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xx Month 2010 Local Government Chronicle xxlgcplus.com?? Local Government Chronicle 25 March 2010

Agenda sdf 1

LGC’s regular special report

Private equity is gaining popularity as an investment option p12

Infrastructure projects may be a good fi t for

pension funds p4

The Environment Agency’s Howard Pearce p20

Cambridgeshire has set up a bank p18

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21 June 2012 Local Government Chronicle 3LGCplus.com

NIC PATONSUPPLEMENT EDITORPast performance, as any pension fund manager knows only too well, is never a guarantee of future results. Nevertheless, there are two clear themes running through this LGC Investment special.

First, pension fund managers are taking what we might term a cautiously innovative approach to the challenges faced by volatile markets, LGPS reform and maturing funds.

As has been highlighted by the CLG’s Terry Crossley and the Environment Agency’s Howard Pearce in their profiles, our review on infrastructure investment, our reader survey and through Nick Clarke of Cambridgeshire CC, local government pension fund managers continue to take their responsibilities for delivering sustainable, secure growth for their funds very seriously.

Yet what, counter-intuitively, also runs through this supplement – and it is a theme that has been increasingly clear within LGC Investment in recent months –

is the scope this security and sensibleness of vision offers to innovate.

Whether it is testing the water around infrastructure investment, pioneering new models of high street banking, balancing the challenges of delivering a reformed LGPS or ensuring vital societal imperatives such as sustainability and environmentalism are not drowned out by the short-term ‘noise’ of economic crisis, local government pension fund managers are continuing to think creatively and passionately about investment.

The fact that local government pension fund managers protect the futures of millions – and act as something of a voice of reason and bulwark in an age of uncertainty and volatility – is a heavy burden. But it is a responsibility, a duty, happily stamped through the local government pension fund community as through a stick of rock. When it comes to securing all of our futures, long may it continue to be thus.

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Contents

LGC’s regular special report ▼

4 Infrastructure investment falls between bonds and equities and is perfectly suited to pension fund requirements, writes NICOLA SULLIVAN

6 Equities are not in as bad shape from a long-term investor’s point of view as some might think, judging by the historical data, writes LINDA SELMAN

8 Terry Crossley was in charge of the LGPS at the CLG until he retired this summer. He looks back over his career.

12 What do local government fund managers think of private equity investment? TONY CHARLWOOD analyses our reader survey

16 Quality of data and an appreciation of methodologies are vital to understanding economic impacts, writes KAREN SHACKLETON

18 Cambridgeshire County Council and Trinity Hall, Cambridge University, have set up a bank. NICK CLARKE explains how it will work.

20 An economic crisis is not an excuse for environmental governance to go by the board, says the Environment Agency’s HOWARD PEARCE

22 The Environment Agency’s new investment strategy is focused on flexible asset allocation and broader investments, continues HOWARD PEARCE

6 September 2012 LGC Finance 3LGCplus.com

xx Local Government Chronicle xx Month 2012 LGCplus.comLGCplus.com4 LGC Finance 6 September 2012

Anyone caught up in the traffic chaos after a section of the M4 was closed in

July because of a crack in the Boston Manor viaduct outside London will be in no doubt that the UK’s creaking infrastructure is in desperate need of investment.

Pensions schemes are increasingly being seen as having a key role in funding major infrastructure projects. And pension schemes, many of which are carrying the burden of increasing liabilities, are craving an asset class that is less volatile than equities but still delivers decent returns.

Mario Lopez Areu, senior policy adviser, labour market and pensions policy, at the Confederation of British Industry, says that over the past 10 to 15 years the returns associated with lower-risk investments such as gilts and government bonds have been low. In addition, equities have been particularly volatile and have not generated the kinds of returns normally associated with the higher-risk asset class because of external factors, such as the financial crisis and the turmoil in the eurozone.

Should pensions plug potholes?The government is keen to promote infrastructure investment as a natural choice for pension schemes. But is it? NICOLA SULLIVAN reports

“What we have seen is that pension scheme deficits have increased significantly over time,” he says. “There have been demographic changes, such as longevity etc but also the returns on investments have been quite low. We see infrastructure as a middle point between what a government bond is and what an equity is.”

