Why is income so important for pension funds and institutional investors at the moment?
Simon Hill: The vast majority of defined benefit schemes are now closing to accrual, so they are increasingly coming into a run off situation. So they start to think much more like an insurance company, in terms of cash flow management and what sort of portfolio they need to have at some defined point in the future which will then run off.
John Walbaum: They need income but they also need growth. You look at many of the cash flow sheets that we are all processing and at how much of those are going to be paid out in the next 10, 20 and 25 years. Funds will spend a lot of capital in that time and have to make sure they spend it sensibly.
Simon Levell: Some are saying, “Actually, we’re just going to sell assets to meet the need as it arises.” But there is an increasing awareness of this event risk or sequencing risk. You don’t want to be a forcer in a downmarket and often in the downmarket, the things that hold up well aren’t liquid.
James Tarry: During downturns in the market, assets you thought were liquid can be badly affected.
Hill: Trustees have to grapple each year, each quarter with the question “What
are we going to sell? How much are we going to sell?” Returns are low generally. So, there is not even the capital gain to consume.
Nick Clay: You could argue low returns are about the only certain thing you have got today. Because where valuations are, there is 100% correlation with likely future returns for the next 10 years.
Hill: If you are an optimist you could say at some point with interest rates this low, the big new thing is going to come. It might be medical technology, robotics that will set off the next big phase of growth and that money will go into it in the same way that development of steel and car making and so on, and
telephones did a hundred or so years ago.
Where can investors find income? From real assets?
Walbaum: Look at the portfolio 10/15 years down the road when everybody has retired. That is what it needs to look like. You can then build back and start filling up the gaps. Infrastructure assets and equities have a part to play, private debt markets and real estate probably have a part to play and so on. Then you ask, “How do I build into that sort of portfolio over time?” It also helps not be a forced seller of an asset. So, it is a discipline that pension funds haven’t had because they thought about an end game and thought about it purely from a balance sheet perspective, not in a cash flow perspective.
Hobbs: In the private asset classes, there could be around $10trn across private equity, infrastructure, real estate and private debt. Of that, probably only about 40% is really providing a good yield. So of that $10trn you have got private equity, opportunistic real estate which doesn’t give you a yield (around 30% of the total) and you have also got listed infrastructure or REITs which give you a pick up on broader equity yields, but they don’t give you a big yield (another 30%). So then you have got quite a small, albeit $4trn, in yielding real assets of core real estate, infrastructure, and private debt. So you are probably at about $4trn, most of which is core real estate and infrastructure is tiny, still. So you have only got a very small amount of market to play in and that is the big reason why those bubbles are appearing because it is a small market and everyone is searching for yield.
Tarry: Around £35bn a year of infrastructure debt is issued annually in the UK, while real estate debt transaction volumes can range from £40bn to £50bn a year. Those are pretty big numbers. Add in UK corporate debt issuance of around £300-odd billion, the private corporate debt market and other structured finance opportunities and the private markets start to look pretty sizeable. But pension funds can’t really access these markets very efficiently.
What is preventing pension funds from accessing these markets?
Tarry: Traditionally these markets have been dominated by the banks, but capital constraints are making it more difficult for banks to lend into these markets. That is clear in the UK real estate finance market where banks once accounted for 80% to 90% of the market. That figure has fallen to 75% and is still shrinking. The alternative lenders are taking more market share. Whether it is a supermarket or a local authority looking to raise finance, it’s now becoming natural for them to talk to alternative lenders. Just as their reflex would have been to go to a bank in days gone by, they are now thinking, “Well actually this is now another real financing option that we can add to the list.” But, if you’re trying to access alternative lending opportunities on the asset side then it’s not always straightforward. Certainly in the wider wholesale markets in terms of the senior lending side, you have to have a specialist platform in order to be able to access the product. We have done that for 30-odd years for our life insurance annuity book, but that requires a pretty chunky platform with 80 to 85 people working every day to keep that machine running. A pension fund may think, “I like the look of this opportunity and would like to get into this market.” However, it’s not always straightforward to access these opportunities, even once they’ve identified a particular asset class and wish to invest, they may not have the appropriate governance budgets to be able to decide whether and how they are going to access the market. Many investors don’t move particularly quickly and researching one private debt class alone takes time. Opportunities in private debt markets also change.
