An Interview with TJ Carlson

Part 1: Public Sector Challenges

The complexities of managing public funds, such as transparency and public scrutiny, are explored.

Williams: So given the breadth of your career and the depth of it and all different segments of the industry, there have to be certain takeaways based on your experience that foster good outcomes in organizations versus less good outcomes. What thoughts would you have on that subject?

Carlson: Well, I think the biggest thing that it all comes down to in any instance, whether you're talking about an endowment, a foundation, a public pension plan is the proper governance structure. And when I think about governance, it's about putting in place a process for good decision making and making sure that the right people are making the right decisions. And there's no one model that has all of the answers for governance. There are various models across the country. But I would say that there are some models that are better for governance structures than others.

And so if you think about a spectrum of governance models, you've got everything from a sole fiduciary model all the way out to-- I guess on the other end, I would say it's an investment board model. And there's a lot of things in between there. And I've worked with many of those different systems and been working with various different ones from a sole fiduciary to an investment board.

And one of the biggest things that you need to try to avoid when you're thinking about the governance is what I call risk of ruin. And that is getting the wrong person in a very powerful seat. Because if you get one wrong person in that seat, they can really derail work that's been done for 20, 25 years fairly quickly. And so it's important to have the right person in that seat.

Williams: I couldn't agree more. And I think we've both lived through that on at least one occasion, if not more than one. So one of the tricks you run into, particularly in public pension plans, is that the process for appointing people to boards or positions of responsibility is often a political one, where there's a knowledge gap between the professional investment fiduciary whose job it is to protect and compound capital, and the individual or individuals vested with the decision authority for putting people in key roles. Are there any guidelines for finding the right alignment for the sorts of people that should be appointed to these roles or elected?

Carlson: Well, I think there's things that you can do that will help increase the possibilities for a positive outcome, which is making sure that people have some kind of investment knowledge. That doesn't mean they have to be investment experts, but making sure that they understand the issues that they're going to be facing with, whether that be actuarial or investments.

There have been times in my career when I was having to educate Lay Boards about what is a stock or what is a bond, and then also relying on those people to make the investment decisions and have the final say on it. And I think that a better model in that type of situation would be to delegate the decision-making authority to the person that has the most information on whatever topic it is that you're dealing with. And so if it's investments, delegate that through to the investment teams in some manner. And then have the oversight board oversee that and have them explain the decision-making process, but try to get those people out of that decision-making process.

Williams: I think that makes sense. There are only so many hours in the day, and you want to use those hours to make decisions that are meaningful for the plan and its beneficiaries as opposed to investments 101 for board members. And the structure you just described is essentially what we had in Florida when I was CIO there.

The board was three statewide elected officials whose role was to set high-level investment policy, approve that in a public meeting, accept an investment policy statement that documented all the key elements of the policy. And I would be interested in your thoughts on the importance of documentation-- and then oversee implementation. But all of the implementation and administrative duties were delegated exactly as you say.

And that kept A, the trains running on time in the investment process. And B, it established very clear accountability for the person in your job or the one I had at the time, that if it didn't go right, you had full delegated authority and therefore it's your problem. And conversely, if it went great, then take a bow and do a victory lap.

Carlson: Exactly. And most of the investment people that I've met through my career, they're willing to accept that trade off between having the responsibility to make the decision and willing to be held accountable for the results of those decisions, because I think those two going together is very important.

The other thing about the delegation is, I think, selecting the right investment team members is critical. And with regards to this delegation, I've worked at many plans where-- in fact, I would say, most of the plans where I did not have delegated authority. And so we had a very structured process to go through, get investments approved by the board or approved by the consultant, things like that. And that can, in some cases, be counterproductive. It is exciting and enticing for board members to want to be involved in that decision-making process. But I think that that's better left to people who are doing it every day.

And secondarily, I had a couple of experiences. So for example, at MOSERS where I'm at right now, the system has been put in place. And the governance has been done very, very well for several decades now. So we had a great foundation. We have delegation with reporting responsibilities to various people. We have checks and balances in the system to make sure that we're following our policies and our procedures. And so documentation is very important, as you were alluding to.

However, I think it's also important to remember that just the way that it is today or when a new CIO would join a fund, it's not the way that it has to stay. You can work with the governance structure that you're within and try to change that. And one of the things I did at a fund that I was at that worked out very well, we had a-- they were a governance as a whole, which meant that the whole board made all decisions on every topic, whether it was actuary or investment. And they wanted to retain that control.

However, having an investment committee, I think, is a very valuable process. And so when I was there, after about two or three years, I decided to try to get an investment committee put in place at the board to help us with that as a first step towards that delegation. And the board was not inclined to do it at that time.

So I put an investment committee process in place among the staff members. And we made a commitment that said we're going to run this just like a normal investment committee. We took minutes. We had a charter. We had all the voting members defined in the charter as to who could sit, who could sub in for a different investment director.

