Are Pension Funds The New Banks?
Steven Daniels, chief investment officer at Tesco Pension Investment – the principal investment manager for the supermarket giant’s £7bn UK staff pension scheme – told delegates at the National Association of Pension Funds conference yesterday: “Pension funds are the new banks. Everyone sees us as long-term lenders, and that is great. I’m happy to participate. We are the new banks, good banks potentially. But we are not mugs.”No doubt about it, the next great rotation is in bricks and mortar. As financial repression hits pension funds, heaping on liability risks, global pensions are moving assets into private equity, real estate and infrastructure, and some are worried they're taking on too much illiquidity risk at the wrong time.
His comments echo those of Martin Mannion, chairman of the NAPF’s investment council and director of finance and risk for GlaxoSmithKline’s £11bn UK pension funds, who warned on Wednesday that governments should not treat pension schemes as “a kind of slush fund that can be dipped into when the going gets tough”.
As long-term investors, pension funds are increasingly being seen as an alternative financing option as banks, under balance sheet pressure, continue to deleverage and decrease lending. The UK government has been urging pension schemes to step in to fund initiatives, such as infrastructure projects, where public investment has dried up.
But pension funds point out that the lack of suitable investment and financing vehicles is limiting their activity.
James Duberly, director of pensions investments at the BBC Pensions Trust, said: “It’s a brilliant idea. It works to the advantage of pension schemes with a long-term horizons.” But he told delegates that there was a shortage of sufficiently simple structures. The BBC has yet to make a big move.
Michelle McGregor Smith, chief executive of British Airways Pension Investment Management, is also interested in the idea, and said consultants had been pushing the concept. “The opportunity is there, but it is difficult to find the right vehicle,” she said.
Pension schemes are looking to diversify their holdings. According to an NAPF conference poll, 78% of defined-benefit scheme delegates confirmed they were moving away from equities.
Mike O’Brien, global head of JP Morgan Asset Management’s institutional client group, said: “There is a structural move away from equities within institutional portfolios worldwide. The next great rotation will be into bricks and mortar.”
He added that sovereign wealth funds were making a big move into direct investment in real estate and infrastructure.
Nonetheless, faced with historic low bond yields and volatile equity markets, pensions are moving more of their assets in bricks and mortar. In the UK, the government is letting public pension funds raise stakes in infrastructure:
The British government has made it easier for local authority pension schemes to invest in infrastructure by doubling the amount they can invest to up to 30 percent of their assets, paving the way potentially for billions of pounds of investment to be made in projects such as new roads and railways.It's about time the British government does something to help UK pensions invest in their crumbling infrastructure. Canadian pensioners already own a good chunk of Britain's infrastructure.
The National Association of Pension Funds (NAPF) said on Wednesday that from April local government pension funds will be able to raise the amount they can invest in key infrastructure projects from 15 percent to 30 percent of their assets under new rules set by the government's Department for Communities and Local Government.
Britain's local authority pension schemes had been lobbying the government for more leeway to invest in infrastructure, arguing that current rules were hampering their investment in the sector.
"Many local authority pension funds have told us that they are prevented from making the best decision on investments because of outdated rules which place limits on the amount that can be invested in infrastructure," Darren Philp, policy director at the NAPF, said in a statement.
A new Pensions Infrastructure Platform (PIP) has been launched as a way for pension funds to invest in capital projects with the backing of six large pension schemes, including the London Pension Fund Authority (LPFA), West Midlands Pension Fund and Strathclyde Pension Fund.
Volatile equity markets and rock-bottom interest rates have already caused a surge in new pension fund money going into transport and other major facility projects.
And it's not just British pensions that are looking to boost their investments in infrastructure. Dutch News reports, Pension asset manager APG to boost spending on infrastructure:
Asset manager APG, which runs the giant ABP pension fund and construction sector fund bfpBouw, is planning to increase its investment in infrastructure by some 50% over the ‘coming years’, the Financieele Dagblad reports on Tuesday.The Netherlands will not profit enormously from this change in strategy but APG is a global powerhouse and can invest in infrastructure assets across the world.
