Teacher Retirement System of Texas External Private Markets Strategy. The Texas Way

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1 Teacher Retirement System of Texas External Private Markets Strategy The Texas Way 1

2 Overview of TRS History Established by State Constitution in 1937 Paid out nearly $77 billion in benefits since 1937 Mission To build portfolios that identify and invest in top tier managers to provide superior risk adjusted returns Beneficiaries Size Provides retirement and health benefits to 1.3 million public school employees Average salary of participant is $42,000/yr $6.3 billion in benefits were paid in 2009 (average $2,180/month) Trust Value: $105.3 billion as of 1/31/11 Return Targets Actuarial target returns of 8% per annum Number one performing public pension plan in

3 TRS Diversification Framework Stable Value 20% Treasuries Hedge Funds Cash Global Equity 60% Internal and External Managers US Large Cap US Small Cap Non- US Developed Emerging Market Equities Private Equity Real Return 20% Global TIPS Commodities REITS Real Estate Other Real Assets GDP surprises are negative Inflation surprisingly low with weak demand Negative earnings surprises Out of line valuations Flight to quality GDP surprises are positive Inflation surprises not dramatic Positive earnings surprises Reasonable valuations Political stability generally exists Economic Conditions Real GDP growth too low Inflation surprises on the high side Real earnings too low Commodity-oriented demand exceeds supply by an above normal margin 3

4 Portfolio Diversification in Different Market Conditions 2 nd Quarter 2010 Results Global Equity: -12.1% Stable Value: 8.6% Real Return: -0.8% Global Equity 60% 22% - US Large Cap 5% - US Small Cap 15% - Non- US Developed 10% - Emerging Market Equities 8% - Private Equity Global Equity Regime Favorable GDP/CPI 70% of observations Average Inflation: 3.1% Global Equity: +15.9% Stable Value: +7.7% Real Return: +9.1 % Stable Value Regime Stagnant GDP & Low CPI 13% of Observations Average Inflation: 0.2% Global Equity: -15.4% Stable Value: +19.2% Real Return: -6.2% Real Return Regime High CPI, Low GDP 17% of observations Average Inflation: 7.9% Global Equity: +6.3% Stable Value: +5.3% Real Return: +11.1% Source: Data from Bureau of Labor Statistics (CPI) and Bureau of Economic Analysis (GDP). Graph depicts year-over-year quarterly observations from 1948 to date. Market returns based on TRS policy, dependent on QOQ inflation and GDP prevailing since

5 Divisions of TRS Investment Centers External Private Markets Private Equity Real Assets Real Estate Other Real Assets Energy External Public Markets Traditional Long-Oriented Investment Managers Hedge funds Internal Public Markets Strategic Research and Risk Management Trading 5

6 Role of Private Markets Investment Team as of 1/31/11 Oversees $35.3 Billion; $17.1 in current investments and $18.2 Billion in committed capital that is to be invested ( Dry Powder ) Private Equity $9.4 Billion NAV $9.1 Billion Dry Powder Real Assets $7.7 Billion NAV $9.1 Billion Dry Powder 6

7 Role of Private Markets Investment Team (Continued) Invest as a Limited Partner with Premier List network of Global General Partners 57 General Partner relationships in 103 Private Equity funds 52 General Partner relationships in 84 Real Assets 128 Advisory Board Assignments Collaboration with Three Consultants Private Equity: Hamilton Lane & Altius Real Estate: Townsend Group Transitioning to 10% Private Equity; 15% Real Assets over time 7

8 Private Markets Organizational Chart 8

9 TRS Philosophy Alignment of Interest and Fairness TRS has a commitment to reward alpha Focus on long-term results promotes partnership Cost structure competitive with other best-in-class institutional investors TRS has adopted the ILPA Principles and the LPA clauses outlined by PREA InvestOps Address: investops@trs.state.tx.us The first filter for potential investments is the InvestOps folder Manager s investment opportunities are sent to this address The manager will receive an auto reply on guidance for submitting an investment proposal to TRS 9

10 Manager Selection Process TRS limits the number of managers TRS creates a Premier List of managers Investable Managers Track record on Institutional Funds Over $1 billion AUM Meet TRS Strategy and Portfolio Needs Emerging Manager Program: $2 Billion AUM or less Fund 1, 2 or 3 Top quartile management Strong operations and back office capabilities 10