And after about two years of us-- everything that went to the board first had to go through our staff investment committee, not because it was required by the system, but it was required by me. And it actually worked out really well because as the board watched us through this investment committee process, they gained a lot of confidence in our ability, our processes, and our documentation so that after about two years of doing that, they just said, well, why don't you guys just go ahead and take this over. We'll see how it is. And we put a guardrails in place with regards to how much flexibility we had to invest across different asset classes.

And so, for example, we had full authority for investments in indexation-type products and for private market investments. We can invest up to 1% of the trust fund in an investment. But if we wanted to go above that, we had to get board approval. So we had guardrails. And that system actually worked really, really well for us. And so for several years-- and it's been that way for about 10 years now that they've got full delegation down there. And it's been working really well.

Williams: So what you've just illustrated is an important element of public fund management or really any public endeavor, which is earning the capital of credibility. And incrementally, unlike the private asset management business where firms have a very clear unity of purpose to manage capital prudently and effectively for clients and cost effectively in ways that make the business sustainable and serve the clients' needs, in public funds, you have almost unlimited stakeholders. You have those who fund the plan, those who are the beneficiaries. And those whose other responsibilities, elected officers, et cetera, may be tangentially affected by the plans' actions in ways that they want to be involved and have a say.

So by doing the process you just described, what you did was earn the credibility that made them comfortable delegating. And I think that process and the value it can add cannot be overstated, nor can the importance of documenting it. For the simple reason that when markets are dislocated, and there's deep uncertainty, and there's permanent capital taking place, and liquidity is gone from the markets, those policies that you have at the governing level and then at the asset-class level-- in Florida, we used to have portfolio guidelines for each individual portfolio. And then asset-class guidelines at the asset-class level, those all rolled up into the total investment policy statement for the entire plan.

And all of those guidelines and policies became the muscle memory in the financial equivalent of the fog of war when nobody knew which end was up. You didn't which way to turn. You were just trying to preserve capital and hopefully return to a period where you can compound it. Or the ultimate extension of having good capability, good staff, good delegated authority, and good policy is that in those times of dislocation, you can go on the hunt for great values and make investments that will be generationally good in their ultimate performance.

Carlson: And I think one of the other thing that's very important that goes along with exactly what you were just saying is that you're educating all of those stakeholders, making sure that people know when you do an investment that there are going to be multiple short-term outcomes for this. But we understand why it's a good long-term investment. And so when you have a 15% to 20% pullback in the equity market, you want to be able to look back and say, remember, we talked about this when we were going through whatever the education was or the asset allocation practice.

And so when you can go back and you can say, oh, yes, we talked about that. We said this was a possibility. Now it's happening, but now what do we do? And to your point, it says, well, at that point, now we have levers we can pull for liquidity for whatever we need so that we're not in a dire situation. And that people are comfortable that said, oh, I knew this was going to happen at some point. I just didn't know when it was going to happen.

Williams: Right. And we used to actually do tabletop exercises for certain sorts of things. Hurricanes, for example, are a big deal in Florida. And when they happen, people can't get to work. Communications could be down for some period of time. Different information networks may not be available. It would affect operations. So we had to notify stakeholders about our ability to get through a storm and what our plans were. And by modeling that out, when we did have storms, which happened pretty regularly, we knew exactly what to do. And while it wasn't business as usual, it was business continued with the best interests of our clientele taken care of, which is very important.

Part 1: Delegation and Accountability

The benefits of delegating decision-making authority to investment teams are discussed, ensuring accountability and efficiency.

Williams: I think the other dimension that's interesting, doing all this in a public fund environment is really, I think, more challenging than in the private asset management business for the simple reason that you're doing everything in public. You're subject to public records laws. You're covered by the press.

And when there's some sort of an event in the financial markets and there's a big market drop or some other outcome, you're very likely to find a TV crew in the lobby of your building wanting to stick a camera and a microphone in your face, and ask you some question about what's going on. And is your fund in danger? Or can employees and beneficiaries count on their money being safe? And that's an element very few executives in private business have to worry about. But it's a real factor. And the transparency is a big deal. And you've got to manage that.

I guess the other piece you've got to make provision for is conflicts because again, in the public sector, that trust is everything. So there has to be some standard of disclosure and affirmation that members of your governing body don't have conflicts, et cetera.

Carlson: Yeah. And I would say that it's also important to get the right people in the room and involved with all of the decisions. So when we're getting ready to do an investment, we have lots of people who are involved in the oversight process. So we have our front-line investment staff. We have our more senior investment staff that are involved. We have our internal lawyers. We have our external lawyers.

Our executive director reviews the process to make sure that we're following all of our policies and guidelines. And so we have these checks and balances in place at each level as we proceed going forward. And so it's important to then be able to say, we followed our process. We followed our policies. We were within our guidelines. And we know all of the various different outcomes that are possible with this.