Mr Lopez Areu also says infrastructure suits the long-term nature of pension funds. “In that sense, infrastructure is good because you can invest in a road or an airport or a train line and hold that asset for a very long time and it will give you small returns little by little which you can use to pay off those pension benefits. In that sense the asset matches the liability.”

So is infrastructure a natural investment choice for pension schemes?

The government seems to think so. In November’s autumn statement chancellor George Osborne declared his aim to secure £20bn of investment from UK pension funds to invest in infrastructure projects.

Funding platformThe government also signed a memorandum of understanding with the National Association of Pension Funds (NAPF) and the Pension Protection Fund (PPF) to develop a pensions infrastructure platform, due to launch next year.

In July the government announced plans to underwrite up to £40bn of infrastructure investment to restart stalled projects.

The UK guarantee scheme, which would offer ailing

‘‘ We see infrastructure as a middle point between what a government bond is and what an equity is”

infrastructure projects access to private funding, has been praised by the NAPF, which believes it will give investors such as pensions schemes more confidence to provide the funding projects need.

When it comes to investing in infrastructure, pension funds can put money into greenfield sites. In doing so they would take on construction risk, but could benefit from the returns associated with new projects.

Alternatively, pension funds could put money into brownfield sites, where the projects are already up and running and generating cash flow. This option is appealing because it is lower risk and offers inflation-linked returns.

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The problem, says Mike Taylor, chief executive of the London Pensions Fund Authority, is that there are not enough UK infrastructure funds providing long-term inflation-linked cash flows.

If there were more of these funds, says Mr Taylor, the

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Should pensions plug potholes?

LPFA fund might increase its infrastructure allocation, which is currently 5% (between £120m and £130m). It has also committed a further £50m.

“There are a lot of funds you can buy which invest in Western Europe, North America, Australia, the Far East, but there are not very many in the UK,” says Mr Taylor.

The pension infrastructure platform being developed by the NAPF and the PPF is designed to provide pension funds with more opportunity to invest in long-term and low-risk infrastructure funds with inflation-linked cash returns.

NAPF chief executive Joanne Segars says:

“[Infrastructure] should be able to give pension funds inflation-linked cash returns with low risk and that’s what pension funds, particularly those that are maturing, really crave. And, of course, they can’t get that at the moment from the gilts market.

“In part, pension funds have also found that the risks associated with infrastructure are simply too high, partly because the model of infrastructure investment is not aligned with pension funds’ needs as long-term, low-risk investors and it is because the leverage is also too high and that squeezes out some of the inflation linking.”

Ms Segars says the platform aims to raise £2bn worth of investment, which could be leveraged up to £4bn, from pension schemes. Discussions are under way with a number of funds, including local authority pensions funds. For example, the Strathclyde Pension Fund has indicated it will provide financial backing for the platform.

The LPFA’s investment

committee has considered supporting the platform, but has yet to do so, because of fears this could lead to the fund exceeding the current 15% limit on contributions to limited partnerships.

Mr Taylor says: “Many schemes are bumping up against that 15% limit and to date the Communities and Local Government Department has not increased it.

“The government is trying to encourage investment in infrastructure but there is actually an impediment in the regulations that prevents a number of authorities from increasing their investment any further.”

Pooling resourcesNevertheless, partnerships and the pooling of funds are increasingly being seen as key ways in which UK pension funds, which tend to be smaller than their Canadian, Dutch and Australian counterparts, can invest in a number of different infrastructure projects and diversify their returns.

“One of the things the CBI is calling for is a pooling of

resources between different pension schemes,” says Mr Lopez Areu. “Perhaps local government schemes could join with private sector schemes.”

In April, councils in London announced plans to create a pooled pension fund to reduce administration costs and divert more than £2bn to infrastructure projects in the capital.

The proposed London Pensions Mutual could hold up to £30bn of assets, and would be modelled on Canada’s Ontario Municipal Employees Retirement System (OMERS).

But there are fears that this sort of arrangement could weaken the principles on which trustees are appointed to look after members’ interests.

