The role of multi-manager solutions in the age of LGPS asset pooling

Written By: Alistair Dryer Senior Fund Manager, Global Indirect Real Estate Aviva Investors

Alistair Dryer looks at the government’s pension scheme pooling proposals with particular reference to the complex question of the transfer of property assets

With local authorities having been asked to submit their initial asset pooling proposals to government by 19th February, 2016 and with final submissions due on 15th July, 2016, we are still some way from knowing how the new collective portfolios will be structured. Even so, we’re already in a position to consider the likely shape of the new regime, its potential costs and time frames and to assess the potential risks that could accompany any changes to current portfolio strategy.

The problems with property
Under the government’s current pension scheme pooling proposals, six collective investment vehicles (CIVs) would be formed to aggregate asset portfolios and so force down charges through synergy. According to the results of the 2014 consultation process reported by the Pension Fund Service, the majority of those participating agreed that such CIVs would deliver savings for the LGPS thanks to the economies of scale that are envisaged. They are also anticipated to improve governance and decisionmaking and, by reducing costs, deliver value for money. The plans are also seen as a means to improve the viability of infrastructure investment for such schemes.

So far, each CIV is envisaged to be of at least £25 billion in size. While local authorities are currently busy assessing their options here, the transfer of more liquid assets such as equities and bonds could begin as soon as April 2018, according to analysis commissioned by the government from PricewaterhouseCoopers (PwC).

However, the picture is more complex for property assets. Currently, with average LGPS allocations to real estate running at around 7% according to research from Hymans Robertson, we anticipate that the six real estate pools within the CIV structure are likely to be of at least £2 billion in size. This is quite a departure from existing scheme allocations that vary in size from below £100 million to well in excess of £500 million.

The recent report submitted to government by a working group of local authorities known as Project POOL suggested that the savings on property investment were to come from the removal of multi-manager and fund-of-funds property investing and the migration from indirect to direct property investing. However, the report also stated that where pension schemes allocate less than £200 million to property, they tend to invest indirectly. The paper goes on to add that for multi-asset pools with allocation to property of between £1 billion and £3 billion, indirect vehicles would still be needed for specific exposures. Aviva Investors was identified in the paper as one of only two managers that have the broad range of property investment capabilities across direct and indirect management; that means we are well placed to work with the LGPS as they consider their options for pooling.

Any move to the new collective model will require a clear set of rules for amalgamating and restructuring as well as a clear strategy on the types of assets that they will be holding, those they plan to sell, and likely future purchases. Because of the high costs associated with property transactions, it could take several years for such disposals to be intelligently delivered. The Project POOL report suggest that when factoring the costs of pooling property it will take 10+ years for savings to emerge. The changeover is also likely to result in the proliferation of relatively small assets and unlisted real estate investments, principally in the UK, but also overseas.

A vision of the future
At Aviva Investors, we envisage that, over time, the collective portfolios would start to look something akin to the real estate holdings held by state and industry pension funds in countries such as the United States and the Netherlands. Here schemes have implemented a number of different ways in which to invest in real estate (see case study below).

The current assumption in the United Kingdom is that the new collectives will principally look to create larger real estate portfolios comprising direct UK real estate assets. This has great appeal if the limit of a scheme’s ambition for the asset class is to secure low cost “passive” returns that are benchmarked against a UK commercial property benchmark, such as the MSCI. However, in recent years more evolved pension schemes have come to recognise the importance of greater global diversification in their real estate portfolios in much the same way as they previously recognised the need to diversify their equity holdings away from their home market.

Even so, this process remains in its early stages with Hymans Robertson estimating that the aggregated overseas property exposure for the LGPS as a whole is currently only around 5% of their real estate assets. Similarly, as local government schemes mature, they will inevitably need to focus on asset classes that are proven to deliver high levels of reliable income or which can be used as part of a liability-matching approach. Both these factors argue for greater and more diversified exposure to real estate assets as opposed to simply reducing the running costs of investing in UK retail, office and industrial properties.

Best in class
A related issue is that specialist real estate sectors such as the private rented residential sector, student accommodation, social housing, leisure and healthcare markets all require specialist asset management skills quite different from those required to manage the core real estate sectors of retail, office and industrial. Achieving the best results here generally still relies on investing in specific fund vehicles where such specialist management skills are prevalent.

Similarly, with an estimated 5% of the LGPS’s real estate assets in overseas markets – somewhere in the region of £600 million in value – it seems unlikely that we will see a collective vehicle capable of offering global diversification while still delivering reduced charges. As only the very largest pension schemes can afford to invest directly on a global basis, for most schemes the default remains to invest indirectly.

This suggests that there is still an important place both for indirect real estate holdings and for fund-of-fund structures which aim to capture the best of breed in each category. Indeed, the enduring attractions of funds of funds, such as access to specialisation and diversification, entry into hard-to- reach markets, more robust due diligence and professional property management are little diminished by the prospect of the new pooling regime.