And so we want to make sure that in the event that if something ever does, unfortunately, go bad-- because things do go bad once in a while, and it gets on the front page of the paper-- that we have lots of documentation as to why did we do it? What did we do to verify that this was a good investment, that these were good reputable people that we're working with? So that we can make sure that we're comfortable with that being on the front page.

Williams: That's why I used the phrase, the capital of credibility earlier. We're big believers here in JPMorgan and what our leader, Jamie Dimon, refers to as the fortress balance sheet, which is enough capital that we're ready for anything. And when the markets go bad and there're serious problems in the world, we can be part of the solution and not part of the problem. And in the public fund setting, the capital that matters most is that credibility. So it's terrific that you've been able to do that.

And the nature of democracy is leadership changes over time. Term limits at an absolute minimum assure that that will be the case. And you need to re-earn that credibility with successive generations of stakeholders on the political governance side. And the documentation you've just described and the practice, especially if they're paired with a strong record of performance relative to peers, and relative to benchmark, and relative to risk tolerances is just irreplaceable. It is the mother's milk of success in the public pension fund business.

Carlson: And I think that one of the things that's least understood about public pension plans-- because as investors, we all want to be in the top quartile or find the next big 10x type investment. But our real job, over time, is to pay benefits and to earn a consistent return through whatever environment we're going to be facing. So we could be going into 2007. We could be going into COVID. We could be going into the tech crash of the 2000.

So we never know what's coming up. But we've got over 100,000 people that are relying on US to pay their monthly check. And so my team is very focused on making sure that we can earn a consistent return above our benchmark. And we focus less on peers because other peers-- our peers have different benefit streams. They have different liabilities. They have different funding structures.

And so just comparing a return of x versus y is a pretty poor judge of, how well is the pension fund doing? Well, what was your objective? Did you meet your objective? Did you exceed your objective? How often do you exceed it? And how are you doing at funding the liabilities and paying your benefits? Those are very important for us.

Williams: And of course, the funding of the liabilities is not within your control. We used to say at the SBA, our job is to invest the assets prudently to accomplish the long-term objective. The funding was up to the legislature, as was the benefit structure. So one of the elements of these CIO jobs is you have to know what your role is and what you control-- what you can control and what you can't, and make the very best outcomes happen that you can.

Part 2: Governance and Risk Management

TJ emphasizes the importance of robust governance structures and the risks associated with poor governance in public sector success.

Williams: So talking about MOSERS for a moment, when we talk about the long-term investment returns, MOSERS has, in my experience, a very distinct and unique approach to how it has managed assets over the years. And I knew your predecessor for many years.

What can you tell us about the investment approach that MOSERS has used over the years, and why you chose that direction, and what it's been like?

Carlson: So over the years, we've adopted a couple of different models depending on the different environments that we've been in. And I would say that we're now in a model where we're back to where we were probably 20 years ago. So we've come full circle.

We have a portfolio that's very diversified, has a good amount of alternatives in it. We use a material amount of portable alpha in our program. And that's afforded to us partially by the governance structure that we have and the ability to do this. Because we have tools that we've been given the ability to use, that some people aren't allowed to use, so meaning leverage and derivative exposure so that we can take this.

And these are very important tools for us, which I'll get back to in a second. But in about 2012, we went to a full-risk parity model at that point. And the total fund was levered about 210%. And that model stayed that way till about 2017. And in 2017, we pulled the leverage back. Or, I'm sorry. 2016, we pulled it back to 170%. And then in 2018, we pulled the leverage back to 140%. Still staying highly diversified. We're having a lot of diversifying structures, long Treasury's TIPS, real assets in that portfolio, still doing portable alpha again.

And then just recently, we've changed to reduce leverage a little bit more. So we're down to 110. But we've also increased our private markets exposure a little bit. And we're increasing our equity exposure. We had reached kind of a nadir of about 22% public equity exposure. And so now we're up about-- we're going to be up to about 36% once we hit our target.

And one of the other things we've done recently is we've broken out our core fixed income portfolio into its component pieces. So we have our intermediate Treasury portfolio. And we have our asset-backed securities portfolio. And then we have our credit portfolio, which can be either public or private credit. And so we're just looking for the best ways to do that with our portfolio. One of the big tools that we have that a lot of funds, like I said, don't have is the portable alpha.

Williams: And let's pause there for just a second, on the concept of portable alpha.

Carlson: Sure.

Williams: Just give us the, this is about-- this is a ball of-- here's what portable alpha is and why we find it an attractive approach.

Carlson: Sure. So if you look at-- we'll just take public equities. It's the easiest one. And if you look at public equities and the success of active public equity managers, I think most people would agree that active public equity management has left something to be desired over the last 20 years. There's some alpha available in there, but managers have struggled. And I think the latest numbers are 80% or 85% of active long-only. Managers don't exceed their benchmark over time.

