A CAMRADATA panel hosted pension schemes to find out why real assets are becoming more important to institutional investors. Moderated by Brendan Maton.
Participants:
Andrien Meyers (head of treasury and pensions, London Borough of Lambeth Pension Scheme)
Sydney J McConathy (head of global business development, Hancock Natural Resource Group (part of Manulife Asset Management)
Padmesh Shukla (head of investments, Transport for London)
Paul Griffiths (investment manager, Marks & Spencer Pension Fund)
More and more institutional investors are embracing real assets such as infrastructure and property. Data from the UK’s Investment Association show that by the end of 2017, its members held £255 billion (€291 billion) in infrastructure, direct lending and commercial property on behalf of clients.
CAMRADATA, the owner of Funds Europe, held a roundtable recently called ‘The changing face of real estate, infrastructure & real assets’, where asset owners explained why the appeal of owning buildings, windfarms and waste incinerators was on the rise.
Padmesh Shukla, head of investments at the £11 billion Transport for London (TfL) Pension Fund, said that real assets generally provide strong portfolio diversification, in many cases providing inflation hedge and secure income.
A good example of the TfL Pension Fund’s allocation in real assets includes a large infrastructure portfolio spanning the UK, Europe, North America and emerging markets from core, core-plus to value-add strategies. Shukla also believes that from an investment strategy perspective, a globally diversified pool of real assets – be it real estate and private equity or infrastructure – provides a more robust downside protection and superior risk-adjusted returns. However, he did point out the challenge of quantifying and managing currency exposures in such portfolios.
The £1.5 billion Lambeth Pension Fund has far less exposure to real assets, not only because it is a smaller scheme but also because it has recently put more faith in mandates such as multi-asset credit and diversified growth funds where managers can dynamically allocate to improve returns. Having said this, Andrien Meyers, treasury and pensions manager for the Lambeth fund, told the panel that it held 5% in private equity and 9% in European commercial real estate. It has also begun investing in residential housing in the UK.
The third asset owner at the Camradata roundtable was the Marks & Spencer Pension Fund. This has its own matrix of covenant strength and liability profile. Paul Griffiths, investment manager for the £11 billion fund, said that because the fund is both closed and cashflow-negative, its investment strategy is largely predicated on securing income while maintaining an element of capital growth. Therefore equities, as a volatile type of growth asset, have been almost entirely sold.
A proportion of the scheme’s pension liabilities have been bought-in in a number of bulk insurance contracts.
Every pension scheme is unique because of different covenant quality, structure (open versus closed), liability profile and, very importantly, liquidity needs. All, but especially the last, affect the appetite for real assets.
Given the risk, why pursue returns from the complex sources of real assets? Shukla said there are certain opportunities that are only accessible via private real assets, good examples being the European tech sector and emerging markets infrastructure.
He added: “Timing is key in many ways when it comes to real assets, as many of these strategies have increasingly become bond proxies, compressing returns to levels where one may question their risk-adjusted returns. There is always an early-mover advantage in this area.”
The other fruitful area for pension schemes, according to Shukla, has been private debt covering real estate, infrastructure and corporate. “At least until a few quarters back, the mezzanine space provided better risk-adjusted returns,” he said.
“Now key things to look for here are obviously credit selection but also a strong understanding of the local underwriting context and, in this late stage of the economic cycle, workout skills as some names in the portfolio will almost surely get into difficulty.” He noted that with the exception of a few managers, this space is almost a post-GFC (global financial crisis) creation and therefore not many players have the experience of managing serious credit headwinds. “It’s an interesting space to keep an eye on!” he said.
If you go down to the woods…
The fourth participant at the roundtable was Sydney McConathy, head of business development for Hancock Natural Resource Group (HNRG), a wholly owned subsidiary of Manulife Financial Corporation. HNRG manages on behalf of institutional investors approximately 6 million acres of forest and 340,000 acres of farmland around the world.
The farmland properties produce a broad range of crops, including annual row crops such as soybeans, corn and wheat, and higher-value permanent crops such as pistachios, almonds and grapes. The commercial forestlands provide a sustainably managed supply of raw material to a wide end-user market. Smaller-sized trees are directed to producers of pulp, paper and packaging and bio-mass energy, while larger mature trees are converted into lumber, wood panels and other components used in both residential and non-residential construction, repairs and remodelling, furniture and industrial uses.
