Investing Billions - E69: How Texas Municipal Retirement System Deployed $1B into Venture Capital

Starting point is 00:00:00 If a fund is second quartile in the venture world, but otherwise outperforming other asset classes, then yeah, that could be interesting. If a group is second quartile, but they're delivering second quartile returns while, say, deploying a billion plus a year, then that is interesting. Do you think the incentives for pension funds in the United States are inefficient? Peter, I've been really excited, really looking forward to the chat. Welcome to the 10X Capital Podcast. Yeah. Thanks for having me, David. Peter, when you were at TMRS, you deployed roughly a billion dollars across managers. Break that down for me. Yeah. So that billion dollars, that was specifically in the venture capital category. The total amount ended up working on there actually ended up being over $5 billion in commitments. That billion was split between seven managers, a mix of what's called more software-focused groups to biotech from early stage to later stage.

Starting point is 00:01:01 Ended up being diversified across the spectrum of strategies and sectors. But that's not necessarily how I went about building it. I didn't have diversification as the top line goal of this portfolio. I mean, venture is a game of alpha generation. It's a game of capturing and getting exposure, being a part of these outliers journeys. And diversification is kind of at odds with that. So really for me in building that portfolio and filling it out with those seven managers, what I was really keying on was looking for and backing artists.

Starting point is 00:01:46 What do you mean by that? Artists? I might use artists and force of nature interchangeably. But when I talk about creativity and conviction, I'm talking about people, I'm talking about investors that are willing to do things differently from the pack. Investors are actually willing to take risks that aren't necessarily just looking to get into the hottest round led by Sequoia or led by Benchmark. These are people with actual differentiated views on the world and how to build their firms. You mentioned seven managers for roughly a billion dollars. How did you go about building that book? We had to find managers that had the potential to substantially outperform the managers in those other parts of the books. From there, though, it became a task

Starting point is 00:02:35 of boiling the ocean, turning over as many stones as I, to find those seven during the time at EMRS. The total plan was over, over $30 billion because of that. I mean, the tail does end up wagging the dog in some cases here, but you do have to find opportunities where, where we define opportunities where we could put substantial amounts of capital to work. We had to, we had to find opportunities where we, where we could put where we could make $50 million in upsize commitments to these groups. How did you sequence that? How do you practically build a billion-dollar venture book? I called it a hub-and-spoke approach. The very first commitment of that process,

Starting point is 00:03:19 of this program, was to Foundry. It was doubling down on their fund-to-fund work. We created a custom fund with them that, I mean, the initial commitment was a hundred million. It was just going to co-invest alongside them. We were able to write a very large check, tow our way into the venture world with a strategy that, with this fund-to-fund strategy that was inherently de-risked. And it also had these upside notes to it where we could, where over time, the relationships that we were indirectly backing could become direct relationships of ours. That boundary fund that we created with them was that, I mean, it was fee advantage. There was less, I mean, we were able

Starting point is 00:04:05 to negotiate the fees and there was much less fee drag involved there than with, say, just going to XYZ fund of funds and committing to their blind pool vehicle. In this case, we had a good idea of what was likely going to be in this fund. And we also knew that there wasn't going to be a management fee on it too, reducing the fee drag up front. So you invested into their fund of funds with management fees and carry, and then you invested as a co-investor without management fees. Is that correct? Yeah. Yeah. So we were already in Foundry's main fund. We then went to them with this idea and created this separate vehicle, the separate fund

Starting point is 00:04:45 that co-invested into, it co-invested alongside Foundry into the venture funds where they had excess allocation. And that, and that custom, that, that new customized fund would, didn't have a management fees. But there was an underlying management fee in carry. They were just on the incremental vehicle. There was only carry. Yeah, correct. But from an investment standpoint, from a portfolio construction, from a governance standpoint, what mistakes did you make on that venture book? I almost felt like I found myself falling into the trap of filling, you know, wanting to fill this venture bucket and, you know, ultimately filling this private equity bucket that we had. But so most institutional LPs, you know, they have these strategic asset allocations and pacing models that show,

Starting point is 00:05:26 okay, how much do I need to commit annually in order to meet that target or maintain that target or vice versa. And in the case of TMRS, our PE allocation had been doubled or the target had been doubled from 5% to 10% around the time we started making these commitments. And so I felt this inherent pressure to increase the check sizes, to put more money out more quickly. Joshua Berkowitz on the podcast from a family office, and he said that it's very important to think about the pacing model in terms of how do you make sure that you deploy across every single year so that you're able to recycle the capital in year seven, year eight, or however. His model is he invests roughly a sixth over six years.

