PENSION FUND CONSULTANTS & MULTI MANAGERS
Managers must woo consultants to tap pension funds’ appetite for property, writes Alex Catalano
Investment consultants are the gatekeepers to a gigantic pool of pension fund capital. It is their advice that tells their clients how much, how and with whom they should be investing in real estate.
Fund managers who make it onto their recommended providers list will find capital flowing into their vehicles, while those who are still on the outside wonder what it takes to break in.
The good news is that real estate gets pretty positive reviews these days. A good guestimate puts UK pension funds’ allocations to property investment at somewhere between 10% and 15%. However, the way their money is being invested has changed radically.
The old way of looking at allocations – equities, bonds and a bit of property for diversification – has been replaced by finding assets that have the cash flow to match pension funds’ liabilities.
“The traditional allocation to buying buildings is probably declining, but there’s been significant growth in specialist areas such as debt, student accommodation, ground rents, long-lease property and sale and leasebacks on social housing,” says Jon Exley, investment advisory partner at KPMG.
According to KPMG, for every £1 its clients invested in balanced property over the 2009-2011 period, £10 went into long- lease property (see panel below).
Long-lease assets are in short supply as investors’ appetite grows
Long leases are gold-star investments as far as pension schemes and their consultants are concerned. Their capital has been pouring into this type of real estate (see pp10-11); KPMG estimated that at least £3bn – 10% of UK pension funds’ total real estate allocations – was held in this format in 2011 and another £1bn probably went in last year.
The bandwagon is still rolling, with AXA Real Estate having launched such a fund in January, raising an initial £125m and planning to expand the fund’s capital to £1bn in five years.
However, the stock of these assets is very tight. “It is getting more and more difficult to source these properties. In the research team we are looking at how you could get access to something like this but on a more global basis,” says Richard Slater, Deloitte’s head of investment consulting.
Moreover, the intense competition for these assets has tightened yields to the point where some are asking whether it is time to look elsewhere.
Also, not all long leases are created equal. There are location and the tenant’s credit-worthiness to consider, as anyone who held leases on the collapsed Southern Cross care homes found to their cost. “These are crazily expensive deals in my judgement,” says a fund manager. Others question whether investors are taking on more risk than they realise.
“It’s sold as a liability-matching tool, but 20 years to a food retailer at 3.5% isn’t necessarily going to perform,” says one.
“The issue is residual value. It is a big chunk of the value over the long term. With bonds, you get 100% of your capital back. But with a long-lease investment you may be going to more secondary property and locations, and there could be a lot of capital expenditure.
“You might only get 60-70% of your value back, and that is a huge hit on your overall return.”
Others think long leases still make sense. “As a property investor looking at those funds relative to the rest of UK property, I can make an argument for them looking pretty damn expensive,” says a multi-manager.
“But if I am a de-risking pension fund that isn’t thinking about them on a property- relative basis, but on a liability-relative basis, they may still offer good value.” Liability-driven investment and the low returns offered by bonds in these post-crisis years have fuelled the shift.
“Because interest rates and gilt rates are so low and clients are trying to de-risk, they are looking for a substitute for corporate bonds and gilts,” says Paul Richards, head of European real estate at consultant Mercer.
“In the past three years there has been very little straightforward, IPD-index-tracking style, open-ended property investment,” Richards adds. “It is all about de-risking and defensive income.”
“In the past three years there has been very little straightforward, IPD-index-tracking style open-ended property investment. It is all about de-risking and defensive income”
Hence the popularity of long-dated, index-linked income flows backed by hard assets such as real estate or infrastructure.
Advised by their consultants, pension funds have flocked to vehicles such as Standard Life’s Long Lease Property Fund, M&G’s Secured Property Income Fund and Pramerica’s UK Ground Lease fund (see Analysis, pp10-11).
‘Real asset’ products gain traction
“Last year we worked closely with a few managers to develop real asset platforms and these products have gained signifi- cant traction with our clients,” notes Nick Duff, a partner at Aon Hewitt Investment Consultancy.
The latest big thing is real estate debt. “It gives 4-5% returns, which seems quite low, but compared to investment-grade credit it is interesting, given the extra security you’re taking on,” says Paul Jayasingha, senior investment consultant at Towers Watson.
