No longer just about diversification

Written By: Pádraig Floyd LAPF Investments

Pádraig Floyd discusses alternative investments looking at risk and reward profiles of property in particular, and the growing importance of sustainability factors such as decarbonisation

When it comes to investment strategy, alternative assets represents a very broad church. It covers all kinds of equity, fixed income and esoteric investments that don’t fit neatly into the boxes that contain listed stock market or government bonds.

While alternatives has covered flirtations with asset classes like private equity or infrastructure, more often than not, it boiled down to property holdings in most portfolios.

One may argue that there’s nothing alternative about property these days, but until recently, these asset classes were primarily used for diversification rather than as core assets.

Diversification, diversification, diversification
Certainly, the stigma that “alternatives” once carried as being risky and opaque investment strategies has, by and large, been lost.

For most, alternatives now means access to private markets, real estate, infrastructure, private equity and private debt. These have all been key themes for many local authority pension funds (LAPFs) for some years, driven partly by a desire to diversify risk and partly for additional return because these assets are expected to pay a premium to compensate the investor for the liquidity risk they take.

Colin Cartwright, partner at Aon, said “The equity market has done extremely well over the last decade and even the last 18 months has been really strong. Whether it will continue to is the question everyone is wrestling with, but one way to manage that is to sell some equities and diversify into other asset classes. Then, some parts of the private debt market offer attractive risk and return. While some will argue the returns will be lower in the future, they still look attractive compared to some other asset classes.”

“Finally, most funds are are looking at their environmental, social and governance (ESG) objectives and the carbon intensity in their portfolios. That leads people to the infrastructure space as that is where many renewable energy projects are. Here is a natural move into alternatives while seeking to reduce the carbon footprint in your portfolio.”

Building back better can’t be rushed
The government has been keen to highlight the role it feels large institutional investors should play in the Build Back Better project, after he Covid-19 pandemic.

A new report from the Productive Finance Working Group, an industry group convened by the Bank of England, the Financial Conduct Authority and HM Treasury, sets out a series of recommendations to improve access to productive finance investment – infrastructure and other “real” private markets assets that are essential to the economy.

Though largely aimed at the burgeoning defined contribution (DC) market, the government has been clear it sees these asset classes as the home for large pension funds. “Now is the time for institutional investors to seize the moment and invest in longer-term UK assets,” says Chancellor of the Exchequer, Rishi Sunak, in the report. “By doing so, they can help boost Britain’s long-term growth, enable pensions savers to access better returns, and support an innovative, greener future for the UK.”

However, making alternatives – particularly those favoured by the UK government – the poster child of post-pandemic recovery won’t change things overnight. It always takes a lot or hard work and preparation to create what is perceived as an overnight success – and this is no different.

“When you decide to commit capital and private markets, you can’t just go and buy a bunch of stocks,” says Philip Pearson, head of LGPS investment at Hymans Robertson. “It takes years to deploy capital effectively into those markets and many, many funds are still in that in that deployment phase.”

Much has been made of the lack of deployment in some asset classes, with “dry powder” indicating either a lack of supply, or lack of commitment from investors to take the plunge. But Pearson rejects the notion that dry powder is strong indicator of an opportunity lost and that an investment shouldn’t be pursued.

“What really matters is how much dry powder there is in relation to the quantity of deal flow. The relationship between those two is the key metric. When you on that basis, you realise there are still plenty of opportunities.”

Pearson accepts that returns have reduced due to the amount of money chasing available investments, but says that investors still receive a premium above the equivalent listed markets. “The time to really worry is when you’re not being paid a premium for investing with, or lending to, a private company,” he adds.

Alternatives are becoming mainstream
That funds have become comfortable with alternatives is apparent. More sophisticated investors and some of the larger funds have held a diverse range of alternatives for a long time, as have some of the more progressive smaller funds. Now, we’re seeing an increased variety of exposures across property, private equity, to some extent private debt, and infrastructure, says Kieran Harkin, head of LGPS investment at Mercer.

“What’s interesting is the big push towards renewable exposure, with managers, even in core infrastructure space, allocating more extensively to renewables.”

But in addition to investments within the pools, many funds have a desire to invest in a renewable “sleeve”, or segregated sub account on themes that are of particular importance to that fund.

