Alternative investments by pension schemes: avoiding the legal pitfalls€¦ · Full of hidden...
Transcript of Alternative investments by pension schemes: avoiding the legal pitfalls€¦ · Full of hidden...
10 May 2017
Alternative investments by pension schemes:
avoiding the legal pitfalls
Alternatives – An Introduction Tim Gardener Partner – Aon Hewitt Investment Consulting
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Agenda
1. A Short History of the UK DB Pension Fund Asset Allocation
2. Why Alternatives? (including the Cynics Explanation)
3. What Alternatives can add to Portfolio Design
4
Average Pension Fund 1976
Asset Class 1976 (%)
UK Equity* 57
Overseas Equity* 4
UK Gilts 25
UK Property 9
Cash 5
Life was so simple then….
*61% Equity
5
Average Pension Fund 1976
Average Pension Fund 1996
Asset Class 1976
(%)
1996
(%)
Equity* UK 57 55
US 0 3
Europe 0 9
Japan 0 3
Asia Pac 0 5
Other 4 1
Bonds UK FI 25 8
UK IL N/A 4
Overseas 0 4
Property 9 2
Cash 5 6
Life was so simple then…. but getting less so ………..
*61% Equity
*76% Equity
Asset Class 1976 (%)
UK Equity* 57
Overseas Equity* 4
UK Gilts 25
UK Property 9
Cash 5
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…….and now life is anything but simple
Asset Class 1976
(%)
1996
(%)
2016
(%)
Equity UK 57 55 15
Overseas 4 21 26
Bonds UK FI 25 8 17
ILG N/A 4 9
Overseas 0 4 5
Property 5 6 1
Property 9 2 8 Alternatives 9
Equity Allocation: 61% 76% 41%
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Why Alternatives? (incl. the Cynics Explanation)
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Just some of the Alternatives
Duis rutrum
massa quis
sem placerat,
doodio pellen.
Duis rutrum
massa quis
sem placerat,
doodio pellen.
Social housing. Real estate
debt
Infrastructure
debt Agriculture Woodlands. Private Equity
Commercial
Property
Insurance
Linked
Securities
Hedge Funds
Direct Lending
Infrastructure
Diversified
Growth Funds
Commodities
Absolute
Return Bond
Funds
Emerging
market debt
Securitised
Debt
High Yield
Venture Capital
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Whatever happened to the KISS principle?
Compared to mainstream assets alternative asset types can be:
Lacking in transparency
Illiquid or semi-liquid
Difficult to access
Expensive to manage
Comparatively lightly regulated – still in ‘caveat emptor’ land
Full of hidden costs
10
Private equity - examples of practices where Enforcement Actions were taken by
SEC (in US)
1. Undisclosed fees – monitoring agreement. Private equity firm charges companies it invests in
a ‘monitoring’ fee (ten year contract, say) which it ‘accelerates’ if company sold. Not disclosed to
investors,
2. Expense shifting. If a deal doesn’t go ahead then the expenses (due diligence, etc.) should be
allocated to those who would have benefited from the deal. In at least one case the expenses were
all allocated to the investors although the private equity firm would also have had an interest had the
deal gone through
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Conventional wisdom
“Diversification reduces risk”
“Harvest illiquidity premium”
“Uncorrelated returns reduce volatility”
“Lower volatility”
“Low yields on conventional debt”
“Low returns on mainstream equities”
Alternatives – Why?
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The Cynics View
“We need to innovate”
“Everyone else is doing it”
“My client expects me to come up with new
ideas"
DB has been a supply led business
Rear view mirror investing
Alternatives – Why?
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Conventional View
“Diversification reduces risk”
“Harvest illiquidity premium”
“Uncorrelated returns reduce volatility”
“Lower volatility”
“Low yields on conventional debt”
“Low returns on mainstream equities”
Cynics View
“We need to innovate”
“Everyone else is doing it”
“My client expects me to come up with new
ideas"
DB has been a supply led business
Rear view mirror investing
Alternatives – Why?