Wandsworth Council leader Ravi Govindia says: “The investment polices and trustees of the fund would have to by law discharge the ones that would get the best returns on behalf of the people whose trust they hold.

“If a major infrastructure project fulfilled that test, fair dos, we could consider it like we would consider anything else. But to be dragooned into funding an infrastructure project because it is worthy but may not provide a good return does seem to me to be not in the best interest of the scheme members.”

There is no doubt that progress has been made to make it easier for pension schemes to invest in infrastructure. But local authority pension funds still have a lot to consider if they want to play their part in rebuilding Britain.

The M4 closure in July highlighted the need for investment in infrastructure


1

Equities have underperformed bonds over the past 20 years and many

are losing faith. We all know the past may be a good guide to the future – but the future is arguably more favourable to equities than the headlines might suggest.

The cult of the equity took hold in the late 1950s; as the deflation of the inter-war years gave way to steady inflation in the 1950s, the long-term ability of equities to maintain or grow income in real terms became increasingly attractive. Equity dividend yields fell below the yields on government bonds.

Chart one shows the emergence and growth of the ‘negative yield gap’ in the US. The past 30 years, marked by disinflation, have been more favourable for bonds and the US yield gap has closed. Incidentally, this article uses US market data throughout,

Rollercoaster or death slide?Reports of the death of equities might be a little premature, judging by the underlying numbers. LINDA SELMAN offers a perspective based on more than a century of data

but the broad conclusions hold more widely.

The downturn in equity markets in the second quarter has revived discussion about the long-term attractions of equity investment.

The experience of the past two decades has exposed the limits of an unswerving devotion to the cult of the equity, but does not undermine the fundamental case for investment.

The insight that drove the cult was too easily corrupted into a crude simplification that equities outperform bonds.

But current reports of the death of equities have been exaggerated by the relative performance of the past 20 years.

Long-term investors need to get behind the raw performance numbers and look separately at the income generated by investments

companies do have significant scope to boost dividends without over-distributing relative to historic norms.

Our overall assessment is that the income argument for equities remains intact. But the experience of recent decades indicates that valuation – the price investors pay for that income – can be more important.

The thrill of the rideChart three analyses the real returns to US equities and long-dated Treasury bonds since the end of 1999, close to the peak of the equity market.

Since then, total returns (red) have been 1.6% per annum below inflation for equities and 6.8% per annum ahead of inflation for bonds.

But underlying equity performance has not been too bad: an uninspiring return from income and its reinvestment (blue) has been

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US yield gap (% p.a.)

and the value that markets place on that income.

Built on firm groundThe idea that equity income at least keeps pace with inflation is borne out by the historical record.

Chart two depicts the US experience where trend growth in earnings has been about 1.5% per annum ahead of inflation. It has been a rocky ride but is still a record that withstands scrutiny after more than a century of data.

Dividend income has been less volatile, although trend growth has been somewhat lower, around 1% per annum.

Is that a more realistic estimate of sustainable earnings growth? We think current levels of profitability are ahead of sustainable levels. However, dividend income can be affected by many factors (tax, share repurchases and so on) and, at present, cash-rich US

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Chart 1 Chart 2


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COMMENT MATTHEW GRAHAM Business development director Aviva Investors

How can local authority pension schemes improve their funding levels and address the funding gap while reducing risk? A common approach to help reduce portfolio volatility has been to reduce the scheme’s equity allocation. However, with liabilities growing this doesn’t address funding level concerns, due to the historical (and somewhat erroneous) expectation that equities have higher returns.

Sovereign bonds, corporate bonds and real estate are some of the asset classes schemes have switched into. Relatively few schemes have considered convertible bonds. A potential reason for this is that pension funds have not always known how to optimise a portfolio’s asset allocation when it includes convertible bonds. But convertibles can play a key role in investment strategies as they effectively offer the best of both worlds – providing bond-like protection to help de-risk the portfolio, as well as maintaining some of the growth of equities.

Convertibles start life as a corporate bond with the option to convert to an equity. In rising equity markets convertibles have historically risen too and delivered a significant proportion of the returns experienced by equities. When times are tough

convertibles have tended to fall less than equities, due to the protection their bond component provides. Annualised returns for convertibles have therefore tended to be higher than for equities, but with the added benefit of lower volatility (source: Bloomberg and Aviva, 1993 – 2011).