McConathy said that the returns generated by both farmland and forestry have been genuinely uncorrelated with the returns of the traditional financial assets that dominate the portfolios of institutional investors with a long timeframe. Using historical return data for institutionally managed timberland and farmland published by the National Council of Real Estate Investment Fiduciaries (NCREIF), the HNRG internal research group has demonstrated that the addition of a combination of forestry and farmland can lower the volatility of an institutional portfolio and boost its risk-adjusted returns.
The pension funds around the table had limited experience of investing in trees and crop fields. Griffiths said that he had overseen a mandate for forestry at a previous fund; Shukla said that he did come across a farmland opportunity some time ago but had not pursued it further on value-for-money considerations.
The limited experience of many institutional investors with farmland and timberland is not surprising, given the size and accessibility to investors of these asset classes. HNRG research estimates the global value of farmland assets, suitable for institutional investors, at $1.5 trillion (€1.3 trillion). The HNRG estimate of the investable universe of institutional-quality farmland filters out properties that are unsuitable due to government restrictions on ownership, location, property size, access to markets or country risk. Currently, institutional investors who report their farmland properties’ performance to NCRIEF represent a total asset value of $8 billion, and although NCRIEF’s coverage is not comprehensive, it suggests that global institutional investment in farmland is still less than 1% of the investable universe, leaving ample room to grow.
In the case of forestland, a significant portion of the investable universe has already migrated to institutional ownership. HNRG estimates that the global total value of institutional quality timberland is $344 billion, and the value of timberland currently in the hands of institutional investors is between $55-$70 billion, or approximately 18% of the total investable universe for timberland.
HNRG is the largest private timberland investment manager in the world in terms of assets under management and has been active in the timberland space for more than three decades. Hancock also has the longest track record in institutional farmland investments in the US. Both the timberland and farmland under management by HNRG are global, providing geographic diversification to an investor. HNRG’s business model favours integrated property management. With the exception of US row crops, HNRG directly operates the majority of its farmland and timberland assets, maximising operational governance and transparency to the investor. With Hancock employees operating the properties, HNRG’s workforce has a high level of domain-specific training and expertise in agriculture and timberland resource management.
Cheap futures
Shukla asked about the appeal of income from crops when exposure to many soft commodities can be replicated cheaply via futures. He recalled his previous conversation with a private equity-style farmland offering. The manager in this case could not convince him of their value-add in the context of a fee structure that looked very rich. The projected returns, net of fees, looked too optimistic, resting on some favourable pricing environments for commodities and land valuations.
McConathy said that an investment in farmland is not remotely the same as trading commodity futures. Direct income from the sale of crops is only one component of the total return derived from a farmland investment, which also includes appreciation in land values. A majority of the properties managed by HNRG are focused on growing high-value permanent crops including grapes, apples and nuts, which are not represented on futures exchanges. The allocation in HNRG managed holdings to pistachios alone is greater than its position in commodity agricultural products such as soy, rice, corn and potatoes put together. HNRG’s farmland strategy is to assemble diversified portfolios of highly screened assets across a variety of crops and geographies, providing consistent cash yield over extended time periods, which is very different from high-frequency futures trading on a handful of volatile agricultural commodities. In terms of liquidity, high-quality, large-scale timberland and farmland properties are actively traded in well established markets.
In the case of timberland, diversification across different geographies and forest types can also allow the construction of resilient portfolios of timberland, with reduced return volatility. For example, the key market for the pine timber harvested in the Southern states of the US are the region’s lumber mills, whose fortunes are closely tied to the cyclical changes in US residential construction activity. To offset the risk associated with the market cycles in US housing, and to gain exposure to more markets and reduce return variance, HNRG has invested for many years in various US regions and forest types as well as globally, in Australia, Canada, Chile, South America and New Zealand. For both farmland and timberland, geographic diversification can mitigate market risks such as economic downturns as well as physical risks to the trees and crops due to weather events.
The other panellists at the Camradata discussion were concerned about fire risk in California, and climate change in general. McConathy replied that actively managed commercial timberlands are far less susceptible to fire events than less intensively managed forests such as state and federal timberlands, which generally contain overstocked stands of timber compromised by large amounts of underbrush and deadwood.