The increase will take APG’s investment in building projects up to some €9bn, the FD quotes portfolio manager Jan-Willem Ruisbroek as saying.
‘Our clients want to invest up to 3% of their assets in this investment category. At the moment it is around 2%,’ he said.
This may seem like a small shift, but in absolute terms it means billions of euros extra to be spent on toll roads, wind farms, bridges and utilities, the FD said.
Nevertheless, the Netherlands will not profit enormously from this change in strategy. APG has a minimum investment of €100m and this means Dutch projects will be too small or will not meet other demands, the FD said.
It's critical to understand why pensions are becoming the long-term financiers of these infrastructure projects and what risks these assets carry as pensions flood into this space. David Campbell of Citywire Wealth Manager reports, Yield hunters drive infrastructure debt boom:
Income seekers are flooding into the space vacated by deleveraging banks to replace traditional funding sources for infrastructure debt issuance.Apart from infrastructure, Sarah McFarlane of Reuters reports, Pension funds join forces to invest in farmland:
The hunt for yield is tempting many institutional and fund investors to consider the asset class, while project managers are casting around for a replacement to reduced bank finance.
In the first six weeks of 2013 alone, around $900 million was raised for new fund issues, a third of the $2.7 billion raised during the whole of 2012, reports research house Prequin.
Funds being marketed are targeting a total raise of more than $8 billion, it said.
That has tempted new entrants to the market, such as JP Morgan and BlackRock, which both poached management teams and announced plans to launch funds in the second half of 2012, while more traditional mixed debt/equity infrastructure funds have flourished.
‘In the past, the infrastructure debt fund market has been a fairly niche part of the asset class, but it is growing in prominence,’ said Prequin.
‘This shift is partially being driven by incoming capital adequacy requirements for banks [Basel III], which are making new debt investments in illiquid infrastructure assets a more difficult prospect and are forcing banks out of the space.
‘This is creating a gap in the infrastructure debt market for non-traditional lenders that are attracted to the stable revenue streams and the long-term liability matching characteristics of infrastructure debt.’
Boe Pahari of AMP Capital Investors added: ‘Banks have a changed appetite in terms of leveraged ratios and tenders after the credit crunch. As a result, there is a space where pension funds can participate on the debt side, particularly in mezzanine [lending].’
The long-term fixed capital structures of infrastructure contracts make them particularly suitable for matching liabilities over potential multi-decade periods and a potential substitute for managers who might be wary of sovereign duration risk.
Infrastructure credit typically offers a premium of around 2.5% to 3% above Treasuries. Apart from credit risk, that prices in some fairly unusual contract risks that investors need to understand, however.
‘In an infrastructure loan, the issuer agrees to pay a floating rate coupon plus spread, based on a fixed principal repayment schedule,’ warned JP Morgan’s sector specialist team. ‘This amortisation schedule cannot be altered without the agreement of the lenders, nor can coupon payments be altered. However, the borrower has the option to repay the loan partially, or in its entirety, at par and would not have to pay any further coupons or compensate the lender for the loss of future spread payments.’
‘Although borrowers have this option, prepayment rates have historically been extremely low. Full prepayment rates for infrastructure, as defined by Standard & Poor’s and maintained on a bank consortia database, have been 1.6% in total in western Europe and virtually 0% in the UK since the database’s inception in the 1980s.’
The relative illiquidity of the market has also been one of the major factors deterring wider take-up of the asset class until now. Harder to quantify are political risks. For instance, in the UK, the government last year pledged to underwrite up to £40 billion in infrastructure credit.
While generating favourable headlines, Capital Economics said it would be prudent to take the commitments with a large pinch of salt.
‘Some of these measures are not quite as generous as they look,’ said the company’s chief UK economist Vicky Redwood. ‘For example, the money for the temporary lending programme will come out of departments’ existing budgets. And the investment in the railways will be funded by fare rises and efficiency savings rather than extra public sector money.
