We spoke with John Chillman, Head of Pensions at First Group Pension Scheme in an interview for the Diversified Growth & Multi-Asset Funds 2017 report. Here's what he had to say...

Q - How suitable is an open ended mutual or UCITs fund for diversification that extends as far as illiquid assets such as infrastructure or real estate?

A - The vehicle for holding the asset really must be appropriate for the type of asset held. If the purpose is fundamentally to find an asset that can be financed, developed and then exited at a profit in a prescribed timescale (say the typical private equity structure of up to 12 years), then a private equity structure is probably the right one. If the purpose is to own an asset for the long-term, maintaining it and holding largely for the income stream, then an open ended mutual or UCITs fund is likely to be more appropriate.

Investing through an inappropriate structure can add unintended risk to the investment. For me, if the asset is one where the majority of the return to investors is generated by the price at exit, then these should not be held in open ended mutual or UCITs funds. However, if the fund is large enough, there is potentially room for a small proportion of these assets, and they may be required to boost the overall return. However, this then leaves the problem of valuation, particularly for investors that need to exit the fund at specific times.

Q How has demand for illiquid assets from investors, in particular pension funds, affected the development of the DGF/multi asset fund market?

A - Illiquid assets have become increasingly sought after, in recent years, given the high valuations applied to most traditional asset classes and the consensus view from advisers that illiquid assets could offer a premium. Illiquidity, as an additional source of return, but it should be remembered that this premium is available because the investment is locked away, and is not ’free money’, but simply another risk to be considered. There are now increasing numbers of investors chasing these opportunities, which has only increased prices and reduced the available illiquidity premium.

The long timescales available to pension funds should allow them to invest in illiquid assets, and to accept this class within a DGF structure. Whilst multi-asset funds have the flexibility to access some of these classes, they have generally been reluctant to do so, often because investors have used their illiquidity budget elsewhere, or due to the potential impact on fees. Whilst investors should have a long-term time horizon, the ability to get out of a fund quickly, without being gated, remains a significant factor for many pension funds, and could limit the desire to invest in these funds. This is particularly the case as funds mature.

Illiquids within DGFs has been adopted by some large funds. The Railways Pension Scheme includes a significant allocation to residential and commercial property within its liquid growth fund, with smaller allocations to somewhat more esoteric illiquid investments. It can do this recognising that many of its larger sections remain open to new entrants and future accrual, and it can retain a long-term view. This means it does not have a desire to achieve buy-in / buy-out, where funds with illiquid components may be shunned, or marked down, by potential providers.

Q - Are there new or relatively unheralded illiquid asset classes appearing in DGFs recently and what challenges/opportunities do they present to fund managers and investors?

A - Whilst there are some new illiquid asset classes available, and appearing in DGFs these are yet to be of any significant scale, simply due to volumes available. New assets such as royalty income streams are becoming available, but these are of small scale and require significant work in understanding their attributes and what they could add to the fund, which is often not justified by their scale. Significant time could also be spent identifying and understanding the opportunity, which could ultimately be eliminated through a competitive bidding process.

When pension funds invest in a DGF they are buying into philosophy that the manager will use their skill, capital market understanding and deep investment knowledge to be able to tilt the portfolio towards better performing asset classes and away from potential underperformers in a risk managed way. There may be restrictions in what the manager can invest in, even if an interesting opportunity comes along, and for many Trustees the concept of introducing illiquidity (even at small scale) into one of their liquid asset buckets, may not be appreciated. There remains a fear that this would fetter the manager’s ability to move dynamically more than it enhanced return.

Q - How various are the uses of different illiquid assets in DGF structures, in terms of generating returns, income and protection against downward markets?

A - Illiquid assets are generally included in DGF structures to improve returns, with the common understanding that the illiquidity premium will deliver 1-2% additional return beyond that available through quoted markets being.

One of the main advantages of illiquid assets is just that, their illiquidity. Whilst the valuation moves over time, the lack of daily pricing can be seen as an advantage, as it brings degree of stability to the overall pricing of the fund. Whilst this is illusionary, it reminds us of the principle that pension funds are holding their investments for the long-term, and not for file sale.

Illiquidity does cause an issue in the underlying pricing of the DGF in terms of when the repricing of these assets is reflected. If illiquid assets are valued infrequently, and these repricing points become obvious to investors, then it would be possible for the astute investor to time their trading in/out of the funds to take advantage of anticipated price uplifts, or falls.

There are some illiquid assets that may not normally qualify for inclusion in a DGF, due to their modest based return, although the extra illiquidity pick-up could allow their inclusion, and provide some real diversification and volatility reduction.

Q - How positive is the economic/political environment in the UK and globally, for the growth of infrastructure, property and other markets where public investment and a suitable policy environment is important to generating supply of assets?

A - There is a clear requirement for infrastructure projects globally. However, political instability and fiscal austerity has made it challenging to get some of these moving.

Canada, which has been very supportive of PPP type arrangements, and has large pension funds that have been extremely active globally in the infrastructure space, had a multi-year hiatus as a result of the political environment. President Trump made it very clear that his Government would support infrastructure development, whilst this is, in fact, the responsibility of the individual States. Much of the core infrastructure in the US dates back to the FDR days of the “new deal”, and there is a pressing need for investment. The UK has seen major, high-profile infrastructure developments in recent years, but there has been varied success in obtaining funding from UK pension funds, largely due to disagreement as to what return profile the funds need. Indeed, much of the investment in the UK market has been through the Canadian pension funds buying into operational infrastructure projects.

There is a significant political angle in facilitating the development of these assets. Some of the earlier initiatives did not achieve an appropriate balance between benefit obtained, cost to the user, and return to the funder. This is an extremely challenging conundrum, with the public potentially determining in the long-term as to whether something is good or bad value. Corporates getting fat through developing these assets is likely to be deeply unpopular, whereas if sold as domestic pension funds providing the financing to improve the infrastructure, whilst providing employment for many thousands of individuals, this appears much more like a virtuous cycle.

For pension funds, and other investors to want to commit to infrastructure, they must have the right shape of deal. What is the risk, return and duration. One of the major issues is that often what a pension plan wants is not what the asset manager wants to provide. For an asset manager there is a greater financial return from using a private equity type vehicle to raise funds, put these to work over the first few years, finance, build, and refinance the projects then exit, so that the can achieve an early exit and receive their carry.

The maturity of many DB pension plans means that the high-octane private equity-like infrastructure projects are not appropriate. These pension plans do not want the planning and development risk, but really want to ‘clip the coupon’ over many years, using the asset as an income stream in a similar way to fixed income, but with a yield pick-up. The returns for the managers in these types of funds is much lower than in the equity infrastructure, and these assets are much more like a utility, throwing off a known return over the period with the requirement to maintain the operating assets, and ensure that there are fixed price arrangements in place to do this.

It would be possible for the risks during this period to be taken by the Government, with the asset sold once operational, and providing an income stream to pension funds. However, Governments also understand this early stage risk

For pension plans which are maturing rapidly the sweet spot is unlikely to be the equity space here, but in Real Estate and Infrastructure debt. Here the illiquidity is not a real problem, as there is a regular yield, a much easier model for pricing, and potentially the ability to sell on in the secondary market, if a sale was required, because the plan could afford to buy-out, etc.

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