Written By: Alistair Seaton
Alistair Seaton of LaSalle Investment Management looks into the special case to be made for property in the government’s pooling proposals for LGPS funds
It is perhaps no surprise that the implications for property have received relatively scant attention following the government’s announcement that it wants the 89 Local Government Pension Scheme (LGPS) funds in England and Wales to pool into a number of “British Wealth Funds”. LGPS funds currently have just over 7% of their portfolios allocated to commercial property. Given the overarching goals of increased collaboration, cost savings and efficiencies, the debate has so far centred on how the pools might be structured, the merits of greater use of passive investment for listed assets, and the government’s stated desire to increase investment into infrastructure. Property, however, needs to be considered in a different way to listed asset classes.
The government is due to provide feedback on initial pooling proposals, especially where they are not deemed sufficiently ambitious, ahead of final proposal submissions, which are due in July 2016.
There is a lot to like
As a business, LaSalle believes in having a long-term business perspective that builds trust, accountability and transparency with our clients. These beliefs have much in common with the thinking that underpins the proposals.
The criteria for the pooling proposals are: i) to achieve the benefits of scale, ii) strong governance and decision-making, iii) reduced costs and excellent value for money and, iv) improved capacity to invest in infrastructure. In stating that active fund management should only be used where it can be shown to deliver value for money, the government has acknowledged the benefits of a focus on long-term performance, informed by the 2012 Kay Review on UK Equity Markets and Long-Term Decision Making. A focus on the long term and the belief that scale can introduce efficiencies aligns with our belief that portfolios can be effectively managed and deliver performance with fewer, larger assets. Hymans Robertson supported a number of the participating LGPS funds in formulating their response to the proposals (“Project POOL”). The resulting report notes that, using data from IPD, over the last 30 years larger portfolios have outperformed their smaller peers. The IPD data suggests that this has been accompanied with slightly higher volatility. The performance of larger portfolios mirrors our own experience. Evidence from LaSalle’s portfolios shows that over the last 20 years, returns on portfolios greater than £1 billion have exceeded the market by, on average, 50 bps per annum. At odds with the IPD data, our larger portfolios have also displayed lower volatility and tracking error relative to their respective benchmarks, although this does depend on the style of investment.
The main benefit of larger portfolios is diversification, as demonstrated by separate analysis by LaSalle and the Investment Property Forum, showing that effective diversification of risk is achievable with just 15 assets. A separate property allocation for each pool could mean an average of £2 billion per pool. Such a large portfolio would maximise diversification, spreading assets across a range of sectors, lot sizes, styles and locations. Direct investments predominate for our UK separate accounts of this size. Our use of indirect investments is focused on gaining access to specialist managers and sectors. They are not used for accessing scale.
Accountability and co-operative working is recognised within the proposals and closely aligns with our investment philosophy that seeks a disciplined and collaborative approach that places clients’ objectives at the heart of our decision-making. We place knowledge-sharing at the core of our processes and believe that this ensures best practice and take-up of innovation.
As acknowledged by the proposals, strong governance is key and something we wholeheartedly support.
A pooled portfolio would also give the smaller local authorities access to a major real estate investment manager in a way that previously may not have been economically viable. The number of investment managers with the capacity to manage a £2 billion portfolio without undue risk to their own business is very small. The shortlist is even further reduced if the long-term aim is to diversify internationally.
Property is different
Property is a heterogeneous asset class and investment managers will need to maintain a reasonable fee level, even as a portfolio reaches a very large size, in order to maintain resources and to continue to attract and retain skilled employees. Cost benefits will be enjoyed more by the smaller local authorities than those with already significant real estate portfolios.
Project POOL highlights that “the benefits of seeking the lowest possible fee for the provision of services in respect of physical assets where quality is a factor should also be considered. A willingness to pay (slightly) higher fees may give access to more experienced people and could represent the difference between an asset being let and an asset remaining vacant.” We hope that the drive for cost reduction does not see managers judged solely on how low they can get their fees without balancing this with the service they can deliver at that level of remuneration.
The notion of single asset pools appears to be an unlikely outcome. As noted in the Project POOL report, a £13 billion portfolio would be among the ten largest portfolios globally and it is unlikely that any single investment manager would have the capacity to take on such a mandate.
Sensibly, the proposals acknowledge that existing direct property investment may need to be kept outside the pools initially, with only new allocations committed to a pool. This will avoid forced sales, and acknowledges that reinvesting proceeds would incur stamp duty at 5% (total purchase costs are usually close to 7% after legal and agent fees).
Project POOL identifies two contenders for the pooling format. The first is “regional pooling”, meaning a property allocation for each of the “Wealth Funds”, with existing assets managed alongside each other under a single manager. These holdings would be wound down over time, with the proceeds reinvested into a unitised vehicle in which the participating funds hold units. We would certainly support calls for the government to consider waiving stamp duty if the speed of transition to a pooled vehicle is required to be any quicker than that facilitated by market disposal rates. Indeed, the recent announcement that PAIFs and CoACSs will receive stamp duty seeding relief looks a potentially interesting solution to this issue. Under the “regional pooling” scenario, one of the compromises would be that all authorities would have the same target return for property. Once a unitised vehicle for one pool is established it may even make sense to open up to all other investors.
The other structure is being called “virtual pooling” where each manager consolidates their current mandates under a single mandate. Our analysis suggests that 10 investment managers currently manage over 80% of the LGPS property allocation. The remaining 20% is managed by 20 managers, although much of this will be via indirect investment. In our experience transitioning portfolios is rarely straightforward and needs careful management. In both cases there is agreement that transitioning existing indirect investment to direct is essential as part of the drive to reduce costs given the additional layer of fees on the former.
For both scenarios, there will be overlap within the merging portfolios in relation to the number of smaller lot sizes, assets, sectors, locations and risks. How to efficiently manage the existing assets will need considerable thought.
In our view “virtual pooling” will mean initially that the size of the portfolios will vary by manager and therefore create the potential for uneven fee levels and cost reduction benefits. As Project POOL notes under this scenario, the challenge will be “the larger-term consolidation of assets into larger assets pools.”
With a wide range in funding levels across the LGPS funds – below 60% to fully-funded – Project POOL rightly recognises that employer-specific investment strategies might be appropriate in some cases. In this context maintaining asset allocation at an authority level makes sense. There could also be benefit in pools considering a range of return target buckets for property (for instance, real, absolute, benchmark relative or value-add), much in the same way that access to low, medium and high risk infrastructure investments are being considered.
It is encouraging that property is being treated with an appreciation that it has much to offer a multi-asset portfolio, and that it needs special consideration. We do not expect as significant a cost reduction for real estate as for other asset classes such as equities, bonds and other alternatives such as infrastructure, where the removal of fund-of-funds costs will see significant fee reduction.
There will be real benefits from pooling LGPS real estate portfolios, particularly in relation to diversification of risks and cost efficiencies, despite reduced control by individual local authorities over portfolio strategy. Our view is that from where we are today, this will be best achieved through “regional pooling”. These benefits are particularly pronounced for local authorities with a relatively small allocation to real estate. The ability to access large lot sizes within a pooled portfolio provides further outperformance opportunities to those with smaller portfolios.
The transition will not be without challenges and could take many years. Pools will need to partner with experienced investment managers who have transition experience, with both direct and indirect investments, and the resources to manage such a change, a goal that may be incompatible with accessing the lowest fee levels.