An interview with Antony Barker, Former Director of Pensions And Chief Investment Officer, Santander UK. We spoke to Anthony about real estate – still considered an alternative asset class by many, where does property fit into a portfolio today?

Pádraig: What do you consider to be an alternative asset?

Antony: You can have only an equity or debt interest or a physical asset, and every other asset class is merely a combination of those in some form. Infrastructure, for instance, is a physical asset with an (equity interest in an) operating business on top.

The definition of an alternative seems to be that someone has come up with a new product structure that adjusts the tax or regulatory regime and, possibly through the use of derivatives, changes the cashflow profile but doesn’t change the underlying investment thesis. I’ve always preferred to think of investment opportunities we already held and those we didn’t!

The trouble with so called alternatives is that the very name makes people fearful because it suggests different and/or unconventional.

Even though it has been around 30 years since we’ve been using peer group averages as a industry performance benchmark, there is still a herding mentality amongst pension schemes not wanting to go out on a limb.

Weirdly, real estate is not seen as one of the core investments and most pension funds now have a large holdings of index-linked gilts or overseas equities and forget they were holding property before both of these asset classes.

When I took on board the Santander scheme, one needed to understand quickly that stability of valuations through the accounting numbers was crucial for the capital impacts from the sponsor perspective. That’s not true only for Santander or any financial services entity, as any sponsor would arguably prefer a stable valuation coming through on their accounting numbers. It wasn’t too difficult to demonstrate to senior management that following a Yale endowment model through a combination of reducing public market exposure – and therefore volatility – coupled with a hedge fund programme that dealt with the liability volatility allowed you a lot of risk budget to then invest in private markets to generate return. It was effectively a utopian approach – higher returns for less risk and lower capital impact.

We ended up recommending about 40% in private markets as a way of driving returns. We also said that this wasn’t going to be simply about going and buying London office properties and renting them out which was the accepted wisdom for property investment, because the yields were pathetic and you were gambling on ever rising capital values. We wanted to identify embedded value in properties, whether it was because the existing asset owner or the market more generally wasn’t seeing the value that could be extracted through a sensible capital investment, change of use or other development program over a number of years. We also wanted to get people more comfortable with doing direct deals.

This applies across the board and I have long argued that real estate, physical and real assets are not alternatives, but just areas that people haven’t invested in before or during the last tide of the current trustees.

Pádraig: On this basis, are there any particular roles for alternatives? As it is a broad spectrum surely there are things there that should be generating growth?

Antony: I would firstly distinguish between hedge funds which get thrown into this and other alternatives. I have never been a great believer in hedge funds, in part because I have seen so many equity managers become involved in this sector, who have not been that great at running long-only portfolios before, let alone being worried about shorting something.

As every asset class is just a recombination of other things, hedge funds are largely an equity investment with debt overlay to leverage their position.

We feel we need to get somewhere in the order of high single digits and low double digit returns and this has to be reflected in the underlying opportunity, not a mediocre opportunity that is highly leveraged and therefore dependent on the continuing availability of cheap finance.

Taking hedge funds out of the equation, there is a clear role for other private equity, infrastructure, real assets and property because they are the only areas where I can see returns coming from, but also it is a purer form of return if you are prepared to get involved directly in the deal and ongoing management.

Equities have had a great run, but everyone feels they are due for a wobble, gilts are fairly sensitive to government and monetary policy so it doesn’t look like there is an awful lot more yield compression that can come from this direction.

Inflation is also picking up as well so if you have got gilts already then great, but if you are trying to buy inflation protection then it is going to become quite an expensive proposition.

If you take these all together, conventional assets aren’t going to give you the returns that you want and with pension funds collectively running deficits, given their funding methodology and needing to generate sustainable returns somewhere around 2% to 3% above inflation net of all costs and fees, you won’t get this from treasury, public equity markets or cash as it will do you nothing in terms of returns or liability matching. Why, then, would you not consider going into alternatives?

Pádraig: Are you still involved in real estate projects that take over old government property portfolios?

Antony: I am still working on some things now being looked at by the more established local authority pools who are more familiar with this sort of thing.