An allocation to convertibles has the potential to diversify the fixed income component of your portfolio. This is because 60-70% of convertible bond issuers do not issue non-convertible corporate bonds.

There are also the broader diversification benefits as convertibles have their own risk and return characteristics, which have relatively low correlation compared to those delivered by equities or bonds. As convertibles can offer better risk-adjusted returns compared to equities, an allocation to this asset may also enhance the risk/return profile of an overall portfolio of equities and bonds.

A strong role to playThe combination of equity-type returns with bond-type security makes convertibles an attractive investment, particularly during volatile times. Their bond-like protection characteristic enables schemes to de-risk slowly whilst not foregoing all the returns that equities offer.

Converting the converted

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Rollercoaster or death slide?

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boosted by strong real income growth (yellow).

Overall returns have been savaged by devaluation (green) as the dividend yield has risen from just over 1% per annum to almost 2.5% per annum. At present, it may be too optimistic to assume dividend growth of more than the 1% per annum norm.

This means income plus growth, in aggregate, remains below historic averages. Further devaluation of equities is possible, hence we are cautious about their prospects in absolute terms.

Equities may look cheap relative to recent history but they need to be cheap to compensate for the risks.

We are more optimistic about equities relative to long-dated bonds. A real income return from bonds of just over 2% per annum since the end of 1999 was close to historic averages.

The starting point now is

significantly worse – real yields on long-dated inflation-linked bonds are barely above zero.

Bonds have outperformed equities in the US by 8.5% per annum since 1999 – all that has been revaluation.

Now equities start with an underlying advantage of around 3.5% per annum and seem more likely than not to get a boost from relative valuation changes, if bond yields start to revert to mean.

The level of equity exposure must always be seen in the context of the individual fund circumstances; however, now is not the time for local authority pension funds to abandon equities in favour of bonds – although that time may come when the current extreme relative valuation reverts.● Linda Selman is head of LGPS Investments at Hymans Robertson

Chart 3

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▼

As head of the workforce, pay and pensions division of the CLG, civil

servant Terry Crossley was at the heart of the reform of the LGPS until his retirement this summer. He looks back over his career and predicts where the main challenges for fund managers are likely to be.

How did you get to the CLG?I originally qualified as a chartered town planner , achieving membership of the Royal Town Planning Institute in 1973, and spent three years working for Hillingdon Council and then with the GLC. In 1974 I moved on loan from the Department of the Environment to the Welsh Office before transferring back to the DoE in 1980. Successive policy jobs and promotions led in 1990 to my being appointed to look after the Local Government Superannuation Scheme.

Central government always appealed to me, even as a local authority planner. I was also keener on the ‘big project’. At Hillingdon, for example, it was the Colne Valley Regional Park, at the GLC it could be preparing a master plan for brownfield greenbelt land; in the Welsh Office I could be preparing papers on energy policy or

Refl ections on the LGPS

airport expansion and so on. I’ve loved being responsible for significant new areas of legislation, policy or resources. The greater the political focus the better.

What is your view on the LGPS reforms? And what are the key challenges?Having responsibility for the LGPS – and more recently the unfunded firefighters’ pension schemes – has always been totally absorbing. Virtually everyone I have encountered in my most recent role has had a

‘‘ There is a strong commonality of purpose across all interests in the LGPS and fi re schemes”

common aim to ensure the schemes deliver their benefits while remaining affordable, viable and fair to members, employers and taxpayers.

In some policy areas, a unified view is surprisingly not always prevalent. There is a strong commonality of purpose across all interests in the LGPS and fire schemes. Ministers have consistently taken particular care when exercising their statutory responsibilities, aware at all times of the need for consistency, balanced regulations and providing the appropriate legal framework for locally elected councillors within which to manage and administer pensions and investments locally.

Lord Hutton’s framework provides a reasonably broad reform foundation for a locally administered, nationally prescribed scheme such as the LGPS.

The upcoming 2013 primary and eventual primary and secondary legislation coming through will be critical to high-quality fund management, a centrally prescribed future scheme cost-management, a more transparent valuation process and rigorous independent scrutiny.

