for retention. Based on the proposed structure of the investment organization that is under consideration, it is contemplated that Albourne would be available to the SDCERA Board and to Salient as a resource with respect to hedge funds. We believe that Salient s capabilities, under Mr. Partridge s leadership, in conjunction with the external resources available to Salient, such as Albourne, would provide SDCERA with enhanced and robust capabilities across the public market space. External Manager Operational Due Diligence The operational due diligence efforts are led by Philip Mason, who is an accountant by qualification and has experience at a public accounting and consulting firm prior to joining Salient. Until recently, Mr. Mason was the only individual dedicated exclusively to operational due diligence. Additional support on operational due diligence was provided by members of the investment team. More recently, Salient has identified two individuals within the investment team who will focus their attention exclusively on operational due diligence. Mr. Partridge has indicated adding one or two more full time positions to support the operational due diligence function over the next six months. Salient has established exhaustive due diligence checklists to facilitate their operational due diligence these include an initial review, quarterly and annual reviews, review of valuation procedures, and reviews of audited financial statements. Salient indicates that their operational due diligence function covers approximately 300 investments across the public and the private spectrum. Given Mr. Partridge s desire to have professionals focus on a specialization, Salient has allocated two individuals that previously focussed on investment and operational due diligence to now focus exclusively on operational due diligence and plans to add one or two more professionals.while this is a process that is clearly in transition, we view the addition of dedicated resources to support the operational due diligence function favorably. Mr. Mason reports to Salient s Investment Committee through the CIO. We would prefer if Mr. Mason also had a dotted reporting line to the firm s Board of Directors. Under the proposed structure of the investment organization that is under consideration, in addition to the resources available at Salient, SDCERA would also have access to the operational due diligence resources from Albourne.
Page 11 We believe that Salient s resources, which are being enhanced, in combination with external resources, such as Albourne, would provide SDCERA with extensive capabilities with respect to operational due diligence on public markets. Compliance Salient s compliance function is headed by Paul Bachtold. Mr. Bachtold joined Salient less than a year ago, prior to which he worked in the compliance group of Barclays Global Investors. There are four professionals dedicated to the compliance function that report to Mr. Bachtold. In addition to the internal compliance, the compliance team led by Mr. Bachtold is responsible for compliance relating to Salient s mutual funds (40 Act funds). Mr. Bachtold has a reporting line to Salient s Board of Directors, the Board of Directors of the mutual funds, and to Summit Partners, which owns 38% of Salient. The compliance group maintains relationship with several reputed external counsel to assist and support them in their functions. At the time of our review, we were informed that the SEC was conducting a routine review of Salient and the funds it offers. It is important to note that Integrity was not covered by the SEC as part of this review. Based on subsequent discussions with Salient, it is our understanding that the SEC has requested additional information, which has been provided. The SEC also recommended additional procedures relating to Salient s mutual funds. At the time of writing this report, Salient was awaiting further comment from the SEC and did not anticipate any material findings from the SEC examination. Salient has offered to provide the final exit report that they receive from the SEC once it is available. While Salient does not currently conduct an SAS audit of its internal controls, they noted that they are considering conducting such an audit focused on their due diligence procedures and processes. Salient indicated that given the transition in roles and responsibilities that is currently under way for instance, separation of the operation due diligence function from investment research they planned to hold off on conducting such an audit until all transitions had been completed. Overall, the compliance procedures appear to be robust and in line with institutional standards. Trading Capabilities and Corporate Actions (Proxy Voting, etc.) Salient s trading infrastructure, capabilities, and processes appear in line with institutional standards. There are three individuals dedicated to manage the trading function. Salient s global macroeconomist, James Sivco, also serves as the head of trading. They have the ability to execute across equities, fixed income, options markets, as well as conduct block trading. The primary execution service providers that Salient works with are BNY Convergex and BTIG. The primary trade order management system / front-end application is Moxy, which is a product offered by Advent and an