14
Making sense of alternative investments
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Three broad categories
Real Assets Alternative
Debt
Absolute
Return
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Real assets – enhancing the growth portfolio
Examples: Real estate, private equity, infrastructure,
woodlands, etc.
Common Characteristic: Ownership/part ownership
Raison d’ être: Real growth, alternative to equities
Reference portfolio enhancement: Increased return, reduced
volatility, (lower price volatility and/or follows different cycles),
diversification
Biggest single risk: Asset becomes worthless
Real Assets
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Alternative debt – enhancing yield and providing cash flow
Examples: Direct Lending, real estate debt, infrastructure debt
Common Characteristic: Debt either fixed or floating rate
Raison d’ être: Yield enhancement
Reference portfolio enhancement: Increased return, enhanced
yield, diversification
Biggest single risk: Default, investor misunderstands level of
security
Alternative
Debt
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Absolute return – uncorrelated return reducing volatility and/or protecting the
downside
Examples: Hedge funds, absolute return bond funds
Common Characteristic: Investing in ‘skill’
Raison d’ être: Uncorrelated return – protection in falling
markets
Reference portfolio enhancement: Improves return/volatility
characteristics of growth portfolio
Biggest single risks: Leverage, ‘skill’ is illusory
Absolute
Return
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Alternative investment and how it should be done – outcome investing
At a high level decide on: 1. The outcomes needed -e.g. growth, income, source of cash, hedging liabilities, etc.
2. The balance between the sub-portfolios (growth, income, etc.) etc.
3. The reference portfolio for each sub- portfolio.
Example:
Strategy
Growth
Income
Hedging
Cash
Ref: Global
equities Ref: Scheme
liabilities
Ref: Inv.
grade credit
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Conclusion
Investing in Alternatives can lead to:
– Better outcomes
– More certainty of achieving a desired outcome
– Reduced risk during the ‘journey’
But:
– Look very carefully at the ‘small print’
– Be wary of fashion and supply led advice
– Understand how your provider is making (so much) money
“If you've been playing poker for half an hour and you still don't know who the patsy
is, you're the patsy” – Warren Buffet
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Ed Harris and Amran Hanif
Trends in Limited Partnership investment strategies
Hogan Lovells | 24
Typical Private Fund / Limited Partnership (LP) Structure
Trends in LP investment strategies
Investment
Manager
General
Partner
Limited
Partnership
Investors
(Limited
Partners)
Portfolio
| 25 Hogan Lovells
• Continuing downward pressure
– Smaller number of fund managers can resist this
– Negotiation focussing on detail, not just %
– Management fee offsets
• Discounts
– Early bird discounts remain common, as do fee rebates, particularly for cornerstones/large investors
– Loyalty discounts
– Group discounts
• Timing of fees starting, stepping-down and stopping
• Regulatory scrutiny
Management Fees
Trends in LP investment strategies
| 26 Hogan Lovells
• LP rights
– to suspend or end the investment period
– remove/replace the manager
– wind-up/terminate the fund
• Manager removal
– No fault and for cause
– Possibility of cure
• Key person
Governance: LP rights
Trends in LP investment strategies
Hogan Lovells | 27
Limitation of liability
– Commitment v assets of scheme
– No personal liability for trustees
Reporting requirements
– More detailed and more frequent
– Greater accountability on cost
– Communicate what you actually need
End of Life Solutions
– US$600 million in funds of pre 2007/8 vintage
– Historically under thought and under negotiated
Trends in LP investment strategies
Hogan Lovells | 28
Co-investments
– Part of most private equity deals, either pre signing or post closing syndication
– Process now streamlined and element of competitive tension with potential co-investors
– Co-investors often a mix of current and prospective LPs
– Push back from GPs on no fees/carry?