Duff adds: “Stretched senior or junior debt also looks interesting, achieving returns of up to 8-10% net.”
The money going into this type of property largely comes from funds’ fixed-interest or inflation-linked, liability-matching buckets, rather than the usual property allocation.
In fact the traditional, IPD-tracking, balanced property unit trusts have had athin time of it recently. Richard Slater, head of investment consulting at Deloitte, says: “In the past few years we’ve been very much focused on property’s income play, rather than core, balanced property funds. That’s been justified if you look at what happened with capital values over the past few years.”
“We drill down into quite a lot of detail, to understand a team, what motivates them, how they are tied in with investors, and tied in with the business in terms of their alignment”
However, there are signs that investors’ risk appetite is perking up and value-added real estate is starting to make a comeback. INREV’s 2013 Investment Intentions survey found that 43% of European investors now had a preference for value-added strategies – almost double last year’s 22%.
“There is a significant yield gap between secondary and prime real estate and some interesting opportunities to get involved with good property companies, or fund managers with property company backgrounds, looking to launch such a fund,” says Duff.
Richards seconds this theme: “There is a time-limited opportunity at the moment in second-tier property, where there is an element that is underpriced relative to the risk it offers. For the first time in three to five years in the UK, we’re seeing something that is a bit value-added being attractive.”
International diversification gets mixed reviews. “UK pension funds are not putting a lot of property money outside the UK at the moment,” says Richards. “They are still concerned about the eurozone – it is a risk too far. And if they go outside the UK they are taking currency risk.”
Duff adds: “The jury’s out for us on overseas investment. Clients need to understand the risks of investing in less transparent markets abroad, which are less investor friendly, more illiquid and where gearing remains common in driving returns.”
However, some are seeking extra returns globally. Towers Watson allocated clients to an opportunistic Asian strategy last year, looking at returns of 15-20%, and is considering a couple more such funds.
“We’re also looking at European and UK opportunity funds and some distressed-type funds in the US and Europe, where they might be buying non-performing loans or restructuring/recapitalising,” Jayasingha says.
“Most people frown when they think about Europe, or worry about the turmoil, but history has shown that when people are most afraid turns out to be a pretty good vintage for allocating to these opportunity funds.” But he adds: “We tend to be pretty selective with opportunistic funds, picking a handful – five to 10 – a year.”
For consultants, their job has become more complicated. “There is also now an overlap with other asset classes, which means I’m working closely with colleagues outside real estate when providing clients with ideas and solutions,” says Duff.
“The expectation from clients these daysis ‘you need to be providing us with a lot more ideas’. We’re doing much more that is not ‘off the shelf’.”
Accessing the ‘gatekeepers’
How easy is it for fund managers to get access to pension funds’ gatekeepers?
“We try to have an open door policy with managers, though sometimes that can be difficult,” says Duff. “Just because I haven’t come across a manager before doesn’t mean that I will keep to the managers that I have strong relationships with.”
This isn’t necessarily how the fund managers see it. “They stick to their favourites and it is very difficult to break into that magic circle,” says one manager whose funds span the risk spectrum.
Another, who runs big, institutional real estate funds, adds: “They can sometimes be terribly standoffish to the point of arrogance,” while a third says: “You have to keep knocking on the door to get an audience.”
From the stories Real Estate Capital hears, it is clear that personal networks help greatly when it comes to fund managers getting that initial hearing with a pension fund consultant.
“We were able to call someone senior in the organisation and say, ‘Can you please ask your guys for half an hour and if we can’t make our case for further examination in that time we won’t darken your doors again’,” says one manager who tried for “quite a long time” to get a hearing from one of the big three firms. “It’s not easy to get in with these guys and I understand why. They have very finite resources.”
Indeed, the consultants’ teams are relatively small and there are a lot of fund managers and funds; some 100 new ones are being launched this year.
The consultants say they could spend all their time discussing such funds over coffee, but there is no point in doing so if the vehicle is a “daft idea” or there is minimal prospect of their clients ever investing. “It’s not a good use of our time or the fund manager’s time either.”
Once a manager has got its foot in the door, it is an exhaustive process to make it onto the consultants’ recommended providers list, never mind getting clients’ capital to invest.
“We had to put in the time and effort to build a relationship, to explain what we are doing, to be patient,” one fund manager recalls. “We did that for about 18 months to two years, then we started to win mandates.”