An even greater change will be new requirements to improve the internal local

governance of individual pension fund authorities. Local government minister Bob Neill, for example, recently spoke at the National Association of Pension Funds conference to clarify the very special role of elected members and their likely forthcoming new responsibilities expected from the Public Service Pension Bill once enacted. There will continue to be a role for a possibly revamped policy review group in advising ministers, and it will provide a proper transparent focus for national interests across the LGPS as a whole.

LGPS reforms remain challenging in terms both of substance and timing. The government is committed to radical change to provide a better balance between benefits paid for and received by scheme members, as

Eland House: home to some significant changes

Top civil servant Terry Crossley has been one of the architects of the LGPS. On his retirement, he assesses its achievements and challenges

xx Month 2012 Local Government Chronicle xxLGCplus.comLGCplus.com 6 September 2012 LGC Finance 9

against the costs of provision met by employers. The stage reached in the reform process between the LGA, acting on behalf of scheme employers so far, and the trade unions is an LGPS-specific solution within a broad framework allowed by ministers.

It remains to be seen how the membership and employers view it. Like all pension reform packages it has its plusses and minuses. Whether it will deliver reformed and (most critically) affordable benefits for members and employers alike will guide government decisions about its forthcoming autumn statutory consultation.

So the key questions for the reforms now on offer are: is it fair in its balance between the interests of local taxpayers and employers and scheme members; is it

affordable for the long term; can the LGPS also remain viable for the long term? Everyone hopes so of course, and 2013 valuations will be critical, but there are emerging significant internal and external forces affecting the LGPS, which is worrying. All of these factors will quickly influence not only the shape and structure of the LGPS, but will also create implications for future fund management.

Apart from LGPS, what would you identify as the main challenges facing pension fund managers?Fund managers, I would suggest (as it is not an area for which the department has a specific regulatory responsibility), need to have a multiple focus on economic conditions and the market trends at all levels, including a specific eye on eurozone matters; the inter-connectivity of the vastly reformed LGPS, the 2013 recession and the wider effects of zero pay growth, diminishing workforces, member opt-outs and the prospects of continuing austerity in local government.

Together with fund authorities and their actuarial consultants, there are some very difficult conditions ahead. Without the vital income stream from locally determined investment strategies and fund manager success, there could be severe resourcing pressures on the newly reformed LGPS from April 2014 and beyond.

The risks of even greater future structural reform cannot be ruled on one level of risk – however unpalatable that sounds at the moment.

Some commentators, who have no part in the actual investment process, seek to denigrate the scheme’s funded profile, its governance and achievements. Ill-informed and even self-motivational casting of aspirations needs to be robustly countered by those legally responsible within pension fund authorities and around them.

After all, liabilities in the LGPS fall initially to the pension fund administering authorities and ultimately employers, with council tax payers standing as a last resort. Scheme members’ pensions are guaranteed and prescribed by statute – they are risk free.

How has local government pension fund management changed?The fund manager’s role and outlook has changed fundamentally over the past decade. It has become more sophisticated, totally global and repositioned the diversified nature of investment portfolios.

Authorities themselves and their governance have also become much more professional and analytical as if in response to the need to secure the important benchmark figure and income stream from locally owned and very valuable assets. This success is essential to protect council taxpayers and employers alike in their provision of employee benefits.

Computerisation also clearly had a major effect, as did Paul Myners. The days of an elderly gentleman, armed with the FT, in charge of a London borough’s fund is now definitely in the past.

Will we see a different sort of fund manager emerging?Fund managers need to be highly rigorous, analytically agile and very professionally knowledgeable. Their range of competencies is always going to be necessary but it seems an even greater specialisation is likely needed for the future, for example in specialist commodities, overseas’ equities and infrastructure models.

Other issues are likely to be international political geography and skills for managing and matching short-term adjustments to increasing long-term liabilities alongside actuaries and, of course, elected members who maintain local, final accountability for the whole process.l Terry Crossley was head of the workforce, pay and pensions division of the CLG until retiring in the summer

‘‘ Ill-informed casting of aspirations needs to be robustly countered by those legally responsible within pension fund authorities”

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COMMENT BERNARD ABRAHAMSEN Head of sales and distribution M&G Investments

As the UK economy continues to struggle, hit by a struggling banking sector and the fallout from the rest of the world’s economic ills, politicians, investors and analysts are left scratching their heads, trying to figure out where economic growth in the UK is going to come from.

