THE ALTERNATIVE INVESTMENT FUND MARKET FROM A PENSION FUND PERSPECTIVE With a great deal of focus recently being on the long-term sustainability of pension funds, many funds are looking to develop their programmes in alternative assets as a means of facilitating improved returns over the long-term and finding a viable substitute for bond mandates in the current economic climate. The Lothian Pension Fund s investment team has been engaged in the alternative markets for the last decade and, with a strategic asset allocation to invest 28% of its circa 4.2 billion portfolio in alternative assets, view this as an important sector in growing and preserving the asset positions of UK pension funds. Here Lothian s investment and legal professionals let us have their current view on accessing this market. Alternatives: what s all the fuss about? There has been a great deal of focus recently on pension funds, including Local Government Pension Schemes (LGPS), accessing alternative assets, with internal investment managers increasingly looking to improve the funding levels of their schemes by maximising investment returns, diversifying their portfolios, protecting against inflation, smoothing investment volatility and generating efficiencies through improved governance. Critics of alternative assets often point to the numerous barriers to entering this market, such as the specialist skills and experience required for investing in private funds (e.g. business valuation, financial modelling, market awareness and knowledge of the underlying assets and sometimes complex legal structures) and the costs associated with acquiring, deploying and retaining these skills. It has also been suggested that the drag effect of management incentives typically applied in these funds makes them unattractive long-term investments and that complex structures allow managers to conceal fees and other charges. These are valid considerations but should not necessarily dissuade those with a commitment to fully engage in this market from doing so, with a number of pension schemes already operating relatively sophisticated alternative investment programmes and able to demonstrate good performance and an ability to overcome such concerns. In our experience, a sensible and informed approach to investing in this sector can have significant benefits for LGPS funds. Recent independent research around the efficiencies that can be generated by LGPS funds has shown that returns can be improved through more active internal management and a reduced reliance on funds-of-funds vehicles. We recognise the merits of all means of accessing the alternative markets, with various pension funds at different stages in the development of their programmes and with different risk profiles, but do view good active management of alternative investment programmes as an important way to eek out the long term returns that will help funds narrow the gap between their assets and liabilities while playing a valuable role in diversifying pension fund portfolios in inflation correlated assets.
Accessing the market There are a number of different ways of accessing the alternative market. Primary funds Traditionally pension funds have opted to commit capital to primary funds with a mandate to invest in a particular asset class (e.g. private equity, infrastructure) which may also be restricted to a certain geographical or other focus. The manager of these funds will have scope to make appropriate investments within a fixed investment period (generally 5-6 years) and so investors are effectively backing the track record and skill of the manager in their ability to make the best investments for the benefit of the fund over that period. The managers will then have a fixed period to realise those investments to generate maximum returns for the fund and its investors. Essential to this model is the alignment of the interests of management and investors and that the managers have certainty in accessing capital to allow them to execute transactions efficiently for the benefit of the fund. As such, investors are generally tied into these funds for a fixed period (10-25 years, depending on the underlying asset class) with necessarily severe penalties for defaulting on their obligations to fund their commitments. The manager is usually incentivised through the combination of an annual management fee (usually between 1-2% of total commitments to the fund during the investment period and a reduced percentage of actively invested capital thereafter) and a further carried interest percentage (usually 15-20%) of any returns over and above an agreed amount of return (generally around 8% IRR) for investors. However, the development of the secondary market in primary funds (see below) has made interests in these funds more liquid than has historically been the case. Private fund-of-funds vehicles This has also been a popular route of access for the LGPS and other pension funds, with fund-of-fund managers offering their expertise in acquiring vintage fund interests and the potential to diversify exposure in a chosen alternative asset class. This arguably limits the need for the pension funds themselves to commit the necessary expertise, time and resource to assemble a portfolio of this nature and allows exposure to this asset on a lower risk strategy. Listed funds Like fund-of-fund vehicles, listed funds offer investors the ability to gain exposure to a diversified portfolio of assets in an efficient and relatively low risk manner, ultimately relying on the manager s expertise in the sector. These funds also offer more liquidity than private fund-of-funds, where investors are usually tied in for a fixed term rather than having the ability to sell their interest on a regulated exchange. However, listed fund managers can be less flexible in structuring their underlying investments and so sometimes less competitive in bidding for underlying assets than their competitors operating private funds, accepting that the corollary of investing in private funds can be the acceptance of a higher risk profile. Single asset funds In a competitive fund-raising environment, managers are increasingly choosing to launch mini-fund or single asset vehicles in order to take advantage of particular opportunities. These types of investment, of themselves, do not provide diversification within the alternative market, but do often offer opportunities that are very competitively priced and allow investors to carry out detailed diligence on the underlying assets and so make a fully informed decision