11 Manager Selection Process Real Assets Private Equity What Markets? Domestic and International Domestic and International What strategies/property types? MF, Industrial, Retail, Office, etc. Large Buyout, Mid/Small buyout, Venture Capital & Distressed Core: up to 50% Large Buyout: Average 4.7x Debt/Ebitda Value-Add: up to 65% Mid/Small Buyout: Average 4.2x Debt/Ebitda How much leverage? Opportunistic: up to 75% Venture Capital: typically no leverage REITs: company specific Distressed: typically no leverage Other Real Assets: Dependent on strategy/asset type Core: 8-10% net Large Buyout: 20%+ gross Targeted returns? Value-Add: 11-14% net Mid/Small Buyout: 20%+ gross Opportunistic: 15%+ net Venture Capital: 20%+ gross REITs: 9-11% Distressed: 20%+ gross Other Real Assets: Dependent on strategy/asset type Target deal size for TRS to invest? $150 M - $250 M Large Buyout: EBITDA > $50M Mid/Small Buyout: EBITDA < $50M 11

12 External Private Markets Process and Methodology Real Estate and Private Equity 12

13 External Private Markets Premier List, Investment Certification and Approval Process PIM Preliminary Investment Memo DDM Due Diligence Memo IR Investment Recommendation 13

14 Premier List Overview Established in 2007 for External Private Markets Narrow universe of top quartile managers Focus limited time and resources on fewer best-in-class managers who will serve as long-term partners All new investments must be through a Premier List Manager Meetings held 2x/year to approve and remove managers Number of managers permitted per list: List Capacity Currently on List Invested Bench Real Estate Private Equity ORA

15 Private Equity 57 Managers/103 Funds (8/31/10) Blackstone Group Blackstone Capital Partners IV Blackstone Capital Partners V Blackstone Capital Partners VI CVC Capital Partners CVC Capital Partners Asia Pacific III CVC European Equity Partners III CVC European Equity Partners IV CVC European Equity Partners Tandem Fund CVC European Equity Partners V Apollo Management Apollo Investment Fund VI Apollo Investment Fund VII Apollo Parallel Partners A Credit Suisse Credit Suisse CFIG Middle Market Buyout Credit Suisse CFIG RE-UP Bridge Program CSFB Emerging Opportunities Fund Carlyle Group Carlyle Europe Partners III Carlyle Partners III Carlyle Partners IV Carlyle Partners V TPG Capital TPG Partners IV TPG Partners V TPG Partners VI TPG STAR First Reserve Corporation First Reserve Fund IX First Reserve Fund X First Reserve Fund XI First Reserve Fund XII Apax Partners Apax Europe V Apax Europe VII-A Avenue Investments Avenue Special Situations Fund V Charterhouse Group Charterhouse Capital Partners IX Charterhouse Capital VIII Onex Partners Onex Partners Onex Partners II Onex Partners III Providence Equity Partners Providence Equity Partners V Providence Equity Partners VI Kelso & Company Kelso Investment Associates VII Kelso Investment Associates VIII Oaktree Capital Management Oaktree Opportunities Fund VIII Oaktree Opportunities Fund VIIIb OCM Opportunities Fund VI OCM Opportunities Fund VII OCM Opportunities Fund VIIb Kohlberg Kravis Roberts & Co. KKR 2006 Fund KKR Heford Co-Invest MBF Co-Invest (Pets at Home) Gores Group Gores Capital Partners II Gores Capital Partners III TGF Management Texas Growth Fund 1998 Trust Warburg Pincus Igloo Co-Invest (IDC) Warburg Pincus Private Equity X Lee Equity Partners Lee Equity Partners Lion Capital Lion Capital Fund I Lion Capital Fund II Oak Investment Partners Oak Investment Partners X Oak Investment Partners XI Oak Investment Partners XII Bridgepoint Capital Bridgepoint Europe IV Clayton Dubilier & Rice Clayton, Dubilier & Rice Fund VIII Blackrock Private Equity Partners Red River Direct Investment Fund Lindsay Goldberg Lindsay Goldberg III Permira Permira Europe III Permira IV Advent International Advent International GPE VI-A Leonard Green & Partners Green Equity Investors V Wayzata Investment Partners Wayzata Opportunities Fund II Crestview Partners Crestview Partners II Triton Capital Partners Triton Fund II Triton Fund III TA Associates TA X TA XI Hellman & Friedman Hellman & Friedman Capital Partners V Hellman & Friedman Capital Partners VI Quad-C Management Quad-C Partners VI Quad-C Partners VII Quad-C Partners VII Co-Investment HgCapital HgCapital 5 HgCapital 6 Kohlberg & Company Kohlberg TE Investors VI JP Morgan Investment Management Red River Venture Capital Fund J. H. Whitney & Co. J.H. Whitney V J.H. Whitney VI New Enterprise Associates New Enterprise Associates XIII Bain Capital Bain Capital Fund VIII Bain Capital VII Coinvest Fund Bain Capital VIII Coinvest Fund Platinum Equity Platinum Equity Capital Partners II Thomas H. Lee Partners Thomas H. Lee Equity Partners V Jordan Company The Resolute Fund Madison Dearborn Capital Partners Madison Dearborn Capital Partners IV Morgan Creek Capital Management Morgan Creek Partners Asia Squadron Capital Squadron Emerging Asia Fund Willis Stein & Partners Willis Stein & Partners III Encap Investments EnCap Energy Capital Fund VII Cerberus Capital Management Cerberus Institutional (Series Four) Candover Investments Candover 2001 Fund Nautic Partners Nautic Partners V Austin Ventures Austin Ventures VIII Polaris Venture Partners Polaris Venture Partners IV Highland Capital Partners Highland Capital Partners VI - B Nordic Capital Nordic Capital Fund V Goldman Sachs Goldman Sachs Vintage Fund Groupe Alpha Accueil Alpha Private Equity Fund V 15

