Written By: Matthew Craig
Matthew Craig looks at the range of alternative assets now available to institutional investors, including diversified growth funds, alternative risk premia and direct lending
Alternative assets are increasingly important for local authority pension funds. And LGPS asset pooling could be highly beneficial in this area, as larger funds have more scope to invest directly in assets such as infrastructure. Indeed, George Osborne, when he was Chancellor, is understood to have started the LGPS asset pooling process after asking why there were no UK pension funds bidding for the HS1 high speed rail link from London to Dover, and being told UK funds were not large enough.
The proportion of assets allocated to alternatives now tops 20% at some local government pension scheme (LGPS) members. According to the website pensionsperformance.com, funds such as the East Riding of Yorkshire, Lancashire and Merseyside have around 20% or more held in alternatives, often with much of this in private equity and infrastructure. Mark Mansley, chief investment officer at the Brunel asset pool commented: “There is a lot of interest in this area; it’s one of the key areas we are looking at. Pooling offers positive benefits in terms of cost saving, and also doing things more efficiently, with better access to underlying alternative assets.”
As many growing businesses remain private for longer, private equity offers access to everything from the next internet giant, to turnaround stories at struggling enterprises, or value unlocked by efficient management and sharp financial engineering. Hedge funds have fallen out of favour for many, but can lay claim to offering alpha created by manager skill and a different risk and return profile to other assets. Infrastructure and real estate, as well as real assets such as timber land, farmland and more esoteric assets, for instance, insurance-linked securities (ILS), are other examples of potential alternative assets.
In the past, many LGPS funds entered the world of alternatives through collective investment vehicles, operated by external managers, such as funds-of-hedge-funds. Another example of this approach is diversified growth funds (DGFs), which are funds that contain a mix of assets, from equities to exposure to alternatives such as private equity or real estate, in an effort to generate good returns from a wide range of sources. PAAMCO head of research, Lisa Fridman, notes that UK LGPS funds tend to use DGFs more than their equivalents elsewhere. She commented: “Pension funds in general, and local authorities in particular, are looking for diversified sources of returns, but the way that they go about it may be different. Many DGFs were created after the financial crisis, so they may not have been tested in a sharp drawdown. Some of them are sensitive to the performance of equity and fixed income markets, so their ability to cope with a changing market environment has not been put to the test.”
If DGFs are unproven in a crisis, then another trend in alternatives, the use of alternative risk premia, has yet to be fully tested as well. Alternative risk premia can be thought of as a way of carving out the market returns that drive many assets in a systematic way; or if some hedge funds are the hare, capable of spectacular performance and periods of inactivity, then alternative risk premia is more of a tortoise, steadily accumulating returns. Fridman commented: “In general, I would describe alternative risk premia as the use of systematic strategies implemented on a long-short basis across asset classes, targeting low sensitivity to long-only traditional asset classes, namely equities and bonds.”
One reason why alternative risk premia is gaining ground is that they could offer cheaper access to diversified returns than hedge funds. GAM head of institutional, UK & Ireland, Ben Edwards, said: “We are seeing less interest in direct hedge fund investment and more in alternative risk premia, based on the belief that a lot of risk premia in the market can be harvested systematically. Equity indices can be tilted towards risk factors, such as value or momentum, which is what smart beta is about. The alternative element comes from trying to do this in a market neutral way, so you obtain, say, the premium for value but without market beta.”
Another growth area for investors among alternative assets is the use of private market debt, as well as private equity. GAM’s Edwards commented: “The biggest trend I see is the pull back by banks in providing capital to asset managers, with new lenders, such as asset managers, stepping in to provide capital on a longer-term, lock-up basis. This trend is continuing with direct lending now a generic term for lending to corporates, commercial real estate and infrastructure sponsors.” And Brunel’s CIO, Mark Mansley, commented: “The Brunel members already have asset allocations to private markets and as the control of those investments passes to Brunel, interest in private markets looks set to increase, so we can expect to see growth in this area.”
For LGPS funds and other long-term investors, direct lending allows them to benefit from the illiquidity premium, or their ability to supply funding over a longer period in return for a better return. It can also fit in with funds’ investment beliefs related to ESG and sustainability. Edwards added: “A lot of local authorities like the idea of stepping in to replace banks as lenders against commercial real estate or to support infrastructure either in the UK or in Western Europe. Some of the more esoteric areas that we are seeing interest in are with dedicated funds set up for green energy, solar power, and wind power.”
It should be noted that compared to public debt, managing an investment in private debt can be very time-consuming, complex and it may need a range of skills. Some pension funds have been building up their expertise here, as this can enable them to find the best opportunities and act quickly. “Due diligence, monitoring loans and working with the borrowers is very time-consuming, especially compared to managing investment grade credit and you need people with expertise in niche areas to do this,” Edwards said.
One risk for direct lending is a recession or market downturn. As such, Edwards said that lenders need to model more severe outcomes and put covenants into place. “For property, ultimately we can take the keys but we look to avoid this through very conservative underwriting of loans, for instance setting the loan-to-value at a level to get as much downside protection as possible. We usually have 25-30% in protection built into UK CRE as a junior lender.”
Most of the LGPS asset pools are planning to tackle equities and bonds first, as the asset classes seek greater pooling but, alternative assets is one area where size can bring real benefits. Brunel’s Mansley said: “We are looking at opportunities to invest more directly, as we will have an allocation of around £5 billion and that is a substantial amount of money to invest. We won’t be one of the largest investors in this space, but it will give us a greater degree of critical mass, so we need to think about our approach; how can we work with managers as peer investors, as well as fund investors? We won’t necessarily buy large, premium infrastructure assets, where valuations look stretched, but there are smaller, more niche areas where direct investment makes sense and there is less intense competition. The bottom line is that as a larger investor, we can look at a wider range of models, beyond the standard Limited Partner/General Partner model, to co-investment, joint ventures and other ways of collaborating with other investors in the LGPS and beyond. There is a whole range of possibilities that becomes more viable for larger institutions.”
One trend which may be of interest is the use of managed account platforms for hedge fund investing, which give larger investors greater control and oversight. Bruce Keith, founder and CEO of InfraHedge, said managed account platforms can also provide cost savings for larger funds. “Realistically, an investor should have at least $50 million per manager and to get diversification, around 10 managers, so $500 million is probably the minimum allocation to hedge funds. If a fund allocates 5-10% of its total assets to hedge funds, you can see why you have to have scale to make it work.”
It is clear that the options for institutional investors in alternative assets are increasing, both in terms of the asset classes under consideration and in how they can be accessed. Once the large asset pools are up and running, they should have the scale and resources to be able to explore the full range of alternative asset opportunities for the benefit of their members. Done properly, alternative assets could help the LGPS funds meet their investment objectives, so interest and activity in this area looks set to continue in the future.