And so what we try to do with portable alpha, you can think about that in two different pieces. You have your alpha piece and your beta piece. So let's just say that your benchmark is S&P 500. So you can either hire an index fund and just get that return. Or you can invest and get that index return through a derivative structure like a swap or a future. And then you can take the money that you didn't have to get on your exposure, and you can invest that in something else.

And different people do different things with portable alpha. They may do longer duration on the Treasury piece or the cash piece to try to pick up a little alpha there. You can design some system. We tend to favor market-neutral hedge funds in there. And so on our equity portfolio, we take-- we do most of that through our Swaps program, which don't require any cash at all up front. And then we hold back 50% of the value of that as cash, as our security. And then we take the other 50%. And we can invest that in market-neutral hedge funds.

And so we're very cognizant of how much beta exposure is in those hedge funds. We want to make sure that that's as close to zero as possible so that it's pure alpha. And if we can hire hedge fund managers that will get cash plus 3% or 4% at a 50% holdback ratio, that's 2% or 3% of alpha that we can port on top of our S&P 500 beta return. And so if you think about a long, lonely equity manager and how difficult it would be for them to consistently add 200 or 300 basis points of alpha, we have a lot more confidence in our ability to add it with portable alpha than picking and choosing different individual managers.

And I guess, that would be the other thing on portable alpha that I didn't touch on was we actually use the portable alpha across our entire portfolio. We're using it in private credit. We're using it in real assets. And so when you separate the alpha and the beta-- so for example, in our real asset portfolio, which is a brand new portfolio, we can actually get derivative exposure to our benchmark, which is the S&P Global Infrastructure Index. So we get our beta exposure—

Williams: It's locked in.

Carlson: It's locked in.

Williams: Now we're after the alpha.

Carlson: Yep, and now we're after the alpha. And we already have this 20-year very successful portable alpha program that we just have to size up a little bit to then put it onto our real assets. So we use it as a funding vehicle while we're waiting to get those real assets into the private market. We can actually earn that spread in return, using the portable alpha program. So we use it in public equity. We use it in real assets. We use it in private credit. We use it in fixed income. So it's a very useful tool that we use across our portfolio. And we can size it up or size it down as we deem fit.

Williams: The Swiss Army knife of these products.

Carlson: It is.

Williams: Pretty cool.

But to your earlier point, what that requires is a pretty sophisticated governance body that understands the components of that approach—

Carlson: Correct.

Williams: --the complexities of that approach and its potential frailties. So, for example, on your market neutral hedge funds, it would be very important to have a hedge fund manager portfolio that had a consistent level of competence. So you didn't have material disappointments there or worse, blow ups, which have been known to happen. And you would also have to have counterparties on your derivatives that you weren't going to have counterparty risk.

I vividly remember in the great financial crisis, one of the things that blew up in a way that surprised an awful lot of people was securities lending. The anxiety and securities lending for the owner of the securities had historically been the return of your securities. You had cash collateral to back them up. Nobody worried about the cash collateral. It was cash. As the saying goes, what could go wrong?

And of course, the answer was that cash collateral was invested. And it turns out the nature of the investments that the cash collateral was in was inappropriate for the illiquidity crisis of the GFC. And so people got seriously injured on losses on their cash collateral. And as a result of that historical experience, securities lending was restructured permanently. And you have some of that kind of risk embedded in the strategy too.

So you have to be able to get your head around that, and be comfortable that you've bounded that risk in appropriate ways, and that your governance structure understands it. So that if some component somewhere turns out to be a weak link and fails, number one, it's sized in a way that it doesn't threaten the success of the entire program. And number two, your governing constituency understands it and can accept it. And they're not going to panic and do the wrong thing at the wrong time.

Carlson: Yeah. And we have a lot of checks and balances, so counterparty risk is a great one. We actually manage our account or monitor our counterparties on a daily basis. So we get a daily report. We get a daily leverage report. We get a daily exposure report on these. And so making sure that that is that way, and that it's consistently followed up on. We have a risk manager that helps manage all of that.

I would say the other thing on portable alpha that is interesting-- I was just watching a different show on portable alpha and how they were doing it. And they were saying that they would put 35% in cash and invest the rest into other earning assets.

And from our standpoint, we don't think 35% is enough if you have a bad equity event, that we want more protection than that. So the way we've come out to about a 50% hold back on the cash is that we want to be able to handle an almost simultaneous or instantaneous to standard deviation event, and that we won't have to worry about where is our cash coming from in order to handle that.

And so that's why we keep 50% instead of a lower amount that other people might. Because we think it's prudent risk management that still allows us to earn 200 to 300 basis points of alpha, which is better than we would earn in the long-only markets. And so we think it's a good balance. It's a good way to use those tools that we've been afforded through our good governance structure, and it helps us balance that.