‘Meanwhile, take-up of the guarantees scheme may be limited due to the long list of conditions that companies have to fulfill. To qualify, projects have to be nationally significant, ready to start construction within a year, have equity finance already committed, be good value to the taxpayer and have acceptable credit quality.
‘Accordingly, it is questionable whether there are many projects that meet these criteria but cannot find full funding from the markets anyway.’
Major asset managers, cowed by the cost, the risk and the controversy involved in investing in farmland, are joining forces to increase investment in the historically under-capitalised sector.I've already covered bcIMC and PSPIB's joint venture in TimberWest and how Harvard is betting big on timberland. Farmland is a bit more tricky as pensions are sensitive about the appearance of gambling on hunger, but here too you will see many club deals in the future.
In one example, Swiss fund of funds Adveq is in talks with three European pension funds, a private family and a Korean asset manager to buy farmland, in which it will act as the originator and lead investor.
Last year one of the world's largest institutional investors, TIAA-CREF, partnered with pension funds including British Colombia Investment Management Corporation and AP2 to create a $2 billion investment vehicle to buy farmland.
The new approach is likely to attract significant amounts of money from pension funds and other institutional investors into farmland, a sector in which they are reluctant to go it alone.
"We see agriculture and farmland as an asset class that's still being shaped," said Biff Ourso, director and portfolio manager of farmland investments at U.S. asset manager TIAA-CREF.
"It (working together) creates alignment for investors, economies of scale, cost-sharing and the transparency that a lot of investors want today," he added.
Adveq expects three institutional investor club deals to close in the next 12 months, each between $200 million and $400 million in size.
Investors are attracted into farmland by the rising global demand for food and a low correlation of agricultural land prices with traditional asset classes.
Pension funds have been cautious in how they approach the sector, however, because charities worldwide have voiced concern that large-scale land grabs by foreign investors could push up food prices, push farmers off the land and increase hunger.
"Agriculture is a very sensitive subject for two reasons, one is the fundamental human right for food in a food-insecure world, and secondly land is sacred to every country. To sell land in some societies is not acceptable," said independent consultant Mahendra Shah, member of a panel advising Adveq on agricultural investment strategy.
"My personal view is these pension funds are afraid to go into the field alone, and they want to spread their bet or their risk by having partners join them."
FLEDGLING ASSET CLASS
By working together, pension funds aim to create bespoke investment vehicles in a fledgling asset class that meet requirements for responsible investment in a sensitive area.
Research by Macquarie in 2012 showed institutional investment at a meagre $30 billion to $40 billion out of a total global value for farmland of $8.4 trillion.
Most farmland is owned by family farmers, giving institutional investors huge scope for buying up individual properties to form larger operations.
Institutional investors say that by working together they have a much better chance of being successful in terms of social responsibility as well as economic returns.
But some agricultural experts questioned the benefits.
"It's not absolutely clear to me that the simple fact that just a few of them come together is going to produce a better overall result," said David Hallam, director of trade and markets at the United Nations food agency (FAO).
"Unless the nature of the actual investments changes substantially, then I don't see the fact that a few companies get together would necessarily improve things," he added.
RICH SEAM
Institutional investors have generally focused on regions that are net exporters of food including North America, Australia, South America and Central and Eastern Europe.
"We like to be a in a situation where we're not taking food from the local market, where we are not taking food away from its natural value chain for speculation purposes, (where) on the contrary we contribute to increasing food production," said Berry Polmann, executive director at Adveq.
"While doing so, we don't want to undercut local farmers by producing more at lower costs, eroding their competitive power and wiping them out. That's one of the reasons why Africa for us is very difficult."
Adveq's group is looking for farmland assets in North America, Central and Eastern Europe, Latin America and Oceania.
Through partnering, institutional investors aim to become more efficient and share knowledge.
"We prefer to go with other institutional investors," said Ibrahim Abdulkhaliq, portfolio manager, alternative investments at MASIC, a Saudi Arabian institutional family office.
Abdulkhaliq cited two reasons for the trend - more difficult governance and due diligence in farmland and the ability to reduce costs, making investments more viable.