Starting point is 00:06:14 How do you look at institutional pacing models in venture for an institutional LP? We look at the growth assumptions of what we already have under management. We make assumptions around, again, how much capital is going to be called down over time, how much capital is going to be distributed. But in, you know, in this case, and this gets back to the tail wagging the dog, there is a pressure to reach, you know, to reach these target allocations that are set in a timely manner. The most important thing in these pacing models is to actually be able to have exposure to multiple vintage years. So you're not overexposed to just one single vintage or avoiding just being exposed to 2021 venture, for instance. Absolutely. What is the biggest lesson

Starting point is 00:06:59 you learned at TMRS, Texas Municipal Retirement Systems? Making sure the organization is aligned in its goals and how to achieve those goals. I mean, what that looks like for an LP really is just that you, I mean, is that the investment team, the investment team and the non-investment teams within these organizations and the board of trustees as well, that they all trust what each other is doing, that the investment team has delegated investment authority, but that the investment team is also keeping the rest of the organization, the rest of the stakeholders apprised of what's going on. Again, it's governance, it's alignment, it's trust. You mentioned that you managed $5 billion at DMRS. Where were the other $4 billion invested? That was going into other private equity and private equity oriented type of strategies.

Starting point is 00:07:48 So buyouts, growth equity, special situations, which was a catch-all for strategies, for managers that didn't quite fit the private equity bucket neatly. Let's talk about governance. We talked about our friend at State of Wisconsin Investment Board, that they got the governance right and that they trust their investment staff. We just saw recently the investment to Bitcoin and crypto as an example. Tell me about governance and how that leads to returns for LPs. There's all sorts of governance models that you could say range from, again, delegation forward to being on the other end, no delegation, you know, delegation forward to being, you know, to on the other end, like no delegation,

Starting point is 00:08:26 you know, working more with fund to funds and relying more on consultants that governance, you know, and, you know, of these more forward thinking groups, it's, again, like it relies heavily on delegation, that is the investment team, being able to being able to invest the way, you know, the way that they want to the way they see fit, and to do so, again, with the trust of the rest of the organization. I mean, what that looks like in practice is that typically it comes down to a matter of size with investments. As long as a potential investment recommendation is below, say, a certain percentage of the

Starting point is 00:09:04 total fund, then the investment team has full discretion, again, that delegate investment authority to invest in how they see fit. Not every LP is like that. I mean, you'll have some firms or some organizations that have to take every one of their investments to a board of trustees for approval, or they might need sign off from a consultant, or they may just rely on a board of trustees for approval, or they might need sign off from a consultant, or they may just rely on a fund of funds to make all their investments for them. I mean, those are all examples of where there isn't delegated investment authority, where the governance model isn't really built on trust.

Starting point is 00:09:39 We were talking offline about the incentives for LP consultants, how there's misalignment between principal and agent. Tell me about the incentives for LP consultants, how there's misalignment between principal and agent. Tell me about the incentives for LP consultants. Consultants, I mean, they're typically paid on a retainer on an annual or multi-year contract of some sort. I haven't heard of consultants being paid with incentive comp or carry or some, again, like some form of incentive to, you know, to drive high upside type outcomes. The incentives are instead, again, like, you know, not to,

Starting point is 00:10:11 not to get fired, to keep the contract going. And I mean, again, like that's like, like that's, that's an inherent misalignment. I mean, it's, it illustrates just like that illustrates again, like the principal agent problem. The goal is to continue the contract to not get fired. They'll leave consultants, you know, usually recommending like, you know, groups that aren't emerging managers going to these more established options after the alpha has really been generated. So again, like it's, yeah, like it's one of those reasons why emerging managers have a more difficult time raising than established firms with long multifund historical track records. I mean, they're right in the crosshairs of a principal agent problem that they may not even know about. You oftentimes hear venture capital is an access class.

Starting point is 00:11:02 Are there LPs that are self-aware that are continuing to invest in the asset class that know that they're getting exposure to second quartile or even third quartile funds? There have to be. Yeah. There's only so much capacity available for LPs that you're going to have to find other areas of the world, other groups to commit your capital to. Again, if you want to be in venture, you you're going to get naturally pushed to, you know, to groups that may have historically underperformed. I mean, yeah, like the quantitative story may show that this group has historically underperformed, but under the hood, there might be, there might be green shoots, there might be some sort of, yeah, there might be a new strategy or a new team, you know, coming forth from, you know, from this historically underperforming firm that makes it actually makes it interesting to

Starting point is 00:11:45 back. Is there a rational reason for LPs that can't access top quartile to invest in second quartile or median performing venture funds? Is there financial rationale for that or is it purely just to check the box and make their ICs happy? If a fund is second quartile in the venture world, but outperforming, you know, otherwise outperforming other asset classes, then yeah, like that, that, that could be interesting. If a group is second quartile, but they're doing, but they're delivering second,

Starting point is 00:12:17 second quartile returns while, while say deploying, you know, a billion plus a year, then that's like, that, that, that is, that is interesting. I went to my, my mentor who was setting up a billion dollars, single family office, and he asked me what he should do. And I said, you should go to all the top funds inside, let her hire Carrie. What do you think about that? That's one way to get access. Um, have you ever seen that? I, no, no, I've, I've, I've never, I've never seen that. Um, a public institution could, could never like they, they can never do that. A public institution could never, like they can never do that. Like the investment team would get raked over the coals. I mean, but it's one way to get immediate access day one.