– Impacts of GP removal
Trends in LP investment strategies
| 29 Hogan Lovells
Secondaries (sales by investors)
– Well established, liquid market with heavily intermediated processes
– Less bank and state sales and more LPs managing their portfolios
– Pricing, terms and execution very competitive and increased use of leverage to make returns
– Deferred consideration
Trends in LP investment strategies
Hogan Lovells | 30
Other
– "Alternative secondaries"
– GP or tail end solutions (e.g. liquidity for LPs, reset carry for team or end life funds)
– Increased number of deal by deal funds
– Single LP funds
– Acquisitions of PE funds or fund of funds
Trends in LP investment strategies
Ed Harris and Amran Hanif
Trends in Limited Partnership investment strategies
Jeremy Pickles
Hedge fund investment
| 33 Hogan Lovells
• Overview
– Scope of legal review and negotiation points
– Headline features
• What is a hedge fund?
– No formal definition
– Typical characteristics include: target absolute returns, unconstrained management style, "open-ended", performance fee to incentivise skill-based manager, domiciled offshore
• Market background
– High profile articles on pension funds reallocating away from hedge funds and poor performance in the hedge fund sector
– Reality is more nuanced
Hedge fund investment
| 34 Hogan Lovells
• Typical structure
– Offshore company
– Can be tiered ("master-feeder")
• Key documents
– Private Placement Memorandum (or PPM)
– Articles (or equivalent)
– Application Form
• Scope of legal review
– Generally tougher to negotiate changes to key fund terms
– but opportunities for side letters have increased in recent years
Hedge fund paperwork
Hogan Lovells | 35
• Top 5 headline features:
– Arguably weak governance
– Constraints on liquidity
– Unconstrained investment strategies
– Lack of transparency/information rights
– High fees
Headline features
Hogan Lovells | 36
• Arguably weak governance
– Quality of oversight provided by board
– Trend for more independence
– Limited voting rights (changes of class rights)
– But redemption rights
• Constraints on liquidity
– Periodic liquidity, but
– Lock-ins
– Redemption gates
– Suspensions
– "Redemption shares" (or fast pay/slow pay)
– "Side pockets"
Headline features (cont.)
Hogan Lovells | 37
• Unconstrained investment strategies
– Broad and flexible: potential for "style drift"
– Powers to make illiquid investments
• Lack of transparency/information rights
– Information essential for exercising governance rights
– Trend to more disclosure, particularly expenses and conflicts
• Fees
– Management fee
– Downwards pressure on fees in general
– Concern re "asset gathering"
– Performance fee
– High water marks and resets
– Increasing complexity (e.g. benchmarks)
Headline features (cont.)
Jeremy Pickles
Hedge fund investment
John Condliffe and Elliot Weston
Investing in residential property
| 40 Hogan Lovells
• Our recent experience
• A growing market
• Direct and indirect investment
• Jargon busting
• Core real estate and tax issues of which to be aware
• Case study – build to rent on brownfield site
Residential property
| 41 Hogan Lovells
• Four times as many private rented schemes were under construction or in the pipeline at the end of 2016 as were built in the previous seven years in total. (Molior (2016) Q3 PRS Research)
• As at Q3 2016, there were 8,257 PRS units that had been completed since 2009, 8,799 under construction, and 23,022 in the planning pipeline. (Molior (2016) Q3 PRS Research)
• Around £3.1bn of student housing stock was traded in 2016 and £5.1bn in 2015. (C&W UK student accommodation report 2016/17)
• Number of purpose built student beds for the 2016/2017 academic year has reached 568,000, an increase of 5.4% on 2015/2016. (C&W UK student accommodation report 2016/17)
A growing market
Hogan Lovells | 42
• The Guardian, 5 May 2017
• Highly regulated sector, expert knowledge and advice is key.
