Private equity: Florida SBA mulls CFOs as alternative to secondaries

Florida State Board of Administration (SBA) is exploring innovative new strategies in its $18 billion private equity portfolio like Collateralised Fund Obligations (CFOs) and “NAV loans” to tap liquidity and reposition the portfolio as an alternative to selling in the secondaries market where investors continue to get clobbered with massive discounts.

The SBA doesn’t have the statutory authority to put these strategies in place because they involve issuing securities. But speaking to the Investment Advisory Council during an asset class update in June, John Bradley, senior portfolio manager in private equity, said the investment team will resume the conversation with the Legislature next year, adding that these types of strategies have become much more common in the past few years.

Bradley explained that the highly complex CFO process typically involves GPs bundling stakes in private equity-owned companies into a single ($1 billion, for example) portfolio, contributing it to an SPV and securitising the cash flows, marketing interest-bearing securities to new investors to return cash to existing investors.

He added that these types of strategy offer a better cost of capital than the secondary market where in contrast to earlier years when investors used to sell at a premium, they now risk giving up a significant return.

The challenging secondaries market reflects the markedly changed conditions in private equity where the boom of the last decade has swung into reverse.  Low interest rates and high growth led to “massive multiple expansion” but the decade ahead will be characterised by higher interest rates and slower growth, requiring portfolio companies to add value through their operations.

“The value created by GPs in the future won’t be same as in past,” predicted Bradley.

Strategies shaped around borrowing, M&A and growing the EBITDA are over. Today it is much more about being good owners of a business and driving value through operations, he said.

The SBA is preparing for more churn in its  GP relationships. But forming new partnerships and creating access with top GPs is a laborious process alongside working down the existing list of GPs coming back to market.  In the last year, SBA only closed with four new funds after  a journey that began with 326 meetings and calls.

Manager due diligence is detailed and process orientated, striving for a consistent approach in how the investor reviews fund opportunities. At each stage the team debate if the opportunity is worth taking to the next level in a process that takes 3-4 months.

At the end of last year, the SBA was invested in 243 funds managed by 71 GPs  of which 45 count as core relationships. Fifty three per cent of the private equity portfolio is concentrated in ten firms including names like Lexington Partners, Truebridge Capital and SVB Capital. These top ten names together represent 32 per cent of SBA’s committed capital today.

Contrarian strategy

SBA prides itself on a contrarian strategy.

For example, the team dug deep into traditional energy assets in 2020, snapping up secondary oil and gas assets, buying into fund and co-investments, as ESG-minded LPs bailed out of the strongly performing sector. But Bradley warned the benefits of active management and repositioning are often not felt for years.

Like overhauling the European portfolio in favour of regional, and country-focused funds. The SBA “took advantage of the 13-year bull market” to conduct six secondary sales over the past ten years, creating $5 billion in proceeds.

“We sold to realise value in the face of extreme valuations,” said Bradley. “The next evolution in European private equity is sector-focused fund investment.”

An exploration of how these assets sold in the secondary market went on to perform under new ownership revealed these funds went on to perform well. However, sharp falls in the euro produced an FX win that offset subsequent fund performance.

That contrarian approach is also visible in venture.  In 2010 the SBA increased its exposure to venture at a time many other investors were throwing in the towel. The team put together creative investments via SMAs and fund-of-one to gain access.

“It turned out that venture wasn’t dead, and we reaped huge rewards ten years later,” said Bradley.

In 2021 the SBA reduced the venture portfolio via the secondary market, selling $1.8 billion in tech and venture assets.

The SBA’s bias to early-stage venture  makes up two thirds of the portfolio. The majority of the allocation is in IT and software, largely around Silicon Valley, New York and Boston.

Bradley said that although the venture portfolio is down on the year, it has outperformed peer benchmarks and is the strongest performing sub strategy within private equity, an envelope of the portfolio that includes allocations like distressed and secondaries.

The future

The committee heard how the integration of IT into the private equity portfolio is another key focus and will include the modernization and cloud migration of legacy systems. Technology is leading to changes in how the SBA updates PE fund data, and is creating efficiencies.

Bradley concluded that the SBA will remain active in the secondary market and bring more co investment in house where two staff members now oversee co-investment.