There is obviously a natural scope for the pools to say look we’ve got scale, can develop in-house capabilities and can start getting more involved in these direct deals which from a pure returns perspective are very attractive.

There is scope to get somewhere 15% to 40% return per annum, but there is a nice play here in that the UK Government has defined residential investment as infrastructure, so it does tick that box too.

There is also an increased national requirement for housing so the sponsoring local authority can not only fund their pension fund liabilities but also deliver on their own requirement to produce new homes. Moreover, you are utilising existing brown field sites rather than destroying a lot more green belt. It ticks an environmental, sponsor and return box so what is not to love other than that it is not the way that pension schemes have operated before.

There are some people coming together in the pools who still haven’t quite thought through what it is that they are creating and they are hanging onto it as some sort of bulk procurement program rather than thinking that they are at the early days of creating a £100 billion pound asset manager. Not all the pools are going to survive, so there will be consolidation. You therefore need a strategy, a starting point and new resources that will reflect where you are going to be in that five year space.

Pádraig: Do you think there will be any fallout in terms of fear after Carillion as it is another set back for PFI PP area?

Antony: The issue here is that the pension funds have got the wrong advisors so you have either got to build proper internal capabilities with people who are skilled at doing this transactions or you’ve got to have a different advisory bench. Pension schemes had it in their heads that they are tax free entities but didn’t understand that what they were investing in wasn’t necessarily tax free. It just meant they couldn’t reclaim it and more importantly other stakeholders involved in the supply chain weren’t necessarily tax exempt.

It isn’t ever then a surprise that people get their fingers burnt because they are one step removed and cover themselves by saying that they have got an asset manager or a consultant working on it, but how many tax specialists work for the major asset managers and actuarial consultants? Not many, if any at all.

They have in a way delegated away the responsibility and not checked whether anyone is doing the job. I see this as an opportunity, because there are any naive people in terms of how to do transactions and understanding what will win you the prize rather than just burning a lot in transaction costs.

Pádraig: What tips would you give to schemes who may be thinking about increasing their alternative investments?

Antony: Be reasonable in your return expectations. Even with increasing inflation, we are in a low, single digit inflation nominal return world. If someone is offering you 20%+ returns that is not without risk. Of course there are projects that can deliver this but to do that you are generally in the world of private equity and highly involved.

Avoid being mugged over by mediocre projects with a long leverage on top as cheap finance may well not last forever.

If you are new into this, keep it simple. There are some genuinely good opportunities out there and I would encourage collaboration with other pension schemes who are already in this space. There aren’t many who want exclusivity on a deal or who wouldn’t be prepared to share because it is in their interests for the universe of potential buyers to get bigger.

Whenever you are buying something on a private markets basis, already have an idea of who you are going to sell it to before you buy. Ultimately you will have to exit this asset and you won’t make a profit until you do - having strategy for exit is key as it will help you with your underwriting.

Models are subject to all sorts of risk, but create your own doomsday scenario as too many managers will show you stuff that has very optimistic base cases as even though they may have modelled the downside it won’t be extremely down. Be clear as to how bad the world would really have to get before you couldn’t at least get your capital value back.

Ultimately you have to “just do it” as it is the only way that you are going to generate returns, but it needs a lot of experience and a change of culture and thinking as much on the part of the fiduciary as well as managers. It will cost you more upfront to do these investments because it is very transparent but ultimately the rewards are there. We generated a 15% return per annum off of it which was 5% per annum ahead of every other public and private sector pension fund in the UK and we did this ostensibly with a lower risk portfolio. It has to be done as part of a holistic strategy.

If you did want a final industry comparator as a “reason why” then it is worth noting that PPF is quite active in a lot of these things. Not only in taking over the liabilities but in restoring the funding overall, they have moved away from mainstream investments. I have been working on the concept of either a sort of pre-PPF or “zombie fund” for giving people exposure to these investments whilst they are still solvent but considering an end game to buyout that could be a few years short of justifying increased private market allocations.

Pádraig: Thank you for sharing your thoughts on this topic.

This interview is an excerpt from the Investment in Alternatives, Europe 2018 report. You can download the full report for free online.

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