EDUCATIONAL RETIREMENT BOARD INVESTMENT COMMITTEE March 13, 2014 (tambo aaasuseeCeSee Acti Paget APPROVAL OF AGENDA, Approved 2 APPROVAL OF MINUTES February 13, 2014 Approved 3 LONE STAR FUND X— OPPORTUNISTIC CREDIT {$100 million commitment 3 ORCHARD/BLACK FOREST- {$150 million commitment 6 OPPORTUNISTIC CREDIT ~ BURGISS PRIVATE | SOFTWARE CONTRACT Approved 9 WILSHIRE ATLAS SOFTWARE CONTRACT Approved 9 CONFLICT RISK NETWORK CONTRACT Approved 10 OTHER INV REPORTS AND DISCUSSIONS. Discussion 10 NEXT MEETING: THURSDAY APRIL 10, 2014MINUTES OF THE NEW MEXICO EDUCATIONAL RETIREMENT BOARD INVESTMENT COMMITTEE March 13, 2014 1. a. Call to Order ~ Quorum Present ‘A meeting of the New Mexico Educational Retirement Board Investment Committee was called to order on this date at 12:00 p.m. in the Educational Retirement Board Conference Room, 6201 Uptown Boulevard, N.E., Ste. 203, Albuquerque, New Mexico. Members Present: Mr. H. Russell Goff, Chair Ms. Mary Lou Cameron Mr. Larry Magid Dr. Thomas McGuckin Members Excused: None. Staff Present: Ms, Jan Goodwin, Executive Director Mr. Rick Scroggins, Deputy Executive Director Mr. Bob Jacksha, CIO Mr. Mark Canavan, Real Estate Portfolio Manager Ms. Kay Chippeaux, Portfolio Manager Mr. Steve Neel, Deputy CIO Ms. Kelley Koehler, Investment Financial Analyst Others Present: Mr. Allan Martin, NEPC Mr, Dan LeBeau, NEPC [by telephone] Mr, Steve Gruber, RAPM [by telephone] ‘Ms. Charmaine Clair for Judith Beatty, Recorder b, Approval of Agenda Dr. McGuckin moved approval of the agenda, as presented. Ms. Cameron seconded the motion, which passed unanimously by voice vote. New Mexico Educational Retirement Board 2 Investment Committee: March 13, 2014©. Approval of Minutes: February 13, 2014 Dr. MeGuckin moved approval of the February 13 minutes, as submitted. Mr. Magid seconded the motion, which passed unanimously by voice vote. Introduction of Guests Guests were introduced. 2. LONE STAR FUND IX~ OPPORTUNISTIC CREDIT. Ms, Chippeaux and Mr. Martin addressed this item. Mr. Gruber was present by telephone. Mr. Jacksha noted this is for the credit portfolio only and will not be part of the real estate portfolio, as that sector is full, so he appreciated Mr. Gruber providing some additional insight into, Lone Star. ‘Ms. Chippeaux noted that the ERB has previously invested in several other Lone Star funds, mostly in real estate, although in the most recent fund the ERB also included credit opportunities. ‘The total committed investments to Loan Star across all the funds are $200 million and $111 million has been drawn to date. Lone Star Vill, the last commitment, is about one third drawn and expects almost 100 percent of that capital to be committed in the very near future. Ms. Chippeaux reviewed the highlights of Lone Star Fund IX and staff's recommendation of a $100 million commitment. ~ Lone Stars a private equity firm headed by John Grayken. They invest in distressed assets globally, mostiy real estate oriented. Lone Star 1X will focus on noncommercial real estate loans and securities, and other financially oriented asset-rich operating companies. ~ These investments include distressed whole loans, nonperforming loans and structured products. ~ Lone Star IX will focus in North America, Europe and Japan and is supported by Hudson Advisors and Caliber Home Loans, both wholly owned either by Mr. Grayken or by other Lone Star funds. These two organizations support the fund's investment activities and provide due diligence and analysis, asset management and servicing, along with other support services. ~The fund is expected to be $7 billion in size, with 40 percent in the US, 50 percent in Europe and 10 percent in Japan. -- The investment period is expected to be three years from final close and the term is eight years from final close, with two one-year optional extensions. ‘New Mexico Educational Retirement Bo2rd 3 lavestment Committee: March 13, 2014~The strategy is to take advantage of the regulatory requirements in the banking sector and the deleveraging in the US and Europe. They feel this will continue to provide investment opportunities over the next several years. ~ Relationships with major banks in prior investments will help source investments. ‘The size of the fund may give an advantage in its ability to bid discreetly and do large deals. ‘Two subsidiary units are expected to help Lane Star Management understand changes in the market, asset performance, loans to value and pricing of evaluations they bid on. ~The General Partner expects to make 1 percent of commitments plus an additional $350 million of Mr. Grayken’s personal funds. Mr. Martin noted the memo from NEPC states that this will reside in the credit opportunity art of the ERB portfolio, or roughly $2 billion out of $10 billion. Over the next several months. however, money will come back to the ERB from prior investments, including PIMCO DiSCO, so this will replace maturing or redeemed capital returned from successful investments. Mr. Martin said Lone Star has been a proven expert in investing in primarily distressed real estate related loans; particularly single-family residential, The ERB has been investing with them for a long time in its real estate allocation. Mr. Martin highlighted the positive points of this investment plus issues of concern, as