End of the line for Texas Growth Fund?

State investment pool may have run its course

By Robert Elder Jr.
Sunday, March 14, 2004

In 1991, the Texas State Employees Union boasted that it had stopped a "raid" of the state employees' pension fund.

An embezzlement scam? No, the union helped defeat a plan to invest a small chunk of retirees' money into an obscure entity called the Texas Growth Fund. Voters had approved the creation of the fund three years earlier as a vehicle for state pension funds to make private-equity investments — at the time, an exotic and little-understood way to invest.

Today, no one sees the fund as a foolhardy place to invest retirement dollars. Overall, state pension funds have invested $577 million, including $100 million from the state Employees Retirement System in 1998.

Still, the fund — the only one of its kind in the nation — may have outlived its purpose. State pension funds have plenty of options for private-equity investments, from venture capital funds to hedge funds, and a fair number produce higher returns than the growth fund.

The growth fund's investment performance is the issue these days. The $78 billion Teacher Retirement System of Texas, for instance, is refusing to invest any more money because of what it says are subpar returns.

That's bad news for the growth fund, which is having trouble raising a fourth investment pool. In addition, it will go out of business in 2008, 20 years after its creation, unless lawmakers reauthorize it.

But it's also powerful evidence of how state investment funds have come to accept so-called alternative assets in their portfolios. Except for the $19 billion Permanent School Fund, all the major state funds invest in private equity to diversify beyond stocks and bonds.

The employee and teacher systems commit a small percentage, less than 3 percent, of their fund to private equity. The University of Texas Investment Management Co., which manages the Permanent University Fund, is more aggressive, devoting about 25 percent to alternative assets.

Filling a need

The growth fund "is kind of a vestige of the late 1980s, a different time and cycle in Texas," says Jim Fonteno, a Houston investor and a trustee of the teacher retirement system. "Here we are now in the new century, and it's certainly a different time in the Texas economy."

The growth fund's managers say there is still a need for the type of investing they do: putting money only into companies with Texas headquarters or substantial Texas operations, which they say results in thousands of jobs in the state and attracts other investors.

"There are great opportunities in great businesses here," says James Kozlowski, president of Austin-based TGF Management Corp., the private company that runs the growth fund.

One recent example, he says, is the "killer deal" the fund made last summer when it paid $77 million for the ready-mixed concrete operations of British building company Hanson PLC. The fund acquired 63 concrete plants, which serve parts of Texas and Arkansas.

Kozlowski says the value of the plants and equipment alone is more than $100 million.

Yet the deal also underscores the constraints placed on the growth fund by lawmakers and its own board. For instance, the fund must have co-investors in each deal. Kozlowski said the Hanson deal is "one we would have loved to invest in by ourselves."

TGF had to bring in a co-investor — in this case, Austin Ventures, which put in 25 percent of the cost.

Further, TGF can't invest much in startups; its mandate is to focus on established companies with at least $15 million in annual sales.

Nonetheless, the growth fund has rewarded TGF Management. The management firm receives a fee based on the amount of money it manages and a percentage of profits. In the 10 1/2 years that ended Dec. 31, TGF Management had reaped $45.6 million in fees, or about $362,000 a month. The fees pay salaries, rent and the costs of investigating and closing deals.

A source of capital

The growth fund's roots date back to the slide in oil prices in 1982. The state's economy, closely tied to the Texas trinity of oil, cattle and cotton, had faltered. Real estate prices fell, and the savings-and-loan scandal exacerbated the economic decline.

By the mid-1980s, Texas businesses faced a capital crunch. State investment managers, meanwhile, wanted to diversify; in-house managers at the University of Texas System, who then ran the Permanent University Fund, started talking about a vehicle through which they could invest in private equity.

In 1987, lawmakers approved legislation authorizing state funds to put up to 1 percent of their portfolio into the growth fund. Out of an abundance of caution over the legality of private-equity investments, they put the plan before voters in a successful constitutional amendment election.

An executive search firm brought in Kozlowski, who was a managing director at Fortis Private Capital in New York. Kozlowski, in turn, called on an acquaintance in the private-equity business in Houston, Stephen Soileau, who joined the fledgling fund.

