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COMMENTARY 70
SNEAKTNG AN ELEPHANTACROS S A PIJTTING GREENi A IRANSITION CASE STUDY
This commentarv describes the before, during and post-mortem process of what is perhaps the largest portfolio
transition ever executed in a concentrated time frame. The presentation was given at the 8th Plexus Group Client
Conference, featurinq Plexus' Steven Glass moderating, Paul Ballard, Executive Administrator of the Texas
permanent School FJnd, and Alan Rubenfeld, Director of Deutsche Bank Alex. Brown, which handled the bulk of
the transition trading.
ln October 2000, the Texas Permanent School Fund ("PSF") exe-
cuted a $17.5 billion portfolio transition - perhaps the largest potl-
folio transition ever executed in a concentrated time frame.
Oper"ationally, ihe PSF's transition involved 40 asset managers,
2,200 securities, 20+ countries, and 500 million shares.
PSF awarded a first tranche of $2.5 billion to Morgan Stanley
Dean Witter who executed the trades on an agency basis. Post-
mortem analysis was favorable. In early January 2001, the PSF
solicited competitive bids from three transition management firms
to execute the larger, far more difficult remainder. Ultimately, the
PSF selected a hybrid proposal from Deutsche Bank under
which 90% of the portfolio was traded on a pnncipal basis and the
remaining 10% (US small/mid cap stocks)traded agency.
The total loss of asset value incurred on the PSF transition was
66 bp. While this compares very favorably against Plexus' Post-
trade PAEG/L Benchmark of 97 bp, Steve cautioned that trading
is still more art than science. A better measure of the transition's
success was reflected in the process and structure of the PSF's
strategy.
Transitions typically present plan sponsors with multiple imple-
mentation alternatives, each with strengths and weaknesses. As
such, the development of a prudent transition strategy is one of
choices and trade-offs. For the PSF transition, the person who
made those choices was Paul Ballard, Executive Administrator of
the PSF. On the Sell-side, Alan Rubenfeld coordinated the think-
ing, which drove Deutsche Bank's bidding and execution.
Strategic Cancerns
Paul Ballard began by discussing his strategic policy level con-
cerns. These issues represented considerations, the resolutton
of which would overlay the PSF's tactical (execution-oriented)
policies. They included [1] the need to minimize loss of asset
value, [2] the involvement of multiple legacy and target managers,
[3] the operational and administrative burden on the PSF's staff,
[4] the internal politics often present in a public plan, and [5] the
recognition that PSF ran a risk of being viewed as a "one night
stand" with no on-going relationship to the broker.
Paul stressed that while the PSF could certainly have used the
$10-15 million or so in soft-dollar credits associated with trading
500 million shares, he was not prepared to jeopardize execution
efficiency. Since the PSF was not permitted to use futures or
ETF's to maintain market exposure, he felt the need to consider
principal bids and/or firms capable of executing complicated dol-
lar-neutral strategies.
The fact that the transition involved multiple managers presented
Perf ormonce
APRIL 2OO2
several concerns. Various managers would be ready for funding
before others. However, rather than funding each manager as
they completed their paperuuork, Paul felt that any advantages of
funding the managers ptecemealwould be more than offset by [1]
tne cjisruption io ongorn$ iirvestmeni siraiegies, [fi ieakage oi
information regarding the large sell portfolio which was funding
the new managers, [3] increased market-impact as multiple man-
agers bought common securities and sectors, and [4] diminished
opportunities for crossing. Consequently, Paul decided to wait
until all new managers were ready, even if it meant delaying the
imolementation of the PSF's new asset allocation.
Paul was also aware that the sheer size and complexity of the
transition would exacerbate the normal strain on staff and transi-
tion manager resources. He therefore was attracted to the idea of
a principal trade, which would complete everything at once. He
also recognized the need to work with transition managers that
had the technology and human resources necessary to handle
large complicated transitions - and proven track records.
As with many public plans, the PSF was not without internal poli-
tics. The fact that the transition would be implemented in a "fish
bowl" environment only heightened the need for prudent strate-
gies and policies. As a neutral third-party expert, Plexus enjoyed
the confidence of both trustees and staff, and its retention was a
key ingredient in providing the necessary comfort to all parties.
The PSF was concerned that the size of their transition might
tempt the bidding firms to act in ways that would not be in the best
interest+ of the PSF. While ihis is a risk to buy-side firms as well,
those firms can always take their business elsewhere. For the
PSF, there would not be another time. To address this concern,
Paul considered only those firms with long and substantial track
records as transition managers - those who had "franchise risk"
if things fell apar1. He also felt the need to retain Plexus, not only
for its experlise, but to piggyback on its ongoing relationships with
brokers as a Transition Consultant. While the Transition
Managers might not see a lot of subsequent transition business
from PSF, Plexus routinely called upon them for transitions with
other plan sponsors. In this fashion, Paul Ballard was able to
'rent' Plexus' continuing business.
Tactical Maves
From a tactical execution perspective, the PSF faced several
additional challenges. These included [1] the optimal parsing of
the transition portfolio so as to minimize costs, [2] identifying the
Transition Management firms best suited to PSF's transition, [3]
structuring the bidding process so as to encourage aggresslve
bids thus minimizing leakage of information, and [4] evaluating
the bids.