16 Real Assets 52 Managers/84 Funds (8/31/10) AEW AEW Core Property Trust AEW Senior Housing Investors ALTERNA CAPITAL PARTNERS Alterna Core Capital Assets Fund AMB PROPERTY CORPORATION AMB U.S. Logistics REIT ARA ASSET MANAGEMENT ARA Asia Dragon Limited BLACKROCK Blackrock Diamond Property Fund BlackRock Retail Opportunity Fund BLACKSTONE GROUP Blackstone RE European Partners III Blackstone Real Estate V Blackstone Real Estate VI BROCKTON CAPITAL Brockton Capital Fund II CAMDEN PROPERTY TRUST Camden Multifamily Value Add Fund Camden Multifamily Co-Investment Fund CANYON CAPITAL Canyon-Johnson Urban Fund III CAPMARK FINANCIAL GROUP Capmark Commercial Realty Partners III Capmark Comm Realty Partners II Capmark Structured Real Estate Partners CAPRI CAPITAL PARTNERS Capri Urban Investors CARLYLE GROUP Carlyle Europe Real Estate Partners III Carlyle Realty Partners V CB RICHARD ELLIS CB Richard Ellis Strategic Partners U.S. OPP 5 CB Richard Ellis Strategic Partners US Value 5 CIM GROUP CIM Fund III CIM Urban REIT CITI GROUP CPI Capital Partners Europe CLSA CAPITAL PARTNERS Fudo Capital Fund II COLONY CAPITAL Colony Investors VIII Colony Distressed Credit Fund FC Co-Investment Partners DEUTSCHE BANK RREEF America REIT III ENCAP INVESTMENTS EnCap Energy Infrastructure Fund TT-EEIF Co-Investment Funds FIRST RESERVE First Reserve Energy Infrastructure Partners FIVE MILE CAPITAL PARTNERS Five Mile Capital Partners II FORUM PARTNERS Forum Europe Realty Income III Forum Asian Realty Income II Forum Asian Realty Income III HEITMAN Heitman America Real Estate Trust HUNT REALTY Akard Street Partners INVESCO Invesco San Jacinto Core Fund IRON POINT REAL ESTATE PARTNERS Iron Point Real Estate Partners JP MORGAN INVESTMENT Security Capital Income Opportunity Strategic Property Fund KKR KKR Natural Resources I L&B STRATEGY PARTNERS L&B Diversified Strategy Partners LASALLE LaSalle US Property Fund Ranger Co-Investment Fund LIONSTONE Lionstone Cash Flow Partners Fund One MACFARLANE PARTNERS MacFarlane Urban Real Estate Fund II MORGAN STANLEY Morgan Stanley Infrastructure Partners Morgan Stanley RE Mezzanine Partners A MORGAN STANLEY Prime Property Fund PARKWAY PROPERTIES Parkway Properties Office Fund II PCCP PCCP Mezzanine Recovery Partners II PRINCIPAL REAL ESTATE INVESTORS Principal Green Property Fund I Principal Green Property Sidecar I Principal RE Strategic Debt Fund I PROLOGIS ProLogis Mexico Industrial Fund I PRUDENTIAL REAL ESTATE INVESTORS PLA Residential Fund III PLA Residential Fund IV PREI Mezzanine Fund I PRISA PRISA II PLA Retail Fund I RLJ COMPANIES RLJ Real Estate Fund III ROTHSCHILD REALTY Five Arrows Securities V Five Arrows Securities V - Co-Investment SQUARE MILE CAPITAL MANAGEMENT Square Mile Partners III STEELRIVER SteelRiver Infrastructure Fund North America STOCKBRIDGE CAPITAL GROUP Stockbridge Real Estate Fund II Stockbridge Real Estate Fund III TLF Logistics STRATFORD COMPNAY Stratford Land Fund III Stratford Land Fund IV TEAYS RIVER INVESTMENTS AG Real Value Fund THAYER LODGING GROUP Thayer Hotel Investors V TRICON CAPITAL GROUP Tricon IX USAA REAL ESTATE COMPANY USAA US Republic Core Fund U.S. Government Building Fund WALTON STREET CAPITAL Walton Street Real Estate Fund Sidecar V Walton Street Real Estate Fund V Walton Street Real Estate Fund VI WESTBROOK GROUP Westbrook Real Estate Fund VIII ZACHRY HASTINGS ALLIANCE Zachry Hastings Infrastructure Partners 16