reflected in NEPC’s memorandum. Responding to a question by Ms. Cameron, Mr. Gruber said Lone Star employs about 1,000 people, and within that are regional heads and below that acquisition and management professionals. In addition, there are another 2,000 people within Caliber, so this is an enormous financial operating company. If something were to happen to Mr. Grayken, the investment period (other than what is in the pipeline) comes to a halt, and it is up to the investors to vote on whether oF not to proceed. A committee made up of the principals, general counsel plus the president of Hudson would take them through the liquidation of the funds. He added that, if there were Fund X ‘and Mr. Grayken were not included, RAPM would think a lot harder about it than with Mr. Grayken included. Responding to Mr. Magid, Mr. Jacksha said Lone Star employs leverage in two ways: @ warehouse line initially buys the loans for timing purposes and they also often get financing from the seller, often on favorable terms, Ms. Chippeaux added that the limit on leverage is 3x the committed capital. Chair Goff noted that this manager was not approved through NEPC’s Due Diligence Committee. Last month, NEPC brought forward an investment recommendation for Marathon European Credit Fund Il, which also had not been approved by that committee, and this is also the case with Black Forest, next on today's agenda. He asked if this is becoming a pattern. New Mesico Educational Retirement Board 4 Investment Committee: March 13, 2014‘Mr. Martin said no. Black Forest is an exclusive offering and they are only willing to give NEPC clients $400 million out of an overall $1 million fund. For a fund of that size, itis not beneficial for NEPC to do the full work necessary to place them on the Focus Placement List when there are only three or four clients involved. He said it doesn’t mean they don’t like them or don’t endorse them. ‘The situation with Lone Star is similar in that NEPC has a very limited number of clients who will be participating in the fund. Lone Star is a real estate oriented investment that NEPC looked at because Of ERB’s interest. Thus, like Black Forest, NEPC did not take the extra steps to place Lone Star on. their internal Focus Placement List. Ms. Goodwin commented to Mr. Jacksha and Mr. Gruber that one of the things she came across when reading the NEPC and RAPM memos was that both express concern about a lack of ‘transparency, While in earlier funds Mr. Grayken and his firm tried hard to be transparent, it now appears that they have shut the door. She asked them to describe the mitigating factors and why they are comfortable with that. Mr. Jacksha responded that the due diligence process seems much more closed than before, largely because their performance has been good and they are less inclined to open the process up to everyone. He said a mitigating factor is that the ERB sits on the advisory committee for funds it invests in and will get a seat on this one, as well. He said there is a lot of transparency given to the advisory board members in terms of investments opportunities, the personnel issues and organization issues, and so forth. He said they get a good deal of data and he is comfortable with that. Mr. Gruber commented that without the advisory board seat, it would have been a challenge. Mr. Jacksha agreed with Mr. Gruber. Lone Star representatives John Grayken (by telephone} and Benjamin Sarly joined the proceedings and made a presentation. Following the presentation, Mr. Grayken and Mr. Sarly left the proceedings. Mr, Jacksha said a key item touched on during the presentation is buying the assets; if you buy them at a 20-30 percent discount to foreclosure value, then there is flexibility, and the first course of action is to renegotiate with the borrower. If the price is right, there is a nice profit. Mr. Jacksha sald this is related to the other two key items, which is that they are able to this ‘through a big servicing organization, Hudson, which is an integral part of this. While this has been referred to as distressed debt, it is really generally nonperforming loans, where people are not making payments. He said Lone Star has a huge network through Hudson that renegotiates and ties, to the third key ~ because of the company's size and servicing, they get a lot of information and know the values in a given area, That is an advantage to banks that want to unload large packages of loans or securities Mr. Jacksha commented that Lone Star is one of the best, if not the best, in this marketplace. Mr. Jacksha noted that there is no placement agent and there are no relevant campaign contributions. ‘New Mexico Educational Retirement Board 5 Investment Committee: March 13, 2014Ms. Cameron moved that the Investment Committee approve a commitment of $100 million to Lone Star IX, LP. The commitment is subject to New Mexico State Law, Educational Retirement Board policies, and negotiation of final terms and conditions and completion of appropriate Paperwork. Dr. McGuckin seconded the motion, which passed unanimously by voice vote. ORCHARD/BLACK FOREST ~ OPPORTUNISTIC CREDIT Ms. Chippeaux said Orchard Global Asset Management, one of the ERB’s current investment managers for EleganTree, manages Black Forest. The ERB has committed $200 million