Towers Watson’s Jayasingha says: “We spend a lot of time meeting managers who are fund raising, talking about their business plans and assets, then seeing the assets.
“We drill down into quite a lot of detail to understand a team, what motivates them, how they are tied in with investors and tied in with the business in terms of their alignment,” he adds. Examining a manager’s back office and risk controls are also part of this examination.
One fund manager who admits consultants “do quite a good job” when assessing managers, calls their examination “forensic and a pain in the backside. It is time intensive, which irks people. But it is an investment, of our time and theirs.”
“Certain managers we won’t go near, because the potential take-out in fees is so high that frankly, they’d have to achieve unrealistic returns to get anywhere near what they are promising” Nick Duff, Aon Hewitt
Fund managers’ fees also come into it, of course. “We use modelling systems to quantify the impact of performance fees in terms of the drag and what percent of the expected alpha, or genuine outperformance, is being paid away,” says Jayasingha.
Duff says that at Aon Hewitt “there are certain managers we won’t go near, because the potential take-out in base and perform- ance fees – with unacceptably low hurdle rates – is so high that frankly, they would have to achieve unrealistic returns to get anywhere near what they are promising the client. It just cannot be delivered.”
Start-ups struggle to break in
Consultants’ forensic process of appraising managers makes it hard for start-up management houses to break in. “Past performance and track record is key to their analysis,” says one manager who speaks from bitter experience. “If you are a new manager setting up a maiden fund, you don’t have any of that. Your track record from your previous house doesn’t count.”
Deloitte’s Slater retorts: “They may have been a good investor within XYZ, but do they have the same reach, process, infrastructure and capability in their new venture? We’re not averse to looking at them, but it is understanding whether they have the same capabilities after setting up alone.”
So just what does it take to get on a consultant’s recommended providers list? “Being good at something,” answers Mercer’s Richards. “You have to demonstrate that you have a competitive advantage – that you can identify and manage the assets which are going to perform well.”
“We’re focused on the strategic idea,” says KPMG’s Exley. “It’s a bit different to league tables or the sort of thing you would see with the balanced funds. It’s about having the idea and the systems and people to implement it. Ability to originate and credibility in that area is key.” This sourcing and credibility issue is what put consultants off some of the debt funds that have been trying to raise capital.
“You have to be able to do all the due diligence on the properties you are lending against, be able to structure the debt properly, negotiate between different tranches of capital, and also be an organisation that can find the investments,” says Richards. “Not everybody can do it well.”
Consultants insist boutiques can compete with fund management big boys
Does size matter? Boutique managers think so. “The big guys – Standard Life, Scottish Widows and Pramerica – are all schmoozing and talking to consultants,” says one such manager. “They’re not going to give me money, because they see it as too risky to give a small owner-managed boutique capital for a fund.”
The consultants deny this, however. “There are no hard-and-fast rules, but often the boutiques are hungrier, better aligned, have less encumbered past assets that they have to worry about and they’re more willing to be flexible on their fee terms,” says Paul Jayasingha, senior investment consultant at Towers Watson. “We absolutely do research them and in some cases we have put them forward to our clients.”
On the flip side, while the larger firms tend to have more diversified revenue streams and strong compliance functions, they also have a very large cost base to support, which can lead to asset-gathering mentalities,” Jayasingha adds.” There are pros and cons to both business models and we don’t rule either of them out.”
Aon Hewitt has had boutique managers on its buy list for a long time, according to partner Nick Duff. “They have gained traction with clients over the past few years,” he says. “We will back them as long as they have the right structures, procedures, risk management controls and processes in place.”
The beauty of some of the smaller entities is that you get partner-level involvement, plenty of grey hair – they are doing the hard work themselves. I’m keen to see senior people managing my client portfolios, whenever possible. That said, there are some very good younger managers developing too.”
Paul Richards, head of European real estate at consultant Mercer, adds: “If a team wants to launch a niche fund, it is easier if it has institutional backing. Most of them are managed by largish organisations, because they have the resources.”
However, in specific niches, we have also invested in some smaller partnership- type organisations, which are good at what they do.”
If you are investing in a fund that has a 10-year life, you have to be comfortable that if we go through a rough economy, or whatever may happen, the manager is able to ride that out.”