17 Real Assets Allocation Current Allocation (by NAV 9/30/10) Other Real Assets 24% REITs 25% Opportunistic 25% Core 29% Value-Add 10% Diversified portfolio of real estate investments Diversified by strategy (core, opportunistic, value-add) Diversified by property type (office, multi-family, industrial, retail, etc.) Strong inflation hedge 17

18 Real Assets Allocation Current Allocation (by NAV 9/30/10) REITs $2,045 Core $2,391 Strategy Current NAV Target Allocation Unallocated Funds Core $ 2, $ 4, $ 2, Value-Add $ $ 1, $ Opportunistic $ 2, $ 3, $ 1, Other Real Assets $ $ 1, $ REITs $ 2, $ 3, $ 1, TOTAL: $ 8, $ 14, $ 6, Other Real Assets $936 Value-Add $796 Opportunistic $2,102 18

19 TRS Real Assets 2009 Accomplishments Named North American Limited Partner of the Year Continued move into low-risk core real estate investments Invested $3.2B in structures that have increased liquidity Single LP Funds / IMAs $1.4 billion in 7 Open End Commingled Funds $1.8 billion in 9 Single LPs/Separate Accounts Large moves in 2009 paid off $300 CMBS Portfolio up 35% REIT Preferred up 38% $400 million industrial portfolio performing well 19

20 TRS Real Assets 2010 Accomplishments Goal: Committed $4.6 billion in new investments, mostly in core real estate and other real assets Several large investments $500 million in re-cap of General Growth Properties $425 million Fund - seeded with $410 million office purchase in Bellevue, Washington (Seattle) $400 million in Open End Core Fund $300 million Infrastructure Separate Account $300 million in Government Building Fund Named North American LP of the year for second year in a row 20

21 Private Markets Peformance 2010 Performance (through 12/31/10) Private Equity: 19.37% Real Assets: 8.97% REITS: 28.12% 21

22 Noteworthy Recent Investments General Growth Properties Strategy: Attractive retail portfolio at compelling pricing Thesis: Public REITs own 77% of the top quartile malls GGP owns 180 retail properties in 43 states Water Tower Place in Chicago Faneuil Hall Marketplace Glendale Galleria Fashion Show Mall The Shops at La Cantera. TRS invested in pubic shares in a postbankruptcy GGP at $10.25 per share. Size: $500 million Status: TRS closed is a successful restructuring on November 10, 2010 complex restructuring/bankruptcies in history Current stock trading at $14.50 for a 40% gain 22