HNRG is addressing the potential impacts of climate change on its properties by engaging with experts in the field to better identify potential risks to its operations and identify strategies to adapt to changing climate patterns. As an example, the firm created water catchment areas on lower-productivity areas of a large tree nut plantation in California, which during periods of high precipitation or flooding would hold large volumes of water which could then percolate into the ground to recharge the below-ground aquifers. In addition to restoring the natural groundwater supply and reducing the risk of water availability in drought years, the water catchment areas provided habitat to migrating water fowl and contributed to improved biodiversity. McConathy added that the expertise gained in the water management project was readily shared with neighbouring farmers as a means to enhance the water resources of the communities in which they operate.
Harvesting returns
The asset owners were then asked to estimate returns from forestry and farmland. Their answers were all between 11% and 12% gross. Meyer made the point that the similarity among the responses reflected the fact that pension funds these days have a sense of what to expect from alternative real assets, even those like timberland and farmland with which they are not so familiar.
Griffiths added that he views things from an opportunity cost perspective where it is only appropriate if the relative risk and return characteristics are attractive. In the sphere of real assets, this means exposure to various long-dated real assets through a number of vehicles invested across infrastructure and property. In infrastructure equity, this includes social housing, transport, renewables, utilities; and transport and energy for waste. In long-lease-oriented property, leasees include government and social housing providers.
While the relative proportion of income and capital return depends on the nature of the underlying property, the cash yield of timberland investments may comprise a third to a half of the total return over the life of an investment. Appreciation realised when exiting the investment is the remaining component of the total return. This matters in a world where many investors are much keener on securing income than capital appreciation.
Which brought the panel to the salient matter of what a client of a timberland or farmland strategy actually owns. HNRG offers a variety of structures to meet investors’ objectives according to McConathy. HNRG has experience of closed-end portfolios, but prefers open-ended structured vehicles. When the firm makes an acquisition for a segregated client asset owner as part of a purchase of a very large property, the individual investor can participate as either a direct ownership or via a commingled structure. In the former example, clients actually hold title to a specific property and do not share common ground or a sample of crops or trees across the larger property that was purchased. Importantly, the entire property is managed as a single entity to capture efficiencies of scale.
This division of larger properties to align with the client’s target allocations, can also provide greater flexibility in timing the sale of the property, although exits have been rare. McConathy recommended that to fully reap the diversifying benefits of these long-duration asset opportunities, investors ought to stay over a couple of economic cycles. She added that committed capital can take a couple of years to find a home, not least because at the moment in the US, markets for both commercial forests and quality farmland are quite competitive.
Forestry is a patient business. Wealth increases with the age of a tree due to the accumulation of biological growth, which means that owners can choose to refrain from sales when prices are low (so long as they don’t need the income that year).
In general, deferring the felling of timber also can allow the trees to gain value by growing into larger-sized product classes that can be processed into higher-value products.
For example, trees less than ten years old are likely to be utilised for the production of pulp, paper, packaging and wood-based energy, while larger logs from the same forests (25 years or older) can be converted into higher-value building products for the construction industry. When a mature forest is purchased, the property could include a wide distribution of different-aged trees, spanning from newly planted trees to those a hundred years of age. Good management selects which trees are felled and when, to meet a variety of goals including the financial objectives of the investor and the sustainable, responsible management of the forest.
Owning biological assets seems instinctively to satisfy the increasing responsibilities of institutional investors towards the environment. Both Shukla and Meyers agreed that ESG is increasingly becoming a vital consideration in the investment strategy and process for any responsible long-term investor, expecting companies to pivot towards sustainable business models and practices.
In terms of real assets, the TfL pension fund has already been deploying capital in renewables where a diversified pool of solar, onshore and offshore wind investments can provide predictable long-term liability matching cashflows in addition to very strong ESG credentials. Shukla noted that the UK ran without coal power for three consecutive days last year, something almost unthinkable just a few years ago and impossible without the pension and other long-term money flowing into this sector. The TfL pension fund was an early mover into this area, and Shukla highlighted how critical it was that these long-term assets are housed in “low-cost, evergreen” fund structures with transparent reporting and a strong community engagement framework.
In this context, timberland and forestland assets are particularly suited to contribute to environmental ESG objectives, based on their land-based nature, their biological production processes and their location in rural communities. Forests absorb and store carbon, and play a crucial role in mitigating the build-up of greenhouse gases in the atmosphere. McConathy said that third-parties offset some of their carbon emissions by buying carbon credits associated with HNRG-managed forests.
The recognition and use of forests as a carbon sink could prove to be a significant emerging source of revenue for timberland owners, as well as being a reminder of how important trees are to balance the consequences of mankind’s industrial output. Owners of natural resource assets could make the ultimate green investment and buy the lungs of the earth.
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