Starting point is 00:12:53 I imagine most investors, most GPs would take that offer. Speaking of incentives for pension funds, do you think the incentives for pension funds in the United States are inefficient? Yes. Many public funds don't incentivize their investment team. I mean, the team itself, the teams in these cases, they care about not getting fired, but there's no incentive to like take a risk, walk, you know, walk to the edge and find,

Starting point is 00:13:18 turn over the stones and find interesting opportunity as a higher likelihood of underperforming than, you know, a $10 billion buyout fund, but could deliver, you know, multiples upon multiples upon multiples of, you know, better, better return. I think the Canadian pension funds are much closer to seems to be principal agent alignment. And the way that they do it is they pay seven figure salaries to the very best in class and the top people. And those people typically would have gone on the GP side. They go on the LP side. And there's a lot of research and a lot of evidence

Starting point is 00:13:48 that that system is working really well for the Canadians. If you were running a pension fund, let's say you were CIO, how would you go about attracting and retaining top talent? Well, I mean, you hit on it. You just hit on it. It's following whether that Canadian model or the Singapore public sector model. If you want to build a strong, cohesive team that isn't going to be constantly worried about jumping or constantly worried about their own compensation growth or their own skill set growth, then you just have to pay them and compensate them really well. We'll get right back to interview. But first, to stay updated on all things emerging managers and limited partners, including the very latest data

Starting point is 00:14:30 on venture returns and insights on how to raise capital from limited partners, subscribe to our free newsletter at 10xcapitalpodcast.com. That's www.10xcapitalpodcast.com. If you could change one thing about the investment management industry, what would that one thing be? It would be a step towards solving that alignment issue.

Starting point is 00:14:49 It's giving the investment teams at every one of these organizations, the delegation, the authority, the discretion to do their jobs, to invest. There's all sorts of strings attached to delegation, to these governance models and, you know, just being able to put the trust back in place with the investment team, you know, to allow them to invest without, you know, without interference from all sorts of other stakeholders, I think would go a long way towards, you know, towards, you know, delivering great financial outcomes to making, you know, to making staff feel more empowered, to reducing that revolving door that we're talking about even. But again, it comes down to trust. It comes down to

Starting point is 00:15:34 people trusting the investment team and the investment team trusting each other. We're speaking offline about LP-GP relationships. What is the best way for LPs and GPs to build a relationship with each other? It just comes down to, it just comes down to time. We all went through COVID years. I mean, I mean, we all committed to groups where, you know, we, you know, we spent more time with them, you know, over, over zoom or over the phone versus in person. But again, that, that, that in-person time is just so important to, uh, you know, to, to getting to know, um, to, to, you know, these people to really like to really start building the mosaic that is, you know, the, the, that is your investment thesis for like, why,

Starting point is 00:16:16 why are you going to partner with them for, for, for years to come building real relationships, um, for first and foremost. Peter, it's been a fascinating interview. I've learned a lot and I know the audience has as well. What would you like to shine a light on for the audience? I spent most of my career on the private investing side, again, but mostly as an LP, of course, as we've touched on today. And during that experience, through that $5 billion or so of you know, of commitments that I've been able to make. I've come to realize again, it's important to look for, look for these investors that are playing at the intersection of creativity and conviction. It's important to look for these

Starting point is 00:16:54 investors that, that are artists who, you know, who, who treat their work with this duty and this feeling of care. Absolutely. Well, it's been really great to chat, Peter. I look forward to meeting, I'm in Austin often, so look forward to sitting down there or in New York city. Yeah, absolutely. Thanks, Peter. Thanks, it's been really great to chat, Peter. I look forward to meeting him in Austin often. So look forward to sitting down there or in New York City. Yeah, absolutely. Thanks, Peter. Thanks, David. Thanks for listening to the audio version of this podcast. Come on over to 10xCabell Podcast on YouTube by typing in 10xCabellPodcast into YouTube.com and clicking the subscribe button. On the YouTube version of this podcast, you could see the graphs, visuals, and key takeaways that accompany every episode.

Investing Billions - E69: How Texas Municipal Retirement System Deployed $1B into Venture Capital

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