Certainly, although the government has introduced a number of initiatives to push UK banks to lend, the withdrawal of non-UK banks has resulted in a decline in lending activity. Furthermore, the banks are borrowing at much more expensive levels than they were pre-2007, so they can’t offer cheap loans the way the used to, and new regulation from the Basel Committee makes lending long-term less attractive to them. With this being the case, it is difficult to see what will spark growth in the foreseeable future.

SME problemThis reduction in lending has left many small and medium-sized companies reeling and the issue has become central to the UK Treasury.

The Government highlighted the problem in the Chancellor’s latest budget, where George Osborne unveiled the ‘Business Finance Partnership’ – an initiative which reflects a growing desire to encourage investors

to lend to medium-sized creditworthy enterprises, either directly or via an investment manager.

But is this a good idea? Should public sector investors be interested in getting involved in this non-bank lending?

Good returnsWe believe the answer is yes, because, in our experience these loans can typically offer very attractive returns for the risks. Furthermore, as these are companies that do not issue bonds in the public debt markets, they offer investors such as pension funds a measure of additional diversification in their portfolios.

And by doing so, investors can benefit from playing an important role in the UK economy by helping to provide an alternative finance to small and medium-sized enterprises that need it to succeed.

So, how exactly can public sector investors or their asset managers become direct lenders?

Perhaps we should put everything in context first. Public sector pension funds already provide a form of

non-bank lending by investing in the public bond markets – but such investing is done with a great deal of help from investment banks. It’s the banks who bring companies to the bond markets, who call up potential investors such as pension funds and who perform a great deal of the necessary additional work like providing the legal framework of the deals, while ratings agencies provide their opinions on an issuer’s credit rating.

Necessary skillsIf an investor chooses to lend directly then, really, they need to be able to do all of this themselves. They need access to the right experience and skills set to carry out the following tasks as a bare minimum: ● A general analysis on the firm’s background, its business and its financial situation. If all is good, then it’s on to step two.● A meeting with the company’s finance director, or CEO, to discuss the company’s business, needs and issues.● A lengthy site visit – if all of the previous activity suggests this is worthwhile – to talk to senior management, operational management and to see the company in action. In depth discussions about the company’s ambitions, risks, strategy, historic accounts, financial projections and so

on are all needed.The above steps aim to

build a detailed picture of the company and its business and can unlock information about a company that public bond investors would not receive. Having done all of this though, investors will still need to negotiate a deal that contains all the right contractual protection to help protect the investor if things do not go to plan.

Compelling attractionsIs it worth it? This type of lending deal can sometimes offer advantages over the equivalent in the public bond markets, so yes, there are compelling reasons to invest this way.

The non-bank direct lending market, currently the road less travelled, still needs to develop. The crisis has revealed that alternative sources of lending could prove very important to the UK economy.

We have been involved in this market since the height of the financial crisis and encourage other investors and asset managers to join us, and help put this road less travelled firmly on the map.

Direct lending benefi ts investors and UK plc

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‘‘ These loans can typically offer very attractive returns for the risks”

‘‘ Investors can benefi t from playing an important role in the UK economy”

*As at 30 June 2012. M&G Investment Management Limited is registered in England and Wales under numbers 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Services Authority. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Services Authority's Handbook they are not available to individual investors, who should not rely on this communication. AUG 12 / 39256

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▼

Austerity could now run through to 2020, according to recent predictions by the

prime minister. There are many factors contributing to the current situation and which affect the ten-year gilt yield, a measure crucial to the valuation of local authority pension funds.

The seemingly insoluble crisis in the eurozone; the credibility of the chancellor’s austerity programme; quantitative easing; lower or negative growth; event risk; high institutional demand for gilts (indeed a 100-year gilt is mooted) – these are all contributing to a worrying scenario for local authority pension schemes in England and Wales approaching the triennial valuation date of 31 March 2013, with Scotland following in 2014.