to EleganTree, a bank recapitalization fund, and $142 million has been drawn to date. Ms. Chippeaux said the Black Forest opportunity is focused on global direct lending to middle- market companies and is partnering with a global systemically important bank to receive deal flow from the US, Asia and Europe. Orchard will use the bank’s sourcing, structuring and risk ‘management and the bank will be invested alongside the fund, These will generally be opportunities when an operating company is unable to address standard or capital market solution, and the bank will continue to monitor the fund for material changes or problem situations. Ms. Chippeaux stated that the target fund size is $500 million to $1 billion and the investment period is two years from the final close; the term will be eight years from the final close with two optional one-year extensions. The general partner has committed at least $5 million to the fund and ERB staff recommends a $150 million commitment, Mr. Martin said Orchard EleganTree has earned 14 percent per annum since thelt inception in March 2012. He discussed how Orchard succeeded where others failed, While alot of people were buying loans from the banks, what they missed was that the banks did not have enough profit to sell the loans. Orchard went after the bank ‘recap’ trade and offered to provide credit enhancement to a bank’s existing loan portfolio. Because ofthat, the regulators would reduce thelr capital requirement. The cost of that was 10-12 percent, and the banks were happier to pay that to the investors rather than selling assets. Mr. Martin said Orchard has worked with a number of large banks and in the last year did so ‘much business with a large bank that they pulled the team aut of the bank. Within the last year or so, the bank approached Orchard and said they wanted to continue to be in this middle-market, asset-based lending business around the world, but needed a group of sophisticated investors to Invest with them and raise about $1 billion in a private transaction. Mr, Martin commented that the loans would be asset-based loans in the $40 million range and too complicated for a local bank to do on their own. They are not big enough for the big global lenders such as J Morgan, so there is a niche. Mr. Martin reviewed the strengths and risks associated with this strategy. He commented that if the bank were to get into trouble and need to pull back from lending, they would be less involved in doing this business. Mr. Jacksha added that an important point is that the bank will retain a piece of each loan and thus continue to have “skin in the game.” New Mexico Educational Retiement Board 6 Investment Committee: March 13, 2014Mr. Jacksha noted another risk mitigantis that the majority wil be first lien loans and some recovery would be expected, Orchard representatives Paul Horvath, John Young and Michael Ford introduced themselves and made a presentation, Mr. Horvath said he wanted to answer a question often asked, which is how long is the opportunity going to last. Orchard feels that bank deleveraging would take a long time. He shared “big picture numbers: the US bank system assets are about $17 trillion and the USGDP is about 1x, but Europe is about 3.5x. Mr. Horvath noted that Black Forest is given full transparency on everything being done with the group within a loan to a corporate entity/group. Mr. Young said they are targeting high quality lending opportunities. They try to focus on cash flow strategies and hope to get money back within 3 to 5 years along with pensions that have requirements for longer-term steady cash flow. Ms. Chippeaux asked Orchard to discuss their due diligence on the bank staff and their ability. to work out problems. Mr. Young responded that Orchard has @ number of strong banking relationships though EleganTree, and looked at banks with a strong legal structure and more robust security packages. A bank in Europe had the best quality in terms of background and legal. Orchard wants to work with a partner that has had experience with defaults. This bank has not had a lot of defaults, but their senior person came out of emerging markets and had experience working out claims successfully. Ms, Chippeaux asked if there was a backup plan if for some reason the other bank exited the business, Mr, Young responded that this fund allows Orchard to look at other opportunities. Orchard always has the ability to take over any loan they are invested in and in the case of new loans they ‘can make sure the borrower acknowledges their presence in the transaction and always have take over rights. Mr. Martin asked the status of the fundraising activity. Mr. Horvath responded that Orchard expects over two closes to achieve $750 million to $1 billion. If ERE joins, they feel the first close ‘would be $200 to $500 million, Rather than delay the first close to get to a certain size, because there is cyclicality to the business, they had set a minimum around $300 million and they are two thirds of the way there. There is a lot of excitement around the second close, so they feel confident that they can reach that. Mr. Young added that Orchard is anxious to get this moving and t the maximum target in order to access the opportunity. west, and would sacrifice [Orchard representatives left the