on the investment. In this way in-house managers can build an alternative portfolio founded on their own commercial diligence, with the comfort of specialist manager support, and often benefit from improved commercial terms and more visibility around management decisions and underlying fees. The secondary market As we have mentioned, the development of the secondary market in primary fund interests now enables investors to more freely sell their interests in these funds and so rebalance their portfolios. This not only makes the asset class more liquid, but also affords the discerning investor the opportunity to gain exposure to particular vintage funds/asset classes at a discount and carry out more detailed commercial diligence on these funds, now at a more advanced stage in their investment cycle. While secondary acquisitions are not straightforward, involving tri-partite discussions between buyer, seller and the manager of the target fund, the market has now become more developed and so these transactions can increasingly be concluded relatively quickly and in a cost effective manner with the appropriate expertise at hand. Co-investment opportunities Co-investments are another way in which investors can access alternative funds on preferential terms and with more visibility around the underlying assets themselves. These opportunities generally arise where managers of funds are looking to complete their portfolios with a particular acquisition but their existing fund does not have sufficient headroom to fully fund the acquisition. In such circumstance, managers will often look to raise a co-investment vehicle to fund the difference and such vehicles can provide access to the underlying asset with reduced management fees and no other incentive fee drag. Accepting the different risk/reward and diversification profiles, co-investments often compare very favourably (in terms of cost/fee leakage) with primary, listed and fund-of-fund vehicles through which institutional investors have traditionally sought exposure to the alternative markets. Co-investments can also provide investors with additional visibility in relation to the fees associated with the underlying investments themselves. Direct investments Finally, a limited number of the larger UK pension funds are able to invest directly in underlying assets without going through an intermediary fund vehicle or relying on manager diligence and advice. This can offer significant cost and fee savings, albeit at a greater operational risk and with increased overheads, but is generally the preserve of pension funds able to leverage from economies of scale that allow them to maintain the substantial in-house commercial and transactional expertise required to mitigate the risks of investing directly in assets in this way. The importance of good diligence Generally pension funds will make commitments to private funds that are discretionarily managed within a particular mandate, with only limited controls afforded to the investors themselves. This not only reflects the legal and regulatory obligations on funds of this nature, but also the complexity of the underlying assets and transactions that require specialist management and skills. As you would expect, it is therefore important to carry out thorough diligence on the managers of the funds in which you propose to invest, with track record, management incentivisation, execution capability and efficient cost control being key
considerations. The most successful investors in this sector are also able to carry out detailed commercial diligence on the markets and underlying assets within which these funds have or will invest and we would view this as critical to maximising the benefits, and limiting the risks, associated with investing in alternative assets. Legal, regulatory and tax diligence on the fund structure and terms would also be required. Diligence is therefore an essential part of the investment process, and does require a commitment to resource and external fees. However, LGPS and other pension funds do have opportunities to work together to make savings in this area. Portfolio diversification Diversification is an essential part of pension fund investing aimed at achieving the required rate of return with acceptable investment volatility. With most sovereign bond markets likely to provide negative real yields over the next several years, alternatives are currently seen as another way to diversify portfolios, offering a measurable degree of independence from systemic market risks while providing positive real returns. The risk/return profiles of many traditional alternative funds have not necessarily afforded this opportunity, but the advent of de-risked operational infrastructure assets and long term timberland and other funds, which generate steady inflation correlated returns, have drawn pension funds to the market. These asset classes, and likely their replacement by something new in the future, emphasise the adaptability of the alternative market and the opportunities available for those able to operate effectively in this sector. There is now scope to re-balance alternative portfolios and selfdiversify your exposure to this market, without purely being