It is likely that the results of the revaluation will show valuation levels around 60%. No doubt this will unleash a media storm of criticism about ‘gold plated’ public sector pensions when the implications of planned deficit recovery strategies are made public.

There will undoubtedly be much comment about strategies that involve increases in employer contributions when local authorities are stretched to provide basic services such as education (a million extra school places needed by 2020), social services and emptying the bins.

An appetite for private equity?Pension funds are seeing private equity as an investment option but are proceeding with caution. TONY CHARLWOOD reports

These anticipated valuation levels will put pressure on managers of local authority pension schemes to invest in higher yielding assets, while heeding risk.

Against this challenging backdrop LGC, with sponsor SL Capital Partners, carried out a reader poll over the summer to gauge the temper of local authority fund managers, with a particular focus on their attitude to – and appetite for – investment in private equity.

Higher yieldsPrivate equity, of course, ranks as one of those higher yielding asset classes. It as an investment vehicle used primarily by institutions to gain equity ownership in companies, frequently using debt to finance the purchase with the usual result that the company so acquired is taken ‘private’ and delisted. Such funds are not readily available to retail clients.

Investment in private equity, therefore, is for experienced institutional investors who can commit their investment for

‘‘ Investment in private equity is for experienced institutional investors who can commit for considerable periods

considerable periods (often more than seven years) to allow for the turnaround of a poorly managed company to enable it to be sold at a profit.

Private equity can give diversification into areas when an investor has limited assets to invest; it can give access to funds managed by top performing managers not otherwise accessible, access to specialist investment strategies or exposure to difficult to reach markets.

Returns from private equity, however, are difficult to monitor. Private equity managers are not required to state performance on a regular basis. Because of the often illiquid nature of their investments it is not possible to value the assets except at the time of disposal.

The reader questionnaire was drafted by LGC, in conjunction with SL Capital Partners, to get a better understanding of what local authority pension schemes are looking for when investing in private equity funds.

Among the first findings was that two-thirds of respondents, when asked to rank asset classes in order of preference, still viewed equities as the choice to deliver the returns needed.

However, what was particularly interesting was that while coming in third to equities and fixed income, as would be expected, private equity as an asset class was identified as being more attractive than real estate and bonds by two-thirds of the survey’s respondents.

Interestingly, the remaining third was very negative about equities, putting between 40% and 50% in fixed interest and bonds and around 21% in private equity. A total of 70% had some investment in private equity. But most also conceded they invested between 3% to 5% in private equity, and no fund committed more than 10%.

Nevertheless, those investing in private equity said they were looking for good returns over the next five

/ SL Capital Partners Survey


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coMMent Stewart Hay Partner SL Capital Partners

Private equity as an asset class continues to have a profile much larger than its position in the overall asset management mix (private equity: $2 trillion v global asset management: $76 trillion) would imply. In the US, Mitt Romney’s time at private equity firm Bain Capital has sparked fierce debate about the industry’s stewardship of investments; in Europe, private equity has been the foil for politicians who are looking to increase scrutiny, regulation and control over certain elements of the financial services sector.

So, when considering an investment in private equity today, you need to look through this ‘noise’ and consider the real opportunity and real risks.

The positives are proven – strong returns over the long term. Recent work by a number of leading academics, including the Oxford University Private Equity Institute, has provided unbiased evidence that private equity in North America and Europe has outperformed listed equities by 300-500 basis points a year since the 1980s. To deliver this performance, further research has shown that investors must select the right private equity fund managers to back, given the high dispersion of returns between them. Investors should also continue to invest over the long term to

capture performance when the cycle is beneficial.

Liquidity remains a concern for pension funds. Private equity develops capital for three to five years prior to exit and, since the financial crisis, exits have slowed. As a result, allocations to private equity have capped out for many pension funds. Given subdued M&A markets, it is unlikely that this will ease in 2013. However, investors that can continue to invest today in private equity should see strong leveraged returns compared to other equity markets as we enter a recovery cycle in Europe and North America. Increasing regulation will affect all organisations in the private equity industry. This hurdle, especially in Europe, means pension funds will need to work closely with internal or external advisors to navigate the new requirements.