With respect to parsing the portfolio, a key factor was that most
of the selling would come from one very large account.
Consequently, Paul felt it was unrealistic to utilize more than
one Transition Manager, since there would be no way to avoid
unnecessary leakage of content without also disrupting the tim-
ing and holdings of the liquidating portfolio. However, the port-
folio lent itself to splitting into pieces that could be executed with
different trading techniques. So the PSF was open to hybrid
proposals from bidders
In identifying the most appropriate Transition Managers, Paul
Ballard's interest in principal bids limited the field to a handful of
firms. Of these, Paul utilized Plexus' broker database to assess
each firm's order flow country by country. Into the stew went the
PSF's and Plexus' past experiences with different brokers. In
this manner, if the principal bids were unattractive, the PSF was
ready to immediately award the transition to the firm best qual-
ified to do the job on an agency basis.
Keeping Secrefs
The PSF was acutely aware that the likelihood of receiving
aggressive bids depended on the comfort level of the bidders
that their interests would be protected. The degree to which
firms felt other bidders could "shoot" against them if they won,
would be reflected in their bids. Paul Ballard therefore wanted
to provide a structure that would help protect the firm that was
awarded the trade. This was accomplished by establishing a
10-day window during which the trade would be awarded.
While bidders could refresh their bids as often as they wished
throughout the '10-day period, only the winner would be notified
that they won. Losing bidders would not be notified until after
the window exoired. The PSF was under no illusions as to the
absolute effectiveness of this strategy, but felt it introduced
enough uncertainty to protect the winning broker.
A related concern was the minimization of information leakage.
From both past experiences as well as pretransition meetings
with the bidders, the PSF developed a healthy paranoia regard-
ing the need for maximum secrecy. This manifested itself in
several unorthodox policies.
First and foremost, Plexus was identified as the sole point of
contact regarding the transition. All communications to, or from,
lhe FSF weni thi-ough Piexus. Seconci, the PSF's securities
lender was not notified until after the transition. Third, the PSF's
custodial bank was instructed to ooen a transition account and
provide guaranteed lists five days before the window began.
Each day thereafter, the bank was required to fonruard an updat-
ed guaranteed list each morning. In this manner, the bank knew
a transition was in the offing, but not when. Perhaps most con-
troversial of all, the bank was not informed until after the transi-
tion was awarded. While the bank was understandably per-
turbed at the late notice and conseouent need to scramble in
order to process the trades, Paul felt the additional secrecy jus-
tified such action. To the bank's credit, virtually every trade
cleared and settled pedectly.
In anticipation of receiving agency, principal and hybrid propos-
als, the PSF ran Plexus'cost estimates on the aggregate port-
folio as well as numerous sub-portfolios. In this manner, PSF
could make applesto-apples comparisons between various
bids. Further, each analysis provided a range of potential costs,
driven by potential market conditions. This enabled the PSF to
understand and identifv their risk in relativelv flat markets, as
well as their down-side risk if markets moved against them.
Given the size of the transition, even an unlikely outcome rep-
resented many millions of dollars in additional costs, so Paul
was hopeful that a principal bid would "lay off'the more expen-
sive worst-case scenarios onto the transition agent.
Once the trade was awarded, the PSF released the security
names by region after the close of each respective market.
Foreknowledge by the winning bidder (that they had won, not
the actual names), allowed the building of futures positions
throughout the day, thereby lessening market-impact on closing
nnaaQ
Broker Perspective
Following Paul Ballard's remarks, Alan Rubenfeld shared the
thinking of Deutsche Bank Alex Brown in submitting the winning
bid. The factors and considerations which drove Deutsche
Bank's pricing fell into four major areas:
1) As an institution, Deutsche Bank has an "appetite" for prin-
cipal bids (clue to a combination of their ability to menage
risk and the trading backgrounds of their senior manage-
ment);
2) As a general rule, Plan Sponsor transitions are "informa-
tion-less" trades;
3) The unique features of PSF's transition structure, the infor-
mation "lock-down," 1O-day bidding window, and willing-
ness to share risk through use of hybrid trading arrange-
ments);and
4) Pre-existing comfort and trust with Plexus as a transition
advisor.
After discussing bidding considerations, Alan noted that the
transition was a huge operational success as well. In this
regard, Deutsche Bank worked with the PSF in advance to
develop communication formats, Deutsche Bank dedicated
personnel for each stage of the transition, and established
intensive communication with both the PSF and their custodial
bank. Back-office personnel worked through the night to
process the heavy volume of trades.
Notwithstanding the lack of advance notice by the custodial
bank, the transition settled with virtually no difficulties.
To summarize the entire experience, in many respects the PSF
transition broke new ground. Key ingredients to success were
mutual trust, creative design, and communication.
While the costs incurred on the transition beat their Benchmark
by significant margins, the true measure of success was the pru-
dent process and structure established by the PSF. Anecdotal
evidence of the strategy's effectiveness include the fact that the
day following the transition, two major program trading firms
repoded that the prior day had been "boring, with little noticeable
activity." Further, one week after completion of the transition, two
other major program trading firms were still marketing their serv-
ices in hopes of participating. Perhaps the bottom-line measure
of success was: Paul Ballard kept his job.
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