23 Noteworthy Recent Investments Principal Strategic Equity Fund I (Bravern Office Commons) Strategy: Gain access to an attractive core asset Thesis: New project of 750,000 SF office in two buildings in Bellevue, Washington 100% leased to Microsoft on staggered longterm leases GP Principal Global Investors Size: $410 million Status: TRS fund closed in September 2010; all cash Obtaining 50% debt for 10 yrs fixed at 4.6% Projected return is 10.5% Microsoft 10 year bonds yield 3.14% 23

24 Noteworthy Recent Investments Prologis Portfolio Strategy: Core industrial assets at compelling price Thesis: Prologis had liquidity issue and needed to sell quickly Other investors were fearful of the crisis and unable to react TRS hired Stockbridge, an existing manager Diligence over $1 billion of PLD assets Selected the 90 best assets of a 300 asset portfolio Pricing equated a 9.5% capitalization rate Obtained 10 yr fixed rate debt at 4.56% with first 5 yrs IO Size: $400 million Status: TRS fund closed on asset in June 2009; all cash Since inception return is 14.5% Large investor recently purchased $1 Bn in assets from PLD at a 8% cap rate (200 bps lower than TRS) 24

25 Noteworthy Recent Investments CMBS Portfolio Strategy: Take advantage of the fear in the CMBS credit market Thesis: Hire a seasoned CMBS manager to invest in super-senior CMBS Risk of loss was minimal Spreads were at all-time highs Work with current fiduciary Principal Global Investors Size: $300 million Status: TRS funded $300 immediately in Spring 2009 Since inception return is over 40% 25

26 External Private Markets 2011 Goals Project Focus Deliverable Timeline Continue to stress the full implementation of the IMD culture Develop IMD Culture Continue to stress the full implementation of the IMD culture Q1 Actively lead the EPM team through a constraint reduction process Initiate Cross Platform Investment Collaboration within IMD Develop a more mature and complete management committee within EPM Develop IMD Culture Utilize the Flippen program. Q2 Develop IMD Culture Increase collaboration Q4 Develop IMD Culture Host two off-site training and strategy development sessions Team Development Develop IMD Culture Analyst development program Senior Associate/Associate Development Senior Investment Manager/Investment Manager Development Write 1-2 White Papers Develop IMD Culture Write 1-2 papers to improve returns and build the investment culture within the EPM team Q4 Q4 Q4 External Private Team Development Develop IMD Culture Hold an offsite fun event once per quarter for the EPM team Q1-Q4 Energy and Commodities Platform Improve Returns Develop a new capability within Private Markets that specializes on Energy and Commodities Q1 Strategic Partnerships Improve Returns Select and effectively implement 2-4 global SPN relationships Q1 Emerging Manager Development Improve Returns Effectively implement the investments within Private Markets related to emerging managers Q2 26

27 External Private Markets 2011 Goals Project Focus Deliverable Timeline REIT Portfolio Improve Returns Take full responsibility for the REIT portfolio and implement anactive management strategy Q3 i. What? % Private (80-90%) % Public (10-20%) i. How? Passive Active Internal External Funds with REITs as the GP Chunky positions with influence/control Bridge capital from private to public Take private capital i. Who? Review the Capital Allocation Process Improve Returns Sponsor a full review of the capital allocation process based on the characteristics of Equity and Debt, rather than pure asset classes as currently done this is particularly important for real estate Q3 Elephant Hunting Improve Returns Shoot another Elephant that can move the needle Q4 ILPA Improve Risk Management Finish the job with the ILPA Principles Q2 Portfolio Management Increase Productivity i. Develop a more robust analysis of the specifics of our Private Markets portfolio ii. Request increased transparency from GPs on: 1) Sector allocation/concentration 2) Debt levels, terms, and maturity 3) Revenue/EBITDA/NOI actual and projected performance i. Rank all funds into top 25%, middle 50%, and bottom 25% Q2 27

28 External Private Markets 2011 Goals Project Focus Deliverable Develop a Increase Measure the next three years; Supply and Productivity i. Supply TRS available capital to Demand Tool commit/invest based on total fund size and portfolio management ii. Demand Projected funds/capital to be raised by our PL GPs over the next three years Timelin e Q2 Principal Transactions Development Improve the IMD Organization Continue to fully develop and staff the Principal Transaction process Q4 28