Calif. fund seeks ‘safe’ returns

Donald Pierce, chief investment officer of the $9 billion San Bernardino County Employees’ Retirement Association (SBCERA), brings vision and a steady hand to investment strategy.

The portfolio he shapes is built around low equity exposure and diversification, with assets chosen according to their value, along with their contractual and income qualities. All SBCERA investments are viewed through these three lenses, in a blueprint that runs throughout the portfolio. This explains the chunky allocation to alternatives, the preference for debt instruments and the fund being “grouchy” about equity without dividends attached, Pierce says.

Value means buying assets at a significant discount to what they’re worth. A principle recently challenged in the California-based fund’s emerging-market debt portfolio by the sell-off in Brazil, which has tested the mettle of most credit investors.

“Brazil sold off, we bought in and it got worse,” says Pierce, a United States Air Force veteran who saw active service in the Gulf War fresh out of high school. “When you are interested in an area that has been beaten down, it doesn’t mean as soon as you enter it won’t get beaten down more. And the one time you avoid the first round, you can guarantee it will rally on you and you’ll get mad at yourself.”

The portfolio’s contract and income principles mean SBCERA favours assets containing contracts that at some point in time settle up or pay money back to investors.

“Benjamin Graham’s The Intelligent Investor talks about buying assets below intrinsic value, yet one of the things rarely talked about – which we take to heart – is that the market may never take you out of your position,” Pierce says, in reference to Graham’s 1949 book, which is a bible for value investors.

It means he hunts for assets that extract value through cash flows and don’t ultimately rely on market movements for a return. There is always a danger that the market won’t move. In that case, embedded contracts ensure payment of some kind, at some point, “if push comes to shove”.

These principles sit easily within alternative assets, where the fund has allocations to timber, infrastructure and private equity. Rather than focus on the individual assets, Pierce looks at their components.

“Is it equity or is it debt? Does it have leverage? When does the debt facility mature? Is there a significant amount of asset coverage? Each asset we have we would like to underwrite in some way,” he explains. “It is much more of an underwriting story than an alternative story. The income is the least volatile of those components. The price change is where the action is, but it is also where all the volatility is.”

Pierce, who succeeded his mentor, Tim Barrett, in 2010, has introduced new allocations to international private equity and emerging-market debt, as well as option strategies and a wide-ranging rebalancing program. Here, the portfolio’s allocation is adjusted every month, according to asset prices, within a fixed range.

“It doesn’t change that much; we are a low-turnover portfolio. However, the main criticism I have of any strategic asset allocation [when] folks don’t change it, is that they are saying the price of the asset they are purchasing doesn’t matter. If your asset allocation doesn’t change when the stock price and value have increased by 200 per cent ov

er the last seven or eight years, you are saying the price at which you buy assets isn’t [relevant] to your asset allocation and this doesn’t make sense.”

Cash pile

Accessing assets that combine value, income and contractual elements is a challenge in today’s climate. Couple that with some large sums coming back to the fund from maturing private-equity investments, and it means SBCERA sits on a cash pile amounting to almost 10 per cent of its assets.

“It definitely feels like a weight,” Pierce says. “We are finding it harder to deploy capital in a way that meets our cost of capital and this is reflective of the opportunities out in the marketplace. Spreads are tight, equity is rich, and while there are some isolated areas that are interesting, they are not areas you can lean into meaningfully. And, of course, as the market continues to rally, holding cash doesn’t look like a good idea.”

The cash pile has roughly doubled from its June 2016 proportion of 4.8 per cent. At that time, SBCERA had a quarter of its assets in the alternatives portfolio, with equity (33.6 per cent) fixed income and credit strategies (29.1 per cent) and real estate (6.7 per cent) forming the other allocations.

Managers and fees

SBCERA uses 50-60 managers, but “actively engages” with about 15 of them. The strongest relationships within this group are with managers that “truly understand” SBCERA’s investment philosophy. It is this select cohort that plays a key role in bringing new ideas to the fund.

“Our best managers come to us only with assets we like and have taken our investment approach to heart,” Pierce says. “That said, we do use managers that cause us to stretch away from these principles, test our predilections and bring real diversification. This is particularly related to growth equity, which doesn’t tend to fall into our philosophy of value, income or contractual.”

He likes managers that welcome investor input and are prepared to let him upsize various ideas and “add-on positions”.

“When managers that don’t always ask us for money do ask, it usually makes sense” he says. “When someone is always asking for money, then that is not the partnership we are looking for.”

He also runs a highly collaborative “standing table call-in” process where co-investment decisions involving managers include all investment staff on the call.

“All the co-investment decisions that come through involve the entire team, hands on deck.”

Investment management and performance fees in the alternatives portfolio came in at $47 million in 2016, out of a total investment managers’ bill for the year of $62 million.

Reducing fees is hard in buoyant markets, but Pierce cites examples of successfully securing better fees by working with managers on specific asset structures, such as risk-retention vehicles. He also argues that opportunities to invest with SBCERA are rare.

“It is hard to get into our portfolio, so when it opens up, it is important they agree to our terms.”

Strategy also includes the freedom to invest without constantly referring back to the board.

“We ask for a lot of permissions up front,” he says, although he is quick to nod to the board’s expertise.

“Have I ever had a brushback pitch?” he says, referring to when the board ditches an idea. “There isn’t a CIO out there who hasn’t had one of their ideas shown the exit. In some ways, this is better than if it gets in the portfolio, particularly if you [would have spent a lot of political capital defending something that] doesn’t work. At this point, either you kill it or the board will kill it. It’s a humbling business.”