Written By: Pádraig Floyd
Pádraig Floyd discusses the growth of funds’ investment in real asset alternatives previously considered too risky or expensive, such as private equity venture capital and infrastructure
Retro is not so much a fad or even an industry today, as a way of life. Almost every aspect of life, and certainly cultural endeavour, seems to wish to look back to emulate, or even replicate how things were done in the past.
Where are we going?
One area in which it can be dangerous to look back is investment. The mantra: “Past performance is no guarantee of future results” has been drummed into us. Be careful what you wish for and in investment, looking back is only of use to identify lessons to be learned.
Although we may crave a return to the seemingly endless millpond-like markets of the “golden age of defined benefit plans”, those were in fact as mythical as the endless Kodachrome-saturated summers enjoyed by those of a certain age, in which it never rained. Markets could be volatile and good governance and risk control were always central tenets of pension fund management.
Things may have seemed simpler back then, and perhaps they were. For while the choice of asset class wasn’t quite as miserly as Henry Ford’s swatch book, the focus was on equities and bonds. Today, things are very, very different.
A look towards alternatives
Over the past two decades, the world economy has been predicated on low growth and low inflation. But things have changed.
Pension funds – particularly those not seeking to secure member benefits in the insurance market – have sought more sources of return that can beat inflation. Equities have performed well, despite moments of shock, and fixed income has offered potential for return, providing you’ve not had to fill your boots with Gilts.
While many funds will have had some exposure to real estate, they have often shied away from other “real asset” alternatives, such as private equity, venture capital and infrastructure. They were considered esoteric, too risky, too expensive, or with too much responsibility placed on the long-term investors rather than the GPs who would be long clear before they achieve maturity.
Yet, increasingly, funds and especially local authority pension funds (LAPFs) have become more comfortable in thinking about how these alternatives can fit into their portfolios. A recent paper from Alpha Real Capital says that secure income real assets are showing resilience in the face of the higher interest rate environment. They’re holding their own when – at time of publication – equities and credit assets in public markets were experiencing negative returns in the year of around 18% and 15% respectively. The main reason for this is because they are inflation linked. It also doesn’t hurt that investors have been shifting to higher quality credit.
The improving funding levels identified by this year’s valuation process suggests there may be more scope for pension funds to do more in this area to bolster those pursuing self-sufficiency.
“Despite the volatile markets, higher real rates mean most pension schemes have healthier funding levels,” concluded the report. “If spreads continue to be attractive versus the risk/return offered by alternative cashflow generating assets then higher demand could support CGR prices.”
As safe as houses
Perhaps the most common “alternative” or “real” asset is real estate. Back in the day, this meant direct holdings of commercial properties for a lot of these investors, which remains true today across many parts of Europe.
But that can be less efficient and certainly doesn’t tick the boxes for diversification. Unless you have a huge allocation, there will be a few very expensive eggs in one basket.
“Investors have gone back and forth over the years, feeling that they would like to disintermediate the managers, but then realising that having a diversified fund over the long term does tend to provide better, more predictable returns based on diversification not not only on geography, but also on property type,” says Faris Mansour, head of business development for EMEA at PGIM. This is important, because there is no hard and fast correlation that will show that a specific property type or geography will always perform above another.
The last 10 years have seen a greater push towards the private markets and alternatives and Mansour’s average client may have between 7% and 9% allocated to real estate, with some higher still.
“There are lots of reasons that investors are heading into private markets,” says Mansour. “Market stability in your portfolio does provide more comfort and there is the outperformance over listed assets. That’s been particularly true with private equity and there’s been a huge decline in public fixed income markets. “We think that trend will continue over time and you will see a greater allocation to real assets, particularly now, as investors look for an inflation hedge.”
LAPFs’ growing alternative appetite
There has certainly been an increased appetite for exposure to alternatives and private market assets among funds and their pools. Border to Coast committed all £5.7 billion of its initial private markets programme earlier this summer. “With all £5.7 billion of assets committed within our first programme, we are now looking ahead to the opportunities we can pursue as part of our second programme – which include the innovative climate opportunities proposition – and continuing to deliver significant benefits for our partner funds,” said Mark Lyon, head of internal management at Border to Coast at the time.
Earlier this year, the Wales Pensions Partnership announced its first private credit solution. And they’re not alone. Much of the interest around private assets has been driven by the desire to find investments that satisfy ever stricter ESG (environmental, social and governance) investment criteria.
It might seem obvious that ESG strategies would hinder expansion into private markets, not least because of a lack of data, but in fact, it is quite the reverse. Demand is shaping the industry faster than regulation ever would have done.
It may mean taking the process in small steps, but that shouldn’t put anyone off starting the journey, Becky LeAnstey, a climate investment analyst with the Environment Agency Pension Fund told the October LGPS-Live webinar that discussed impact investment.
“It’s being clear about setting the objectives you want to achieve from those impact investments, and then using your strategy documents to be transparent about that,” she said.
“But when you’re setting these targets, you must think how you’re going to monitor them, that you can show whether you’ve achieved those outcomes in the long term. And they are going to be different for different investments.” For instance, the Environment Agency doesn’t separate environmental from social as they’re seen as interlinked and to be considered together.
Opportunities, but also risk
The shift towards alternatives does represent funds moving outside what they have traditionally considered their comfort zone. This requires funds to take advice and get up to speed, but there are also “governance challenges” they must be aware of and manage, says Michael Waters, a solutions strategist at T. Rowe Price.
Investments in private markets occur in two stages, Waters told the audience at the September LGPS-Live session. The first is money waiting, where funds have decided to commit to particular private assets but are waiting for it to be deployed by their managers.
The second stage is what he calls money working, where the capital has been deployed by the manager and they are doing what the LGPS fund expects them to do.
However, there is a period when the capital is not deployed and yet, it is not invested. There may be hedging costs to consider, but this “dry powder” often seems to exist in a kind of accounting limbo and funds should be prepared to deal with that.
“There is a gap in terms of setting appropriate expectations for what the return and the tolerance for risk should be for LGPS funds for money waiting,” says Waters. “For example, capital calls can occur at short notice, so is it sufficient to just use volatility or risk or should we think about things like drawdown for example? Are capital calls more likely in periods of market turbulence? Private equity managers may see good bargains to be had and they’re more likely to hold out some of that money waiting.
When it comes to returns, this is usually focused on the capital once it has been deployed. This focuses just on the money working phase, but ignores what happened when the capital was awaiting deployment.
“That leaves the return generated and the risks incurred by money waiting to be accounted for elsewhere within the LGPS fund’s portfolio as kind of an unintended consequence. Nobody really sees this as part of a particular portfolio,” Waters says.
“One of the reasons we wrote about this is that the amount of dry powder invested in private markets is growing,” he adds. “Mercer estimated last year that about a third of the total private assets under management is in dry powder at the moment. That means the period waiting for money working in the private markets is increasing,” and so, too, will any unidentified risks.
We live in interesting times…
The journey into alternative assets is really only just beginning. The influence of ESG, impact investment and not to forget the government’s campaign to engage institutional investors – in particular LGPS funds – into investing in its levelling up ambitions means the prospects are broad and potentially very exciting.
Despite promising noises about overall valuations, raging inflation and turbulent markets will require a steady hand on the tiller and a firm grip on the risk budget.
It will be interesting to see how funds and pools develop new solutions over the next few years to the next valuation.