meeting.] New Mexico Educational Retirement Board 7 Investment Committee: March 13, 2014Mr. Jacksha commented that what Orchard initially does is provide bank regulatory relief, which involves two areas of skill. One is looking at a pool of assets and doing a credit analysis on the pool and then building a legal structure around that. They have shown they have the talent to accomplish this task; and they are a good partner to work with, and the terms are very favorable to ERB, Mr. Jacksha said he is definitely in favor of this investment. It Is on the lower end of risk and return in the opportunistic credit portfolio as opposed to Lone Star where the return might be more, but there is more risk in nonperforming loans. Ms. Chippeaux noted that she received a detailed description of what is going on with the bank and the risk management that would be done, She thought Orchard had picked a good partner and there would be a lot of professional monitoring. Mr. Martin said the thesis makes a lot of sense, but he is concerned about the fundraising, and ‘the statement that Orchard is two-thirds there with the ERB being in the lead with $150 million. He commented that this is slower going than he would have thought. That doesn’t create a problem, but just means it won't gain the legs and leverage. Mr. Jacksha said he would prefer that the documents state that any individual credit be no more than X percent of the total fund, He noted that this is common in private equity contracts, as. well, Mr. Martin said he felt a condition of approval should be that the ERB doesn’t want to be the only investor or half investor. ‘The committee discussed the terms and limits Mr. Jacksha said he would work with Orchard to come up with terms of the committed capital and no individual credit would exceed 15 percent of the fund. Ms. Chippeaux said another issue is to determine the minimum level of the entire fund, Mr. Martin said that is an issue and the Board should be concerned. He said they could make their commitment contingent on $500 million [Break] Orchard representatives returned to the proceedings. Mr. Jacksha said he talked with them during the break about the concern about credit concentration and that no loan be too much of the fund. He said Orchard had already contemplated that and agreed to a 15 percent limit and that ‘would go into the PPM document. Mr. Jacksha said the second concern is the fund raise and the size of the fund. Currently Orchard has $195 million raised, without ERB's portion, and if approved would be at $345 million. He asked if that would work for the bank. Mr. Young said the initial conversation with the bank was raising a fund of $300 million total and that evolved. He said it was Orchard driving the fund size and looking at the size of the opportunity. The bank is not worried about it and is happy to move forward. New Mexico Educational Retirement Board 8 Investment Committee: March 13, 2018Mr, Horvath sald the first close they want to achieve $300 million and if everyone comes in, including ERB, the number could be over $500 million. Mr. Jacksha confirmed that it wasn't a problem if the committee approved a commitment of $150 million contingent on a total close of $300 million [Orchard representatives left the eating.) Dr. McGuckin moved that the Investment Committee approve a commitment of $150 million to the Black Forest Structured Lending Fund Ltd. The commitment is subject to New Mexico State Law, Educational Retirement Board policies, negotiation of final terms and conditions and. completion of appropriate paperwork; and that the fund has a total of at least $300 million in committed capital, including the ERB investment, Mr. Magid seconded the motion, which passed unanimously by voice vote. 4, BURGISS PRIVATE | SOFTWARE CONTRACT Mr. Neel presented staff's recommendation that the ERB approve the continuation of the current master service agreement for the Burgiss Private | software system (Private |). The system has been in place since 2007 and costs about $45,000 a year and steps up based on the number of ERB commitments. ‘There is a possibility with the new custodian-bank contract this may be rendered redundant. Mr, Neel said he asks authorization at this point to approve a four-year term; each year to be renewed annually. If this does become redundant, ERB would not be obligated for all four years. Mr. Magid asked if the system is prorated each year. Mr. Neel replied he didn't think it was. Dr. MeGuckin moved that the investment committee approve the continuation of the master service agreement with Burgiss Private | for a period of up to four years, renewable annually, subject to, and contingent upon New Mexico State Law, Educational Retirement Board policies, and negotiation of final terms and conditions and completion of appropriate paperwork. Mr. Magid seconded the motion, which passed unanimously by voice vote 5, WILSHIRE ATLAS SOFTWARE CONTRACT Ms. Chippeaux said the ERB has had this contract for more than four years and staff asks approval for continuation of service with this vendor. She noted that Wilshire provides an equity analytical service and ERB has used them since 2007. This is a license to optimize the S&P 500 and the Wilshire REIT, which ERB internally manages. This service tells ERB what securities