October, 2016 Print
Matthew Craig, LAPF Investments.
Matthew Craig examines the approach local authorities are taking to alternative investments and the possible impact of pooling arrangements
The world of alternative assets stretches from the roads, bridges and tunnels of infrastructure, through to the likes of litigation finance, or catastrophe bonds which pay out if a hurricane or earthquake occurs. By using this diverse asset class, investors hope to find new sources of returns and to reduce their reliance on conventional bond and equity markets.
According to the latest OECD survey of the 34 largest corporate and public sector pension funds around the world, the average allocation to alternatives has edged up from 12.9% in 2010 to 13.6% in 2014. Fixed income and cash allocations rose slightly from 53.2% to 54.9% over this period, while equities fell from 32.4% to 29.8%. In contrast, UK defined benefit schemes showed a higher take-up of alternatives between 2011 and 2015 according to research by the Pensions and Lifetime Savings Association. It found that the split of equities, bonds, and other alternatives shifted from 42%, 43% and 15%; to 34%, 38% and 28% respectively or a near doubling in the use of alternatives when compared to bonds and equities. Most local authority funds in the UK have smaller allocations to alternatives. The Local Government Pension Scheme (LGPS) Advisory Board website shows that in 2013, the total allocated to property, private equity, derivatives and other assets was 9%, with 40.8% held in pooled investment vehicles. Part of the latter could be alternatives UCITS funds, a liquid, onshore form of hedge fund investing.
While LGPS funds, overall, might not allocate a very large proportion of their assets to alternatives, it should be remembered they have invested in property and private equity for decades. “Local authority funds have a history of using private equity, property, and a certain amount of hedge funds – although those are falling out of favour. While some are looking at more esoteric assets,” commented Allenbridge Epic senior adviser, John Jones. In the last few years infrastructure has become more of interest to investors wanting steady returns and diversification from listed markets, which have been distorted by quantitative easing (QE). In addition, listed market uncertainty has prompted many investors to look for diversified returns from areas such as shipping, timber, farmland, aircraft leasing and catastrophe bonds, as well as litigation finance, or strategies utilising intellectual property rights or royalties. Investors are also adding new approaches in fixed income, where alternative fixed income, or multi-asset credit (MAC) are two names for strategies that encompass direct lending, mezzanine finance, distressed debt and other fixed income instruments from off the beaten track.
Undoubtedly a desire to diversify portfolios is driving investors to put more into alternatives. Quantitative easing (QE) has been a major factor in this, as it has severely affected bond and equity markets. Peter Wallach, director of pensions at Merseyside Pension Fund, commented: “My impression is that the LGPS is engaged in a ‘hunt for yield’ like many other pension schemes as a consequence of QE. Credit is a focus, particularly high yield, MAC and illiquid opportunities such as direct lending and distressed.” Nick Greenwood, pension fund manager at the Royal County of Berkshire Pension Fund, has a similar view. “It is my view that the drive for yield has left many liquid investments fully valued and that better value can be derived from careful selection of illiquid, so-called alternative investments where patient investors can obtain real value.” Greenwood adds that moving from equities and bonds into alternatives has become a trend. “Flows into larger alternative strategies have been large; potentially driving down returns. Studies in 2015 suggested that after fees, US private equity funds invested in MBO strategies had returns similar to the S&P 500, so no illiquidity premium had been garnered.”
For the LGPS, two important and related issues around alternatives are the LGPS pooling reforms and the use of infrastructure. If the LGPS funds are grouped into six or so larger asset pools of £25 billion or more each, how will this affect the use of alternatives? Wallach feels it will help: “I believe pooling will assist investment into alternatives, particularly by smaller funds which, by working together, will be able to reduce costs for the necessary advice, be able to write an appropriate ticket size and have the resources to monitor/manage alternatives.” On the other hand, Greenwood commented “I still believe that there are good opportunities to be had in smaller opportunities – many of these require small (£20 million or so) initial investments but over time will be scalable. My concern with pooling is that an initial £20 million investment will be overlooked by a pool with £35 billion under management (and say close to £2 billion in alternatives).” Allenbridge Epic’s Jones is neutral on the impact of pooling on the take-up of alternatives: “Funds will make investment decisions and it will be up to the pools to offer a range of alternatives.” He added: “There are some quite esoteric strategies such as litigation finance or cat bonds. Other strategies, such as timber and farmland, are very tangible and easier to understand. Will members and officers be able to understand the risks around these strategies? Pooling should help here, as it there should be more in-house expertise. But I doubt that the more esoteric alternatives will be top of the list of priorities when the pools are being set up.”
One reason for the pooling exercise is a belief in Whitehall that larger funds will find it easier to invest in infrastructure, given that they will have greater resources and the ability to benefit from economies of scale. But some LGPS funds have been actively investing in infrastructure for some time, as Wallach explains. “We have been investing in infrastructure for many years and moved to a discrete allocation five years ago. Our experience has been that the subsidies available on renewables have made that area of investment particularly attractive for the past few years. Prior to that it was social-type projects i.e. public finance initiatives (PFI). We have invested in all areas; solar, wind, anaerobic digestion (AD, the use of micro-organisms to break down biodegradable matter) and energy from waste (EFW). As these subsidies unwind, we are diversifying both domestically and internationally.” As with many other assets, QE has pushed up prices in infrastructure, particularly for high-profile assets, such as ports, railways and utilities in developed countries. But this does not mean that LGPS funds cannot find suitable opportunities. “Our experience is that smaller projects can still be financed at attractive returns. Striking a balance between appropriate fees and potential returns is a challenge and by collaborating with other funds we believe we can invest more cost effectively,” Wallach commented. As well as its infrastructure investments, Merseyside has invested in aircraft leasing, insurance-linked securities and royalties, accruing good returns. But he added: “Our investments in farmland, shipping and timberland have not met our expectations although agriculture related investments are very long-term.”
Looking ahead, it seems likely investors will continue to search for viable and attractive alternatives to the main asset classes given the likely unpleasant side-effects for QE for financial markets. Greenwood commented: “Without giving too much away, natural resources, North American oil, UK housing and small scale power generation all look interesting.”
In UK politics, Tony Blair and New Labour once aspired to offer “The Third Way”. For investors, alternatives offer something similar; a refreshing alternative to the two main asset classes of bonds and equities. Within the overall heading of alternatives there are a very wide range of approaches, from those reliant on the skills of hedge fund managers, to small scale renewable energy projects. For investors, particularly those with large pools of assets, finding the right opportunities can be difficult. Interesting new alternatives may have limited capacity, while investors need to deploy sufficient funds to “move the dial”. But as LGPS pools develop their resources, they will find ways to invest in alternatives from backing major infrastructure projects, through to smart and hungry hedge fund managers who can exploit market inefficiencies. So in a few years’ time, the enlarged LGPS asset pools may become as well-known for their use of a wide range of underlying assets, just as some of the world’s largest pension funds are already.