Finally, as some question whether pensions are the new banks, Neil Weinberg, Editor-in-Chief at American Banker warns, Beware of a New Banking Bubble:
“As long as the music is playing, you’ve got to get up and dance.” With those immortal words, then-Citigroup (NYSE:C) Chief Executive Charles Prince explained in July 2007 what had motivated his managers to steer their bank into insolvency.
The multi-trillion dollar question that regulators and investors ought to be asking is whether bankers are again succumbing to the urge to shimmy while the shimmying is good.
There are a number of reasons to think they’re doing just that. Tops is the fact that with interest rates so low, there’s been a breakdown in the traditional “3-5-3” banking model—pay 3% on deposits, lend the money out at 5% and be on the golf course by 3 p.m.
Compressed net interest margins mean bankers face pressure to under-price risk to win loan business and to look to other questionable tactics to turn a buck.
Regulators’ ever-tightening grip on how bankers run their businesses is taking a bite out of fee revenue, too. Until recently, banks propagated the fiction that they offered “free” services like checking accounts, which in fact cost them around $350 a year to maintain. They recouped their costs and earned a profit by charging fees on the back-end. Some were of the “gotcha” variety, like those for over-drawing accounts, paying card balances late or for credit card payment protection plans of marginal value to buyers. The newly empowered Consumer Financial Protection Bureau has put a plug in many such revenue streams.
In addition to narrow lending margins and increased regulation, bankers are living in a world where animal spirits have returned to financial markets. Stocks and other “risk” assets are back in vogue. Greed is again trumping fear.
In what imprudent ways are bankers likely to respond to these various pressures? Take your pick.
Comptroller of the Currency Thomas Curry warned back in October that regulators were "ready to take action" against banks that boost earnings by releasing reserves with excessive haste. Comptrollers do not tend to talk in such hypotheticals unless there’s a genuine cause for concern behind them.
Federal Reserve Governor Sarah Bloom Raskin warned last month that “The pressure to generate enhanced profits through high fees is palpable, and banks may choose to move aggressively down these paths.”While there are reasons to be concerned about a new banking bubble, I remain favorable on US financials. Steady US job gains and an improving global economy will support their earnings going forward but money for nothing and risk for free can't go on forever as it will inevitably lead to another global banking debacle in the future.
One banking insider also pointed out to me this week that the owners of many small banks are looking to sell. With a high price tag as their beacon, the temptation to pretty the financials is strong. That may help explain the fevered competition to write commercial and industrial loans, he added.
“There are more people in the marketplace and they’re not acting entirely rational, so we all have to end up being more competitive and that means we have to sacrifice margin,” US Bank (USB) Chief Executive Richard Davis said earlier this week of the loan market.
Froth is bubbling up in bank M&A too. Three recent deals involved premiums of 32% to 83% above tangible book value, implying that buyers are willing to bet on the prospect that the targets will be worth more in the future than they are today. "We are seeing in-market [banks buying banks] deals with big expectations around cost savings,” Phil Weaver, a partner at PricewaterhouseCoopers told American Banker recently.
Cost-savings is another term for “synergy,” the buzz-word that over the years has impoverished shareholders and enriched investment bankers in roughly equal measure.
Think this time regulators will remove the punch bowl in time? Don’t fool yourself. Consider how blind they were to JPMorgan Chase’s (JPM) multi-billion dollar London Whale until they read about him in the press. Their early warning systems appear to be no better today than they were when Chuck Prince was leading the dance at Citi.
Below, Bloomberg's chief Washington correspondent Peter Cook reports that payrolls increased more than forecast in February and the jobless rate unexpectedly fell to a five-year low of 7.7 percent. He speaks on Bloomberg Television's "In The Loop."
And Bloomberg’s Michael Mckee reports in-depth on the stronger than forecasted jobs report and the details that shed light on the 7.7% unemployment rate. Mckee and Julie Hyman also break down the components of the February jobs report. They speak on Bloomberg Television's "In The Loop."