Now the other thing we have to consistently do is to re-educate the board all the time. As you were referring to earlier, there is occasional turnover in a public fund board. And so we have to make sure that those new board members get educated on that as they're coming in so they understand the portfolio. We actually do a one-on-one educational session with all of our new trustees just on the investment program. And so I'll sit with them for as long as they would like to go over the program, answer their questions, explain how each of the asset classes work so that we can make sure that they are comfortable with that.

Williams: And has history demonstrated that the expectations of that 200 to 300 basis points of alpha been fulfilled?

Carlson: It has been—

Williams: Consistently over time?

Carlson: It has.

Williams: Very impressive.

Part 3: Innovative Investment Strategies

MOSERS' unique investment approach, including portable alpha and risk parity models, is explained to optimize returns.

Williams: Yeah, so it's just an inherently more complicated thing. So let's come back to the active-passive for just a moment. So I think your statement about active management, particularly equities over the past 10, 20 years, is essentially true.

You could also make the argument that a lot of the conditions globally that supported that being the fact, generally accommodative central bank policy around the world, broadly deflationary trends, broad trends of globalization, and reorientation of production to low-cost centers of production around the world, which help drive the deflationary trends, and a generally benign global environment geopolitically that fostered that globalization of manufacturing, and service reorientation to low-cost locations.

That's gone in reverse. We have shooting wars in the Middle East and in Eastern Europe. We have the ascendancy of China on the global stage for global leadership. And it's just a much more challenging environment. And it would seem we also have the most concentrated US equity market in history, far more concentrated than it was even in the dot-com boom of the late 90s.

So I think more recently, a lot of the performance data suggests that there is success available for active management. And it's probably more so in some areas than in others because of the structure of the markets. An example would be in fixed income, a very broad index that's probably the most universally used, the Bloomberg Agg excludes 40% to 50% of all the credit securities on the market.

Arguably, by having exposure to those sectors, you can materially increase the return of a fixed income portfolio without materially altering its risk exposure. So active seems to be, in my simple view, pretty much an obvious choice in fixed income-- equity, a little more challenging. But again, just like your hedge funds, with competent manager selection and oversight, I think the potential in active is better today than it's been in the past couple of decades. And the recent history tends to support that view. Do you think there's something to that?

Carlson: I think that there is. The question is, how consistent can those managers be? And I'm not 100% sold yet on the equity side. Now, I completely agree with you on the fixed income side, which is why we've separated out our core fixed income into its subcomponent parts. So as I said earlier, we've got the Treasury component, the asset backed, and then the credit component.

Now one of the things that I think is actually going to help that even more going forward is the ascendancy of the private credit markets over time. And I'm not talking about opportunistic credit going out the risk spectrum and stuff like that. There are some fairly conservative credit opportunities, whether they're non-sponsored funds or sponsored, lower-middle market, where you can pick up some good risk-adjusted return on the credit side more so than if you just stick with the public markets.

So I think that's one of the benefits on the fixed income side is we've got a couple more tools there that we can use now. But I think you're right that generally speaking, on the fixed income side, I believe active management is the right key.

Williams: So let's look at another area that's a quintessential paragon of active management, which is private equity. Private equity for many funds has been a top-performing asset class for short, intermediate, and long-term periods. And I know that was true for us in Florida. Our program of private equity and venture capital managers was our top performer-- 1, 3, 5, 10, 15, and 20-year periods-- a top performer among peers, et cetera. It's really great.

And you get used to that leadership in an asset class or a sub-asset class. More recently, we've seen some evolution in private equity where exits have been fewer, distributions have been fewer to LPs. And some of the practices in the private equity industry have changed a bit. And with the cost of leveraging-- leverage going up a little bit recently with the change in Central Bank tendencies, that raises some questions. What are your views on private equity and any things that might be going on in that industry that as an investor, you're keeping a close eye on?

Carlson: Sure. So I actually think private equity is still a very attractive sector of equities. I tend to think of equity on a spectrum with public equity on one end and private equity on the other. So it has similarities, but there are differences along that spectrum as well.

I think that it's going to be harder, going forward, to get those asset-class-leading or portfolio-leading returns going forward. Because there's just a lot more things that I call-- that have been incrementalized, that are going to put pressure on people going forward. It's interesting. One of the trends that everybody seems to be talking about now is continuation funds. And I'm actually not a fan of continuation funds.

Williams: Let's back up what a continuation fund is.

Carlson: So a continuation fund is where a private equity firm has an investment that they've held on to for five, or six, or seven years, and they don't want to sell it yet. They believe there's more value to be had, but the limited partners like Missouri are really wanting some liquidity to help invest in new issues. And so the continuation funds are a legal mechanism to take that company, spin it out into its own new company to where the LPs can continue to own it, or they can get liquidity at that point.