A good example of this approach in action is provided by the Dutch scheme PGGM. It currently manages pension assets in excess of €180 billion and has a sizeable real estate exposure, but it does not hold any real estate directly. Instead, it utilises globally-invested specialist real estate investment vehicles, listed real estate equities and debt instruments.

Learning lessons
Global unlisted property funds still have some way to go if it they are to repair their reputation with some UK pension schemes following the global financial crisis and the plunging net asset values that ensued. For many such managers, the combination of declining real estate markets and being too highly leveraged at the peak of the investment cycle delivered significant losses and caused many investors to question the benefit of global diversification if it comes at such cost.

Our own analysis shows that lessons have indeed been learnt regarding leverage. Most core+ real estate funds have taken action to both reduce debt levels and to rebase fees to a NAV basis as opposed to gross asset value (GAV) basis. This has meant that these funds now more closely follow the underlying movements in their respective real estate markets at a time when correlation between different geographic markets is falling – increasing the benefits of diversifying portfolios by both country and strategy.

Understanding the cost benefits
The prospect of collective portfolios of directly held UK real estate assets brings with it the opportunity for economies of scale capable of reducing base management fees. This continues a well established theme of falling fees, with many LGPS direct and indirect accounts already benefiting from lower base fees than was historically the case.

Nevertheless, much of the reduction in fees that is projected to accompany the new pooling regime comes from the anticipated migration by some schemes from unlisted property investments to direct holdings. There are, undoubtedly, fee savings to be made here, as current fees on open-ended UK balanced property funds vary between around 30bps and c100bps. But, as we shall see, at the actual property level, these managers are producing alpha for their clients.

Unfortunately, the projected cost savings of the new pooling regime so far ignore the costs of actually trading in real estate, which has high transactions costs compared to other asset classes. Total transaction costs for buying UK property, including stamp duty, agents’ fees and legal fees run to around 5.75%. Any disposals of open-ended UK balanced funds prompted by the move to the new collectives would likely be done at either the NAV or the bid price. In the case of the former, then the round trip costs of reinvesting the receipts will currently be around 5.75%. At the bid price it will be closer to 7% (as the bid price is the NAV less the cost of selling assets, which is c1.5%).

Although there may be the opportunity to make in specie transfers of some assets from open-ended funds, this will require that both fund managers agree in principle and the actual asset(s) be transferred. Hence, while there may be some ongoing reduction in the annual management fees, if not done intelligently such repositioning could deliver sizeable capital losses.

Getting what you pay for
There’s no question that investing in unlisted property funds is inherently more expensive than investing in direct real estate, due to the fund wrapper which includes the underlying management fee and the administration and regulatory costs. But unlisted property funds such as open-ended UK balanced funds have historically performed well against the IPD Monthly Index.

Figure 1: Performance of standing real estate investments in the UK (to 31st December 2015) per cent per annum

Source: IPD Monthly data as at 31 December 2015

Moving beyond benchmarks: the evolving role of the multi-managers
In the corporate pension market, it is now becoming increasingly commonplace for schemes to pursue an absolute return benchmark for their real estate assets. As schemes mature, we are also seeing the increased use of cash flow matching strategies which employ long-lease or real estate debt assets thanks to the higher levels of secure income they offer.

However, there have been no indications that the new CIV regime for the LGPS has any absolute return ambitions for the property portfolios that are envisaged, or that schemes will be able to use the new pooled portfolios to match their long-term liabilities.

From our perspective, this suggests that, over the coming years, the LGPS needs to look at how best to divide their current real estate portfolios between the low-cost, high beta UK exposure offered by the new CIV regime and the opportunity to pursue a wide array of different investment objectives through unlisted property funds. When considering the latter, it quickly becomes clear that experienced multi-managers will have a lot to offer.

We think many schemes will come to recognise that the additional tier of fees that will always accompany this approach offers just as much value for money as the new pooling regime when it comes to real estate investment. For somewhere in the region of 30bps a year, schemes can use a well-resourced multi-manager to access the broadest spectrum of specialist funds from best-of-breed managers from around the world – often for lower fees than they might pay as a direct investor.

Investors also benefit from the professional asset allocation skills of a dedicated fund manager and the reduced trading costs enjoyed by such managers. Accompanying this is the improved due diligence and reporting that comes from the ongoing monitoring and analysis that is part and parcel of being a successful multi-manager business. By emphasising best-of-breed managers in all spheres of the market, multi-managers also offer access to the world-class property asset management.

Some schemes might utilise a multi-manager approach to diversify away from their new UK-based CIV holdings into global markets. For others, it could be an opportunity to target high growth or high income portfolio returns. Still others might utilise a multi-manager portfolio to target more specialist areas of the market such as long-lease assets, real estate debt or infrastructure funds.

Where we think multi-manager approaches offer most “bang for a buck”, however, is in helping schemes set absolute return benchmarks for their property holdings – as is already the case for some leading overseas schemes – or build the cash-flow matching solutions that mature schemes require. When it comes to building outcome-oriented solutions we think there’s no substitute for a dedicated fund manager with access to the widest range of best-of-breed managers.