The Breakdown

Explaining Southern California's economy

Why was CalSTRS investing in gun company linked to Newtown massacre?

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36456 full

Just to lay it out for you:

• Adam Lanza, a disturbed young man, killed 20 children, his mother, and six other adults in Newtown, Connecticut on Friday before killing himself

• He used a "Bushmaster" automatic rifle, a civilian variation of the AR-15, a military rifle that traces its heritage to the M-16

• The company that owns Bushmaster, Freedom Group, is owned by Cerberus Capital Management, a prominent private equity fund that...

• Raised at least $500 million from the California State Teachers' Retirement System (CalSTRS) for a fund that invested in Freedom Group.

It's one of those gruesome loops – the serpent eating its own tail – that can only result from the intersection of private-equity, the huge pension funds that provide private-equity with money, and the imperative for funds like CalSTRS to hit their annual return targets.

Dan Primack at Fortune and Andrew Ross Sorkin at the New York Times (and on KPCC's "Take Two" Tuesday morning) have been chasing this story as it developed. The latest is that Cerberus, in swift fashion, announced early Tuesday morning that it plans to sell its Freedom Group stake. This occurred after CalSTRS announced that it was reviewing its investments with Cerberus.

But why was CalSTRS investing with Cerberus in the first place? 

Simple math. Like the much larger CalPERS state employee pension fund — $242.7 billion in assets — CalSTRS, with $154.8 billion under management, establishes annual return targets for its investments. CalSTRS currently expects 7.75 percent, a daunting goal at a time of stock market volatility and extremely low interest rates on bonds. 

This has compelled pension fund managers to make riskier investments. CalSTRS and CalPERS have "alternative" investments in their massive portfolios. Private equity and venture capital make up large chunks of these investments and funds like CalSTRS are anything but comfortable about transparently revealing the nature of the what kinds of companies its alternative portfolio is exposed to, as CalSTRS current disclosure policy demonstrates.

Unfortunately, venture capital, as I reported earlier this year, hasn't lived up to expectations. Private equity, on the other hand, has been supplying returns that far exceed targets — although since the financial crisis, CalSTRS has seen the performance in its alternative portfolio decline. On balance, says the fund's most recent disclosure, the return at 12.35 percent still beats that 7.75 percent target rate, even with VC in many cases dragging it down.

The issue here is that VC, made up of investments in entrepreneurial companies like Facebook, looks far more virtuous than private-equity chasing high growth markets in stuff like...civilian versions of weapons used to murder children and schoolteachers.

But the returns just aren't there. 

CalSTRS has over $38 billion invested in the private-equity and VC aspect of its portfolio, and on the "buyout" front — "private equity" is what we used to know as "leveraged buyout" and CalSTRS tends to still use that term — it's a who's who: besides Cerberus, you've got Bain Capital (Mitt Romney's old firm), Blackstone, the Carlyle Group, KKR, and a host of others.

If you're as big as CalSTRS, you're one of the first stops for private-equity tycoons looking to raise money. Pension funds are the lifeblood of private equity — more so now that the pension funds are under pressure to work with investment partners that can bring in the double-digit payouts (even if those returns are diminished by the fees that swashbuckling Wall Street investors charge, something I wrote about back in April).

And realistically, if CalSTRS expects to hit its return targets and take care of the retirements of the state's teachers, it's going to continue to invest in riskier, higher-yielding undertakings. The problem of course is that once it commits money to a private-equity fund, it's the fund's job to produce the return. That could mean moving in and out of companies at a brisk clip and not expecting an entity like CalSTRS to interfere with the business. 

That type of bargain leads to the extremely awkward position CalSTRS has now found itself in, as we continue to deal with the aftermath of Newtown.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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