And I think that this is being used more often than it should be at this point. Because if you look at the LPs-- I think the latest data I saw was 85% or 90% of the LPs, when they're given a situation where they can go to the continuation fund or stay where they're at, they're taking the cash because they need the liquidity, which to me if you're a good private equity manager, you should stick to your original thesis and sell that firm and not put that into the new vehicle.

And there's been a lot of little things that happen with regards to legal documentation, GP flexibility that they-- sometimes you'll get a thing. We had one several years ago. This was five or six years ago. And the GP came in and said, we're going to go from the 8% preferred hurdle return. We're taking that to zero.

Williams: Well.

Carlson: And we said, wait, what? You're going to—

Williams: I beg your pardon.

Carlson: Yeah-yeah, said was going to zero. And we're like, so why are you doing this? And they said, because we can.

Williams: I knew that was going to be the answer.

Carlson: And the market will support it. And so we're still going to be oversubscribed. And so we're going to do it. Because it takes risk off of the GP--

Williams: Sure. It does.

Carlson: --and puts more of it onto the LP, but that's not the nature of that investment. We are locking up our capital for a preferred return and counting on the GP skill sets to make even more.

Williams: So there are clearly issues here about GP-LP alignment. Now when you enter a partnership, you're essentially committing capital to be called, to be put to work by that GP. And even though the GP has a history, as an asset owner and allocator, when you invest in that new partnership, that successor fund or whatever it may be, you're making a bet that that GP can perform the value-add process operationally, financially, management-wise that they have in the past to realize a good return for you over the life of that fund, which will include an investment period, a management period, an exit period, and hopefully distributions.

And what you've just described is a truncation of the execution phase and a transformance in a way that the threshold for fees and performance is altered in ways that don't seem to be particularly attractive to the LP but seem to be pretty good for the GP. What happened to alignment in this process?

Carlson: Well, that's why I call it incrementalization is that this happens a lot of times when you reach for a little bit of yield in fixed income or you do this, and then two years later you reach for a little more yield, and then you reach for a little more. And then something bad happens. And you're like, well, how do we get way out here?

And so I feel like that's happening in private equity right now. When we model a private equity fund in our expectations, we have to model, what is the investment period? When are they going to call capital? When are they going to distribute capital? And most of the private equity firms have started using all their extensions. It's not even a question anymore. They're going to extend. And so we've-- in our models, we've just built out.

Williams: And the fees stay the same through the extension?

Carlson: Well, sometimes they do, sometimes they don't. They start to get negotiable at that point. And so those are the focus of our due diligence and making sure that we believe that we're trying to stay as aligned as we can as we go through that.

Part 4: Private Market Dynamics

Trends in private equity, including continuation funds and GP-LP alignment, are discussed.

Williams: So you said something earlier that's interesting, I'd like to come back to. When the question was asked, why are GPs doing this? The answer is because they can, which means the LPs are going along with it. Why are LPs going along with this to a degree that it's becoming a norm, if it's counter to their interest? Or is there a circumstance in which it's positive and aligned with their interest?

Carlson: Well, I think even based upon what you were saying, for the last 20 years, it's been the asset class to be in to get the returns. And so people are saying, OK, well, I've got to take it. I've got to take a little bit. I'm going to get a little bit less. I'm going to get a little bit less. But at some point, we have to start making these decisions. And there's been a recent time where we were negotiating. And we came to the end of the deal. And as a good investor, we just had to say, we're walking away.

Williams: But that's fiduciary prudence. At the end of the day, it is your job when no is the right answer, for you to provide the note. And if that is socially awkward at the time or makes you a little bit of an outlier, it does not alter your fiduciary duty. And to put your hand up and make that hard decision and do it publicly, which you are always doing in a public fund, takes a bit of spine.

Carlson: And it's actually one of the things that there's a trend right now with private equity and private credit even that, frankly, I'm more worried about than the markets currently seem to be. And that is with the mass of movement for the democratization of private markets. And I'm not a big fan of that.

I think that there are going to be serious risks that come up for the firms that move heavily into these markets. Many of them, I'm afraid, will move too far into those markets. And in 8 years or 10 years, they're going to have a lot of issues because of retail investors or low-- small dollar, high-net worth people in there. And they're going to be locked up. And they're going to say, well can't have your money back for another five years, eight years. And these people are going to go, wait, that's my retirement money. I have to live on that, so you can't keep it. So they're going to be forced out at lower valuations.

And so we're actually adding stuff to our due diligence process now because this is going fairly, broadly across the markets to try to feel that out with, how far are you guys going to go down the line on doing retailization of private markets? Because I think that that's going to be a business risk. Now, hopefully I'm wrong. But I think that for us to do our good fiduciary job, we have to make sure that we're aware of that so that we don't get locked up with a manager that could end up having a bunch of these issues.