“Though some of the larger funds have done this for a while, we’re seeing increasing demand to do this, particularly with social impact investing, and to some extent, local investing,” says Harkin.

The regulations allow for a certain amount of assets to be held outside the pool, and there are lots of interesting conversations about making a strategic decision to hold between 5% and 10% outside the pool for deployment in impact-based, and if possible, local investment opportunities.

One of the key areas that is slowly becoming a mainstream activity for this is affordable housing in the UK, says Harkin. “This ranges from a pure social housing site through to some private commercial developments. They’re attractive as they offer CPI, plus a margin, plus the potential of some additional benefit for yield by a sale on the open market, for instance.”

Pools will already have some UK property strategies, though the earlier diversification strategies around standard commercial UK property has been placed on hold in recent years as a response to the market conditions. Harkin believes these types of investments will increase, because they tick a number of investment, governance and even ESG boxes. “Because it is local investment, you get to build out locally. But it is important to remember this is not a pension fund and council working together to fund the social housing provision in their own back yard. It’s via regulated investment vehicles, and may have a sleeve for access into a local area, but is also diversified through the rest of the UK. That’s a big area and we’re starting to talk to clients about tangible opportunities to allocate fund assets.”

Unintended consequences
ESG concerns – and increasingly, targets – are driving greater demand in alternatives. In some cases, this is simply because it is easy to access greener investment opportunities as so many new, renewable energy projects are infrastructure investments, such as power generation, battery storage plants, electrical electric manufacture and supply, and the provision of vehicle charging networks. There are many different parts of infrastructure markets that are relevant to the decarbonisation project, either because they have very low emissions themselves, or because they will enable emissions reductions in the economy.

Climate change and the response of funds is driving investment particularly into infrastructure, Pearson warns investors not to overlook other potential opportunities.

“One might think that private debt and private equity would have a similar climate risk profile to a listed equity portfolio. But, oddly enough, it turns out not to be the case,” says Pearson. “Actually, private equity and private debt tend to have a lower carbon footprint. Not because those managers are doing anything special in themselves, but because they tend to focus on lower carbon sectors.”

ESG data, its quality and availability, though improving, remain a challenge for all parts of the investment process. However, while decarbonisation of a portfolio may improve the ESG credentials of a fund, there may be unintended consequences.

The desire to decarbonise may increase governance risks, particularly when investing in new technology, which society will be founded on in the future. While governance is meat and drink to pension funds, a broader dilemma may emerge concerning social factors, and not just for developing economies.

“Our economy is going to require some big new industries to be created, and that will unfortunately result in some big old industries, disappearing,” says Pearson. “That’s going to throw many people out of work who may not have the skills to get jobs in those new green industries.”

“That may be more of a concern for central government, but I believe the inclination of local government pension schemes will be to do what they can to manage the broader social impacts of decarbonisation.”

This may mean some impact investing may be directed towards areas where divestment has caused a rapid social transition.

The complexities of ESG’s ever changing landscape is just one of the reasons that manager selection remains such an important part of the whole governance process, says Harkin. “Some managers have very strong credentials in ESG and not all pools are able to take all strategic asset allocation decisions yet in private markets and alternatives,” he says. “Manager selection remains absolutely key, as managing in private markets is very different from the sizeable liquid markets. That upper echelon of managers can deliver a significant difference in returns.”

Return of an old friend
But no fund is buying assets purely for ESG reasons, they have to stack up from a risk and return perspective, while taking a holistic view, says Aon’s Cartwright. “Managing that equity risk will be key,” he says, “as ESG, low carbon and decarbonisation are all different and have an interesting dynamic at play.”

Social and affordable housing are not going to be the only appropriate investments for the LAPFs either, says Hymans Robertson’s Pearson: “We still need property, both commercial and residential, so it will remain an important asset class for all long term investors.”

“Perhaps we don’t need so many conventional High Street retail shops, but the economy will need lots more logistics and other forms of commercial real estate. Long-term asset owners can play a part in financing those types of assets.”

So while LAPFs are looking to new opportunities in private markets, they shouldn’t forget the benefits of more traditional ones. Property may move from being a problem child of the portfolio to a new, ESG-friendly and rewarding component in the next couple of years.