But…
Hogan Lovells | 43
• Some of you may already have invested in residential property, either directly or indirectly
• The issues we will talk about are relevant whether you invest indirectly or directly (albeit once removed if you invest indirectly)
• If there are any differences in impact we will highlight them
• In either case we want to tell you some of the key issues and drivers so that you know what questions to ask when deciding what funds or sectors to invest in
Direct or indirect investment
| 44 Hogan Lovells
• AST – Assured Shorthold Tenancy – underpins BTR and PRS
• B2R/BTR – build to rent – newly constructed purpose built private rented block intended to be owned by a
single landlord
• BTS – build to sell
• DMR – Discount Market Rent – agreed with the local planning authority
• Enfranchisement – acquisition of the freehold by residential long leaseholders
• Golden Brick – sale of newly built residential accommodation is zero rated for VAT purposes if the sale is
by the person constructing and construction has got past "golden brick stage"
• HMOs – Houses in Multiple Occupation – particularly relevant to student accommodation sector. Landlords
who let houses or flats to groups of students are likely to face extra regulation if property deemed to be an HMO
Jargon busting
| 45 Hogan Lovells
• MDR – Multiple Dwellings Relief – for SDLT purposes
• PBSA – Purpose Built Student Accommodation
• PD right – right for Permitted Development of existing buildings to residential, which does not require
planning consent
• PRS – Private Rented (or Residential) Sector – accommodation that is privately owned and let
• RSLs – Registered Social Landlords – relevant for affordable housing requirement
• SDLT – Stamp Duty Land Tax – a tax on a land transaction
• TDS – Tenancy Deposit Scheme – a regulated and compulsory scheme for holding tenants' security deposits
• TOGC – Transfer Of a Going Concern for VAT purposes, for example, on a sale of a let property
Jargon busting continued
Hogan Lovells | 46
Tax Real estate
Drivers
• It is where people live
• So statutory protection for home owners and residential tenants is woven through all the legislation
• Similar statutory provisions for owners or occupiers of commercial property generally do not exist
• Sales of new residential properties can be zero rated for VAT purposes
• Landlords suffer irrecoverable VAT on letting residential property
• SDLT rates are higher than for commercial property but MDR can apply to reduce the SDLT cost for acquisitions of multiple flats or houses
| 47 Hogan Lovells
• Enfranchisement – rights of qualifying long leaseholders to acquire the freehold and any intermediate leases
• Lease extension – rights of qualifying long leaseholders to extend their leases by 50 years (houses) or 90 years (flats)
• Right of first refusal – triggered by disposal by landlord
• Ground rents – recent publicity and case law
Key real estate issues
Build to Sell
Hogan Lovells | 48
• Underpinned by Assured Shorthold Tenancies
• Management is key – experienced property managers
• Power of attorney for signing ASTs
• Tenancy Deposit Scheme
• Right to Rent
• Policy on length of term of ASTs
Key real estate issues
Build to Rent/Private Residential Sector
Hogan Lovells | 49
• Name of landlord
• Timing of delivery, particularly on development
• Licensing and HMOs
• Non term time income - planning restrictions
• Nomination agreements
Key real estate issues
Student accommodation
Hogan Lovells | 50
• Variety of senior market offerings, often with different issues:
– Retirement flats – usually let or sold to individual owners
– Care homes – run by a care home operator
– Extra care facilities (with nursing or long-term specialist care)
– Retirement villages combining some of all of these, often with shared communal facilities
• CQC registration
• Age restrictions
• Service charge consultation
• Other fees
Key real estate issues
Care homes / Retirement living
| 51 Hogan Lovells
• Sales: trading v investment
• Self-invested pension funds and residential property
• VAT recovery
• SDLT cost
Tax considerations
Tax considerations for pension funds
| 52 Hogan Lovells
• Brownfield site
• Used to be offices and factory
• Forward funding of a developer by an investor
• Land owned by a third party, land value significant proportion of end value
• Knock down and rebuild
• Golden brick
• VAT on land and construction cost
Build to Rent
Case study
John Condliffe and Elliot Weston
Investing in residential property
Coffee
Paul Mullen and Jo Robinson
Direct lending
| 56 Hogan Lovells
• Background
– low interest rate environment
– increased regulation of the Banks post financial crisis
• Debt funds established to lend directly to borrowers in Europe (more mature market in US)
• Pitch by direct lenders
– flexible approach to lending
– streamlined decision making
– investment professionals with bank lending experience
• Non-rated, illiquid assets
• Less volatility than other asset classes
• Floating rate instruments
• Income producing rather than capital growth
What is direct lending?
| 57 Hogan Lovells
• Generally secured debt on Loan Market Association (LMA) terms
• Senior Debt
• Unitranche
• Subordinated Debt (second lien, mezzanine, PIK)
• Equity co-invest
• Regulatory position determined by jurisdiction of borrower
How are direct lending transactions structured?
| 58 Hogan Lovells
• Drawdown structures
• Default rates/past performance
• Reporting
• IRR – asset level/fund level
• Leverage?
