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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 Texaspermanent School FJnd, and Alan Rubenfeld, Director of Deutsche Bank Alex. Brown, which handled the bulk of

the transition trading.

Building Belter Perf ormonce

APRIL 2OO2COMMENTARY 70

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 StanleyDean Witter who executed the trades on an agency basis. Post-

mortem analysis was favorable. In early January 2001, the PSFsolicited competitive bids from three transition management firmsto execute the larger, far more difficult remainder. Ultimately, the

PSF selected a hybrid proposal from Deutsche Bank underwhich 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 was66 bp. While this compares very favorably against Plexus' Post-

trade PAEG/L Benchmark of 97 bp, Steve cautioned that tradingis still more art than science. A better measure of the transition'ssuccess was reflected in the process and structure of the PSF'sstrategy.

Transitions typically present plan sponsors with multiple imple-mentation alternatives, each with strengths and weaknesses. Assuch, the development of a prudent transition strategy is one ofchoices and trade-offs. For the PSF transition, the person whomade 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 resoluttonof which would overlay the PSF's tactical (execution-oriented)policies. They included [1] the need to minimize loss of assetvalue, [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] therecognition that PSF ran a risk of being viewed as a "one nightstand" 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 trading500 million shares, he was not prepared to jeopardize executionefficiency. Since the PSF was not permitted to use futures orETF's to maintain market exposure, he felt the need to considerprincipal bids and/or firms capable of executing complicated dol-lar-neutral strategies.

The fact that the transition involved multiple managers presented

several concerns. Various managers would be ready for fundingbefore others. However, rather than funding each manager asthey completed their paperuuork, Paul felt that any advantages offunding the managers ptecemealwould be more than offset by [1]tne cjisruption io ongorn$ iirvestmeni siraiegies, [fi ieakage oiinformation regarding the large sell portfolio which was fundingthe new managers, [3] increased market-impact as multiple man-agers bought common securities and sectors, and [4] diminishedopportunities for crossing. Consequently, Paul decided to waituntil all new managers were ready, even if it meant delaying theimolementation of the PSF's new asset allocation.

Paul was also aware that the sheer size and complexity of thetransition would exacerbate the normal strain on staff and transi-tion manager resources. He therefore was attracted to the idea ofa principal trade, which would complete everything at once. He

also recognized the need to work with transition managers thathad the technology and human resources necessary to handlelarge 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 enjoyedthe confidence of both trustees and staff, and its retention was akey ingredient in providing the necessary comfort to all parties.

The PSF was concerned that the size of their transition mighttempt 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 thePSF, there would not be another time. To address this concern,Paul considered only those firms with long and substantial trackrecords as transition managers - those who had "franchise risk"

if things fell apar1. He also felt the need to retain Plexus, not onlyfor its experlise, but to piggyback on its ongoing relationships with

brokers as a Transition Consultant. While the TransitionManagers might not see a lot of subsequent transition businessfrom PSF, Plexus routinely called upon them for transitions withother plan sponsors. In this fashion, Paul Ballard was able to'rent' Plexus' continuing business.

Tactical Maves

From a tactical execution perspective, the PSF faced severaladditional challenges. These included [1] the optimal parsing ofthe transition portfolio so as to minimize costs, [2] identifying theTransition Management firms best suited to PSF's transition, [3]structuring the bidding process so as to encourage aggresslvebids thus minimizing leakage of information, and [4] evaluating

the bids.

With respect to parsing the portfolio, a key factor was that mostof the selling would come from one very large account.Consequently, Paul felt it was unrealistic to utilize more thanone Transition Manager, since there would be no way to avoidunnecessary 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 withdifferent trading techniques. So the PSF was open to hybridproposals from bidders

In identifying the most appropriate Transition Managers, PaulBallard's interest in principal bids limited the field to a handful offirms. Of these, Paul utilized Plexus' broker database to assesseach firm's order flow country by country. Into the stew went thePSF's and Plexus' past experiences with different brokers. Inthis manner, if the principal bids were unattractive, the PSF wasready 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 receivingaggressive bids depended on the comfort level of the biddersthat their interests would be protected. The degree to whichfirms felt other bidders could "shoot" against them if they won,would be reflected in their bids. Paul Ballard therefore wantedto provide a structure that would help protect the firm that wasawarded the trade. This was accomplished by establishing a10-day window during which the trade would be awarded.While bidders could refresh their bids as often as they wishedthroughout the '10-day period, only the winner would be notifiedthat they won. Losing bidders would not be notified until afterthe window exoired. The PSF was under no illusions as to theabsolute effectiveness of this strategy, but felt it introducedenough uncertainty to protect the winning broker.

A related concern was the minimization of information leakage.From both past experiences as well as pretransition meetingswith the bidders, the PSF developed a healthy paranoia regard-ing the need for maximum secrecy. This manifested itself inseveral unorthodox policies.

First and foremost, Plexus was identified as the sole point ofcontact regarding the transition. All communications to, or from,lhe FSF weni thi-ough Piexus. Seconci, the PSF's securitieslender was not notified until after the transition. Third, the PSF'scustodial bank was instructed to ooen a transition account andprovide 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 knewa 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 inorder to process the trades, Paul felt the additional secrecy jus-tified such action. To the bank's credit, virtually every tradecleared 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, PSFcould make applesto-apples comparisons between variousbids. Further, each analysis provided a range of potential costs,driven by potential market conditions. This enabled the PSF tounderstand 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 Paulwas 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 securitynames by region after the close of each respective market.Foreknowledge by the winning bidder (that they had won, notthe actual names), allowed the building of futures positionsthroughout the day, thereby lessening market-impact on closingnnaaQ

Broker Perspective

Following Paul Ballard's remarks, Alan Rubenfeld shared thethinking of Deutsche Bank Alex Brown in submitting the winningbid. The factors and considerations which drove DeutscheBank'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 menagerisk 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 transitionadvisor.

After discussing bidding considerations, Alan noted that thetransition was a huge operational success as well. In thisregard, Deutsche Bank worked with the PSF in advance todevelop communication formats, Deutsche Bank dedicatedpersonnel for each stage of the transition, and establishedintensive communication with both the PSF and their custodialbank. Back-office personnel worked through the night toprocess the heavy volume of trades.

Notwithstanding the lack of advance notice by the custodialbank, the transition settled with virtually no difficulties.

To summarize the entire experience, in many respects the PSFtransition broke new ground. Key ingredients to success weremutual trust, creative design, and communication.

While the costs incurred on the transition beat their Benchmarkby significant margins, the true measure of success was the pru-dent process and structure established by the PSF. Anecdotalevidence of the strategy's effectiveness include the fact that theday following the transition, two major program trading firmsrepoded that the prior day had been "boring, with little noticeableactivity." Further, one week after completion of the transition, twoother major program trading firms were still marketing their serv-ices in hopes of participating. Perhaps the bottom-line measureof success was: Paul Ballard kept his job.

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