Kozlowski saw Texas as a frontier of private-equity investing.

"I used to joke that the building I was in in New York had more private capital in it than the entire state of Texas," he says.

That might not be an exaggeration. In 1990, the year the growth fund started to organize itself, Texas companies raised a mere $72 million in venture capital. Last year, the figure was $369 million.

Private equity used to have a rotten reputation among public funds, thanks to a scandal at the Kansas Public Employees Retirement System. In the late 1980s, the Kansas pension fund's investment managers lost hundreds of millions of dollars in secret investments in privately held companies.

Houston money manager Scott Caven, the growth fund's first chairman, says he initially opposed the creation of the fund while he was an economic adviser to then-Gov. William Clements.

Caven says possible political influence over investment decisions was one danger spot. Further, he said, "I don't believe in investing strictly for economic reasons," such as spurring development in certain parts of the state.

Initial fund raising was difficult. Opponents of the fund, Caven says, "felt like putting any money into private equity was like going down the highway and throwing money out the window of your car."

A mixed record

The growth fund closed its first investment pool of $52 million in 1992. A $75 million fund followed in 1996 and a robust $450 million fund closed in 1998.

A handful of companies the growth fund has invested in have gone public, including Kingwood-based Administaff Inc. and Classic Communications Inc. of Tyler. Last year, General Dynamics Corp. acquired network security company Veridian Inc., in which the growth fund invested $20 million.

Nonetheless, the fund's record is mixed. Its first investment pool has an estimated return of 21 percent. That puts it in the top 25 percent of venture-capital and private-equity funds.

The 1995 investment fund was something of a rush job. The money had to be invested by 1998, when the fund was up for its first reauthorization by the Legislature.

So far, its value has lost 15 percent, putting it in the bottom 25 percent.

The 1998 fund has returned about 2 percent so far, which is second-quartile performance, according to data from investment-tracker Private Equity Intelligence Publications.

The growth fund's overall returns are why investment staff for the teacher retirement system recommended against putting any more money into the fund.

Terry Ellis, chairman of the teacher system's board, told Kozlowski and Soileau at a Jan. 29 meeting that their performance wasn't in the top 25 percent of returns, where the teacher system likes to invest.

"I think it's — you know, just bottom line, guys, it's not first-quartile performance by any stretch of the imagination," Ellis said.

The bottom line

Although Kozlowski has made jobs a secondary selling point, pension fund trustees say returns are the dominant factor.

In his pitch to the Permanent School Fund last month, Kozlowski touted the 9,400 people employed by companies in which the fund invested.

Over the life of the growth fund, that's a small number. Experts say it's impossible to attribute the growth fund's investment as the main reason for those jobs; other funds could have invested instead.

"Any economist or serious analyst on regional economics would never attempt to attribute something as complex as job growth to one single variable," says Greg LeRoy, executive director of Good Jobs First, a Washington, D.C., advocacy group.

The fund has bettered the stock market. After fees, the estimated 2 percent return for the 1998 fund is nearly 5 percentage points above the S&P 500's return during the same period.

Kozlowski says his team will use that record, as well as comparisons against other private-equity funds, if TGF Management decides to raise an independent fund freed from state oversight and restrictions. A separate fund run by TGF could invest in the same types of companies, Kozlowski says.

Kozlowski says the restrictions may have hindered returns.

"But if we're out there, I think we should be judged like any other fund," he adds.

relder@statesman.com; (512) 445-3671

Texas Growth Fund

Founded: 1988

Managed by: TGF Management Corp., Austin

Employees: 13

President: Jim Kozlowski, Austin

Chairman: Michael Bell, San Antonio investor

Legal counsel: Vinson & Elkins

Amount committed to TGF: $577 million

Amount TGF has invested: $442 million

No. of companies invested in: 43

Year Amount raised Internal rate of return
1991 $52 million 21%
1995 $75 million -15%
1998 $450 million 2%

Sources: TGF Management Corp.; University of Texas Investment Management Co.

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