• Management fees
• Hedging policy
• Internal governance
• Independent diligence
Considerations for investing in direct lending funds
Hogan Lovells | 59
Active Direct Lenders in Europe
Paul Mullen and Jo Robinson
Direct lending
Philip Brown
Investing in infrastructure
| 62 Hogan Lovells
• Spanish Funeral Business for sale – Infrastructure funds expected to bid.
• Interests in entities that own or operate physical, tangible assets that provide essential services to society.
• Key characteristics:
– monopolistic or quasi monopolistic, high barriers to entry
– long term investments: yields returns when the asset is operating
• Which asset types will suit your fund?
What are infrastructure investments?
| 63 Hogan Lovells
• PPP/PFI
• Regulated assets
• Assets with a stable government subsidy
• Demand-based assets
• Corporate (contracted) assets
• Non-core (trading companies with some infra characteristics)
What are the different types of infrastructure?
LOWER
RISK AND
RETURNS
HIGHER
Hogan Lovells | 64
A. "operating infrastructure projects that have been developed PFI/PPP or similar procurement models"
B. " Environmental Infrastructure projects that have the benefit of long-term contracts or stable regulatory frameworks"
C. "infrastructure assets which the Directors believe have high barriers to entry and are expected to generate an attractive total
rate of return over the whole life of the investment"
Investment Strategy?
Hogan Lovells | 65
• Common risks
– Construction risk
– Concentration risk
– Operating track record
– Geo-political risk
– Reputational risk
• What asset types will the fund manager buy?
• Management incentives: Alignment?
• So…. are Funeral Parlours infra investments?
Other considerations
Philip Brown
Investing in infrastructure
Faye Jarvis
EMIR: where are we now?
Hogan Lovells | 68
• European Markets Infrastructure Regulation (EMIR) introduced in response to the financial crisis
• Designed to improve the stability of the over-the-counter (OTC) derivative market
Background to EMIR
"OTC derivative contracts lack transparency as they are privately negotiated contracts and any information concerning them is usually only available to the contracting parties. They create a complex web of interdependence which can make it difficult to identify the nature and level of risks involved. The financial crisis has demonstrated that such characteristics increase uncertainty in times of market stress and, accordingly, pose risks to financial stability. This Regulation lays down conditions for mitigating those risks and improving the transparency of derivative contracts."
Hogan Lovells | 69
• New rules for OTC derivatives that are not cleared, eg, portfolio reconciliation
• New reporting requirements – have to report OTC derivatives to trade repositories
• Requirement to clear OTC derivatives through central counterparties (CCPs)
EMIR – key requirements
Hogan Lovells | 70
• Parties to an OTC derivative transaction required to clear it through a CCP
– clearing commenced in 2016
• CCPs require parties to post collateral – mainly as cash – to cover the potential losses in the event of a counterparty default
• Problem – pension schemes don't hold large amounts of cash
Clearing and the problem for pension schemes
Hogan Lovells | 71
• Pension schemes granted an exemption (initially to 2015) as it was recognised that in order to clear trades pension schemes would need to divest assets in order to meet the requirement to post cash as collateral, which could have a negative impact on members
• Exemption is only in respect of "OTC derivative contracts that are objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements" ie, it applies at transaction level not scheme level
• Exemption just been extended to 2020
The (temporary) solution
Hogan Lovells | 72
• Pension schemes have to represent to counterparties that the exemption applies
• The Occupational Pension Scheme (Investment) Regulations 2005 specify the basis on which pension schemes can invest in derivatives
• Concern that some trades would be permitted under the Investment Regulations but fall outside of the exemption
Action point: discuss with Investment Managers whether all trades will qualify for the exemption
So there's nothing to do until 2020 … right?
Faye Jarvis
EMIR: where are we now?
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10 May 2017
Alternative investments by pension schemes:
avoiding the legal pitfalls