to buy or sell to match the portfolios to the benchmark and helps determine if they are within the tolerances or if changes are needed. ‘New Mexico Educational Retirement Board 5 Investment Committee: March 13, 2014Ms. Chippeaux noted that Wilshire Atlas is considered a sole source provider; no other provider does exactly what Wilshire does, The license fee is a little over $38,000 a year and the contract expires July 31, 2019, but renews annually. The contract can be terminated with 90 days notice. Ms. Cameron moved that the Investment Committee approve the continuation of the license for Wilshire Atlas for a period of up to four years, renewable annually, subject to, and contingent upon New Mexico State Law and Educational Retirement Board policies, Mr. Magid seconded the ‘motion, which passed unanimously by voice vote 6. CONFLICT RISK NETWORK CONTRACT Ms. Chippeaux said this is another service contract provider staff asks to continue with. Ms. Chippeaux stated that Board adopted a policy that there not be direct investments of ‘companies that do business in Sudan; in particular, the Investment Policy states they will use the Sudan Company Report, published by the Genocide Intervention Network, doing business now as IRIS Conflict Risk Network. She said initially IRIS waived the fee for four years. Last year the contract was negotiated at $3,000 and this year the fee was negotiated to a graduated fee and would raise the fee $500 per year. Ms. Chippeaux said this is a sole source provider specified by the Board to provide the service and staff asked approval to continue the service at the stated fee level Dr. McGuckin asked about the chance of having an investment in Sudan, Mr. Jacksha said there is at least one company that an emerging market manager would have invested in had it not been for this policy; but the policy precludes very few Investments. Ms. Chippeaux said the report used to be sent only to equity managers, but this year started sending to all managers with separately managed accounts. This year a fixed income manager had an investment in a prohibited company and had to divest themselves, Mr. Jacksha clarified it is not the equity of a company actually located in Sudan; it could be a US or Chinese company with business in Sudan, Mr. Jacksha added the policy doesn’t handcuff ERB and changes the Investment outcome very little. Ms. Chippeaux added a lot of asset firms do this or something similar. Ms. Cameron moved to approve the continuation of service under the current membership ‘agreement for access to Conflict Risk Network materials and secure server database for a period of up to four years, renewable annually, subject to, and contingent upon New Mexico State Law, Educational Retirement Board policies, and negotiation of final terms and conditions and completion of appropriate paperwork. Mr. McGuckin seconded the motion, which passed unanimously by voice vote New Mexico Educational Retirement Board 10 Investment Committee: March 13, 20147. OTHER INVESTMENT REPORTS AND DISCUSSIONS Mr. Jacksha said the committee might have read some of the fallout from PIMCO recently in the Wall Street Journal saying that Bill Gross was difficult to work with, He said specific to the ERB investments there are two; PIMCO DISCO, which is run by Dan lvascyn and a team of people that does not include direct involvement by Bill Gross. The second is the PIMCO All Asset All Authority Fund, which has some exposure to Bill Gross but is mainly run by Bob Arnott, whose firm, Research Affiliates, Is a sub-advisor. It invests in PIMCO funds, some of which have exposure to Bill Gross. Obviously, ERB will watch the organization in general, but at this time he has no major concerns. Mr. Martin said his main concern is that PIMCO is in Newport Beach, which is in Orange County, and Orange County has many investments with PIMCO. One of them is in an absolute return bond fund, which NEPC is concerned about and will recommend that they be put on the watch list. Ms. Chippeaux noted that the Board at the last meeting asked staff to look at fixed income ETFs. She prepared a spreadsheet that compares the three most liquid ones that were on Bloomberg. She pointed out the liquidity is not as obvious as it looks. She explained when someone is buying $1 billion worth of fixed income ETFs, for example, the buyer would be charged the transaction costs associated with creating additional ETF shares, which is an expense over and above the ongoing ETF management fees. Mr. Jacksha added that the estimate included the market impact and would be another 6 basis points each way. Mss. Goodwin said they were asked to look at ETFs to compare the costs of hiring two people internally to run a fixed income portfolio as opposed to outsourcing and having an ETF Mr. Jacksha said that the expense ratio at 10 basis points would be equal to $1 million. Ms, Goodwin pointed out that this doesn’t include the bid-ask spreads. 8, NEXT MEETING: THURSDAY, April 10, 2014 ‘The meeting was tentatively scheduled for 12:00 p.m. ADJOURN. Its business completed, the Investment Committee adjourned the meeting at 3:35 p.m. Accepted by: New Mexico Educational Retirement Board u Investment Committse: March 13, 2014—Accepted by: New Mexico Educational Retirement Board Investment Committee: March 13, 2014