reliant on making large allocations to fund-of-funds, listed or other discretionary managed vehicles with broad investment mandates. Governance Investment consultants often point to the need for pension funds, and particularly LGPS funds, to maintain sufficient expertise and governance to enable them to potentially implement investment strategies in line with the prevailing market and other conditions. Pension funds should of-course continue to adopt a long term approach, but the ability to make ongoing adjustments to investment strategy is an important aspect of maximising returns and other efficiencies in any investment programme, while providing comfort that it can quickly react to any seismic market or other shift that might take place. Those pension funds which have established alternative programmes, and the accompanying governance, therefore have the option of investing through that programme and/or re-balancing the alternative portfolio itself to take advantage of new opportunities or market shifts. Informed investing and manager relationships Another benefit in participating in the alternative sector, particularly through secondary transactions, mini-funds and co-investments, is the opportunity for institutional investors to develop a good working relationship with managers and a greater understanding of the underlying assets and investment structures. Participating in these transactions can therefore have significant benefits in terms of developing your team s understanding of the sector and also, more directly, in future dealings with that manager. For instance, developing a trusted relationship with a manager may result in you having the opportunity to participate in off market acquisitions at competitive commercial terms, with managers taking significant
comfort from your ability to provide them with the necessary execution and funding certainty. Transparency of management fees There is a perception that the private alternative markets afford managers the opportunity for clever structuring and a means of concealing transaction and other fees. While there is certainly scope for managers to adopt intelligent fee structures, to generate tax and other efficiencies, our experience has been that a pension fund with an informed approach to investing in this sector is actually privy to more detailed information on management, transaction and other fees than in other types of pooled fund arrangement or externally managed mandate. In particular, investors able to participate in the more direct vehicles are able to benefit from full visibility around the structuring of underlying transactions and, in many cases, beneficial fee arrangements. Infrastructure, infrastructure and more infrastructure Infrastructure certainly does seem to be a hot topic at the moment. We have so far been talking about de-risked operational infrastructure assets which provide long-term index linked returns, but infrastructure investing also includes early stage/brown-field infrastructure investments which offer a higher risk/return profile for pension funds. The alternative market offers access to all forms of infrastructure asset and so enables investors to participate in underlying fund portfolios with mixed exposure to early stage and operational assets to satisfy its particular risk/return requirements. A lot has been said on the subject of pension funds investing in local infrastructure projects and it is worth noting that the alternative markets offer pension funds the opportunity of accessing independent infrastructure funds which can include exposure to local investment. In addition, pension funds with sufficient experience and presence in the alternative market are able to indirectly influence the market and thinking around the investment focus of proposed infrastructure funds, so long as the manager s independent investment discretion is not fettered and the focus of the fund continues to be on generating the targeted risk-adjusted return from the best opportunities available in the market. In this way, pension funds can invest in local infrastructure without compromising the independent fiduciary duties of their trustees/committee members. Finally A recent study by an independent consultant has shown that 40% of pension schemes surveyed are looking at the use of alternative assets to reduce the risk in their portfolios and it is clear that a good number of LGPS and other pension schemes are already actively involved in this sector. The important point for those funds looking to enter the market, and perhaps those with less developed alternative programmes, is to ensure that they have sufficient inhouse and external expertise to fully take advantage of the opportunities that this sector presents and so avoid falling foul of the potential pit-falls of poor fund selection, fee drag, high costs and liquidity concerns. Pension funds, including those within the LGPS, are however well placed to leverage from their collective market presence. In particular, the expertise already available within pension funds with established alternative programmes should present a valuable opportunity for LGPS and other pension funds to collaborate in
accessing this market and so make a meaningful contribution to preserving the pension entitlements for future generations. If you have any queries in relation to this article please feel free to contact either Andrew Imrie or Struan Fairbairn within Lothian Pension Fund s Alternative and Other Assets team. This article is for information only and the Lothian Pension Fund/the City of Edinburgh Council shall not be liable in any way for its contents. For the avoidance of doubt, the Lothian Pension Fund/City of Edinburgh Council does not provide investment or any other equivalent regulated services to third parties and this article does not represent advice or seek to market any such services. February 2014