Page 12 industry-standard front-end trading application. The trade order management system incorporates features that are standard across institutional trading platforms, such as: managing trading based on model portfolios (a critical aspect especially as it relates to the management of passive portfolios) and the ability to embed pre-trade compliance controls. Additionally, Salient has engaged Elkins McSherry, a leading provider of transaction cost analysis, to conduct analysis on transaction costs across their portfolios. As it relates to proxy voting and related corporate actions, Salient utilizes ProxyEdge, a service provided by Broadridge Financial Solutions. ProxyEdge is an electronic service that provides end-toend solutions relating to proxy voting and is used by leading institutional investors (asset management firms and custodian banks). Salient s trading systems and capabilities and their approach to managing corporate actions, such as proxies, are consistent with industry standards. Summary and Conclusions The focus of Salient s business has historically been on the high net worth marketplace. Salient is taking concerted steps to develop a greater institutional focus. This coincides with significant changes relating to the management of the firm and the organization of key resources. Further, Salient has been growing its capabilities (both talent and product) through acquisition of external entities. With significant changes already underway and potential changes that we anticipate Mr. Partridge might make, it is critical to monitor the stability of resources. It is important to ensure the changes being implemented take full effect and are implemented smoothly for the firm to truly be viewed as an institutional quality investment manager. The addition of Mr. Partridge, who brings a wealth of institutional experience, a keen understanding of best practices, and a clearly-defined vision will help Salient in this regard. Salient s investment philosophy and approach, which, today, is largely driven by Mr. Partridge, is progressive, well thought out, and consistent with views emerging across the investment community. Given the more complex portfolio design, Salient has developed robust risk measurement tools and is in the process of enhancing these capabilities further based on Mr. Partridge s experience. The portfolio construction and management process integrates a risk-focussed discipline. The complex, non-traditional approach requires significant, experienced resources to implement successfully.
Page 13 With respect to external manager research and due diligence, Salient does not have a fully built out private market capability. This, however, is not a concern as it relates to SDCERA since the internal investment team will be fully responsible for private market investments as outlined under the proposed structure of the investment organization. Additionally, given the firm s philosophy on replicating market exposures for most publicly-traded asset classes, the principal focus of the external manager research function is on skill-based categories (hedge fund strategies), Historically, Salient s professionals have focused on the smaller, more niche hedge fund strategies, but have also had access to and invested across the large, namebrand hedge funds. Mr. Partridge has introduced a more quantitatively oriented discipline in evaluating and assessing managers/strategies for retention. Given Mr. Partridge s desire to have professionals focus on a specialization, Salient has allocated two professionals that previously focussed on investment and operational due diligence to now focus exclusively on operational due diligence and plans to add one or two more professionals. While this is a process that is clearly in transition, we view the addition of dedicated resources to support the operational due diligence function favorably. Based on the proposed structure of the investment organization that is under consideration, it is contemplated that Albourne would be available to the SDCERA Board and to Salient as a resource with respect to hedge funds. We believe that Salient s capabilities, under Mr. Partridge s leadership, in conjunction with the external resources available, such as Albourne, would provide SDCERA with enhanced and robust investment and operational due diligence capabilities across the public market space. While material transition is underway at Salient, we believe Salient, with the addition of Mr. Partridge and in conjunction with external resources, has necessary elements to support SDCERA with thought leadership and management of its portfolio. Under a separate document titled Structure of Investment Organization, which will be presented and discussed at the Board meeting on April 21, 2011, we have provided a detailed outline on a proposed structure for SDCERA s investment organization. The structure follows from discussions with the Board at its retreat in March 2011 and addresses the roles and responsibilities of various parties responsible for the management and oversight of SDCERA s portfolio. Overall, we believe that Salient, under Mr. Partridge s leadership, and in conjunction with the internal and external resources as identified, is capable of performing its role as outlined in that presentation.
Page 14 In determining next steps, in addition to investment considerations, we believe it is critical for the Board to be comfortable with the business risk (current and prospective) of allocating responsibility of a significant portion of the portfolio to an external entity. This would include consideration of whether an alternate solution can be developed if Salient and SDCERA decide not to renew their agreement at the end of the contract period or whether existing internal resources are fully capable of taking overall responsibility for this portfolio in such an event, etc.