Williams: Well, and we saw perhaps a foreshadowing of that with hedge funds of funds. Back before the dot.com collapse, there were European hedge funds of funds that were investing in hedge funds that did not have terrific liquidity, but they were offering-- the funds of funds were offering clients much higher levels of liquidity than the underlying portfolio could provide. So you saw two things there.

First of all, when things got dicey and at the end of the first quarter of 2000 with the collapse of the dot.com bubble, some of these funds had massive redemptions and were in tough space to try and fulfill those redemptions when they came due. And I think that may be the kind of thing you're foreshadowing here. And of course, the key element that has made private assets one of the reasons they've had higher returns over time is you get paid better rents on capital for tolerating volatility and illiquidity.

And as an institution, a pension fund, for example, investing over a 30 to 50-year horizon, it's easy to tolerate those two things. As an individual with a life span and a declining risk tolerance depending on mortality, how old you are and how long you've got to be around before you need that money, it is potentially a mismatch. So I think one of the keys is firms that are going into this space-- and we're one of them-- is understanding all that with great clarity, having that dealt with up front structurally. So you're protecting your client and your GP, quote, "the constituencies" from problems in that area.

And that the net cost of covering all of those elements of liquidity provision, and anticipating client need, and paying management fees-- all of that is rolled up in the whole thing in a way that you're comfortable that at the end of the day, the net experience for the investor is going to still be positive and make it an attractive move. Not everybody will be that thorough. And I'm sure with all changes in the marketplace, there will be those who get it right and those who don't. And those who don't will be the roadkill of investment law down the road.

Carlson: Well, and I think to your point, it seems like as an industry, we have a tendency to sometimes do too much of a good thing. And we don't tend to be good self governors. So you were just talking about the hedge fund to fund issue. It was the same issue in the sec lending issue that you were talking about earlier.

Williams: That's right.

Carlson: That's exactly what happened there. It's like, well, if we-- instead of keeping cash, if I buy two-year notes, then I can get a little more return on this. And then I've got three-year and then five-year average lives. That should be OK. And so we incrementalize ourselves into a problem. And so we're trying to build the new due diligence questions and research in order to try to help us try to ferret that out up front.

Williams: Well, so that tells a pretty good story about where we are in private equity. And I think one of the things that holds things together there, back on the fundamentals, is operational value add. I think financial leverage and sales of assets to financial buyers, that's one thing.

But I think maybe the most durable determinant of private equity success-- and it would be the same in real estate and the same in venture-- is the ability for a general partner to provide operating value add and actually improve the quality and management of the underlying assets of whatever that fund may be. Because if you can do that over time, that is just fundamental good cooking. That's not about a fancy sign, or an ad campaign, or special pricing on value meals, or anything like that. It's just good, solid, nourishing food.

Carlson: Well, I think that's actually why I-- without liquidity as a restriction, I actually prefer private equity to public equity because there's an actual story there that you can do. It's easier to understand all those operating things. It says, well, here's where it is now. We're going to come in. We're going to change this. We're going to fix that. We're going to-- and it's a much more outlined business plan in the private market space than it tends to be in the public market space.

Part 5: Partnership and Alignment

The importance of alignment and partnership in investment relationships is highlighted, focusing on mutual trust and shared goals

Williams: So we've talked about a lot of things that have worked over time. One of the great things I like about the investment industry is things change all the time. And what has worked changes over time. What's in favor and what's out of favor changes over time. Let's take two seconds and talk about unloved sectors. Because oftentimes, as we said at the open, the best generational investments are made during dislocations when everybody is on one side of the boat and you as an allocator, go to the other side of the boat and see something they missed. And you end up with the best fish of the day as a result.

So recently, venture has been in a tough period and so has real estate. We have just come out with new long-term capital market assumptions. And lo and behold, what brought home the prize for the highest expected return, value-add real estate. Do you do anything in the real asset space? And do you have any views on real estate opportunities?

Carlson: Sure. So we have been a long-time investor in real estate. Most of it is in core real estate right now, but we are actually looking into the value-add space. We've done a couple of opportunities there recently. I do think that there is going to be a lot more opportunity there. But as with any of these turning points or inflection points, you have to be very careful. You have to make sure that you're understanding the thesis about it and why it's going to be money good over the long run.

So, yes, we agree that real estate is a good play. Our board recently added an additional 5% allocation to non-real estate real assets. So we're going to be looking at infrastructure, things like that.

Williams: Transportation.

Carlson: Yeah, transportation.

Williams: I couldn't agree with you more. I mean, if you talk about things that in a world with a bias to inflation, real assets make a lot of sense because they can give you really three critical-- four critical things. One, diversification. Two, cash yield. Three, appreciation over time. And four, inflation hedge-- all of which are very powerful.

And particularly with something like infrastructure where you have what are in many cases, regulated monopolies, you've got things that are perfect gyroscopes or stabilizers for your portfolio. Because whether markets are good or bad, or economies are expanding or contracting, people drink water. They use electricity. They drive on roads. They ride on trains.

Carlson: Wi-Fi.

Williams: And there would be that too.

Carlson: Data centers.

Williams: Yeah, all that stuff is very useful and makes a lot of sense, particularly for long-term capital asset owners.

Carlson: Now one of the things that-- it's been this way for many years. But sometimes that trade off that you get for those infrastructure assets can be-- you have to make sure you're understanding what it is. Because if you get a 6% return on your investment off of this core infrastructure piece-- and that's great for 10, 15 years. But many of the things are like, well, but if it's great for 15, don't you want it for 40 and 50? And it's like, OK, well, maybe, but maybe I want less of it because I want something else that's going to help me do this.

And so similar to private equity, which is turning into a permanent equity kind of a concept, we need a different structure to pay these managers to do this. Because as we get longer and longer on our lock-up time frames, that 2 and 20 model or 1 and 1/2 and 15 doesn't work if you're a long-term, 40-year investor for something. That's much different.

And so trying to figure out that new model-- and I haven't figured that-- figured that perfectly out yet. But making sure that that compensation is shared well between the GPs and the LPs and not just in the short term, but in the long run, and finding that balance is—

Williams: Well, and you've just come back to something we keep touching on, which tells you how elemental it is to mutual success in this business. There has to be alignment. Any relationship that is good for one party and not the other is not a durable relationship, which brings me to the question of partnership. What do you look for in investment partners as critical characteristics that would make them attractive partners for you and for MOSERS over time that you could scale with, that you could trust, that you could use as an extension of staff and magnifying your own capabilities, and quality of your outcomes?

Carlson: So doing a lot of extra due diligence that goes beyond just looking at risk and return is probably the biggest key there, trying to understand what's driving the general partner and their staff and their employees over the long term. A couple of things that are good indicators for me, we tend to like the smaller end of the private equity market, newer managers, lift outs, spin outs. We tend to find a lot of good value there.

But we are looking for somebody who says, OK, well, we're going to do a $500 million fund. And the next fund, it'll be 850. And then it'll be 1.2, and then one point-- somebody who's going to say, we're not going to just raise as much capital as we can and try to get it through the same filter. So making sure that the managers that we're aligned with are disciplined, that they spread their carry throughout the organization.

It doesn't have to be to every last person, but you have to have a reasonable sharing of that to make sure that over-- if we're going to have a 30-year relationship with somebody, we want the person that was hired today to still be there in 25 years if they're good, and they're doing their job. So we want to make sure that that person feels well compensated and is valued by their employer.

This is not a transaction. This is a partnership. And a lot of times when you talk to some money managers-- not JPMorgan-- but they're like to them, partnership means we buy more of their stuff. Well, that's not a partnership.

And so a partnership is looking for somebody where there's give and take. And so I have long-term reputation or long-term relationships with people here at JPMorgan that go back, since I was at my first public pension plan. And I actually worked with some people here to help do the first US universal account back in the mid 90s, when I was at a different public pension plan. And those are the kinds of things that partners do.

Williams: Right, innovation.

Carlson: Innovation.

Williams: And they do the innovation in a way. And I've done a lot of this over my career as well, and some of it with JP Morgan certainly. Finding a new idea that's of interest to both, there's no product, there's no strategy. It's undefined, but it's an opportunity. And so you think about it. You feel it. You look into it. You do diligence. You talk to your peers, and do all that jointly with us or whomever, and figure out something together that makes sense.

And I did a number of investments over the years where we provided the initial seed capital or something, had economics on it, benefited from it, and it worked great. And those long-term relationships, I think the key is alignment, putting the client first. And above all of that is unquestioned, unwavering integrity, and client comes first.

Carlson: Exactly. I think it comes back to the alignment because I've done many of those start up lift outs as well, doing the seeding for different products and strategies. And unfortunately, that's-- or I should say fortunately, that's a great time to get in and make sure that that alignment is good from day one.

When you're coming into a firm that's been doing it for 25 years, you tend to be more of a widget and less of a partner. Now that's not exclusively. You can still become a partner with a very experienced firm. But it takes that GP or that manager to want to be a partner and to not be an asset gatherer.

Williams: Well, yeah, and the truth of it is the ideal relationship has the combination of mutual trust that's earned over time, financial performance that's meritorious-- that those two things together motivate a growing relationship over time so that each party becomes important to the other because of the scale. And the only way the scale is justified is if those tests of integrity and investment merit are met. And then the other motivator is the shared creativity that creates something together that neither party could do alone.

Carlson: Correct.

Williams: And that is the secret to what's referred to historically here at JP as doing a first-class business in a first-class way, which by extension means with first-class partners. So thank you for your partnership. And thank you for being on the CIO Spotlight today.

Carlson: Yeah, great. Thanks for having me.

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