Given all of this, the message that should be communicated to clients is clear – private equity is a strategy that can deliver a strong return. Clients need to be clear on their strategy, how they access the top managers and should be prepared to invest for the long term across vintage years in attractive markets. In this way private equity, even if it represents a small component of a client’s pension fund, can make a positive contribution.

Performance long-term

COLUMN SPONSOreD aND SUPPLIeD By SL CaPItaL PartNerS www.SLCaPItaL.COM

An appetite for private equity?

years, with 62% looking for between 10% and 20%.

Peter McKellar, co-ordinating partner at SL Capital Partners, argues: “The attractiveness of an asset class depends on an investor’s appetite for risk and return, while taking account of its need for liquidity. Private equity is often matched alongside real estate as an asset class given their comparable risk, return and liquidity profiles, although there are significant differences in their respective investment strategies.

“For investors looking for an element of alpha return from their portfolio of investments, private equity offers outperformance against most asset classes over the longer term – we are encouraged that local authority pension funds agree that private equity is an important part of their portfolio allocation.”

When asked how their funds had performed, nearly half – 46% – said they enjoyed

good or outperformance over the longer term of their private equity investment and only 3% reported underperformance. When asked to review recent performance of their private equity fund during the recent period of financial crisis, 9% were very satisfied, with a further 74% giving this an average or above average rating, and 17% considering themselves dissatisfied.

It could be argued that this indicates private equity will show significant

‘‘ For investors looking for an alpha return, private equity offers outperformance against most asset classes

Continues overleaf


1


outperformance as the resolution to the financial crisis is found, giving, in particular, ‘turnaround equity’ a chance to be returned to the market at a premium.

More than half of the respondents looked to advisers or trustees to set their allocation to private equity. In many of the larger funds officers are, subject to due diligence, authorised to invest in private equity within certain limits.

One limiting factor to investing in private equity is the cap on investment in limited partnerships, currently prescribed by regulation to 15% of the total pension fund. Many funds are already substantially invested in limited partnerships of various types (including private equity) so the ability to invest further in private equity is constrained.

Funds saw a variety of ways to manage their investment in private equity, mostly through

careful monitoring of cash flow and further commitment to their existing private equity managers bringing ‘new product’ to them, through the secondary market or through co-investments (which are outside the scope of the regulation).

That said, only half of the respondents – 53% – saw the present as a good time to increase existing allocations to private equity investments, and only a quarter of those said they were going to increase their allocation in the near future.

Varied preferencesThere was no general consensus on the best type of private equity investment. Respondents were asked to rank the subsectors within the private equity universe in order of attractiveness and there was no strong winner.

Turnaround equity was, on balance, the most popular area, with distressed debt and secondaries following closely. Energy was also popular but real estate was an outlier. North America, Europe and

rating this as effective or very effective but 40% either coming back with either a middle ground or outright critical response.

A fund-of-fund investment, if managed properly, should of course give a good spread of underlying investments,

Yes70%

No30%

Are you currently investingin private equity?

0% to 2%12%

3%to 5%64%

Greaterthan 10%0%

21%to 30%

0%

Greaterthan 30%0%

6% to 10%24%

If so, what proportion of yourportfolio value is made up byprivate equity?

0% to 10%38%

11% to 20%62%

What returns are you looking forfrom your private equityinvestments over the next five years?

Yes53%

No47%

Do you believe the current marketpresents a good time to increaseallocations to private equity investments?

Yes25%

No75%

Are you going to increase yourallocation to private equity?

emerging market equity (in particular BRIC) had their allocations but were generally insignificant compared with positions held in other types of private equity investments.

Placing money into private equity fund-of-funds as a method of investment also had its fans – with some 60%

Continued from previous page

▼/ SL Capital Partners Survey


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which should mitigate risk and loss if one of the funds should fail. However, the counter argument is that fund-of-funds investors can end up paying twice, one fee to the underlying fund and one to the fund-of-fund manager. On balance, therefore, respondents thought fund-of-funds was an effective or reasonably effective way of accessing private equity and ignored the double fee ‘downside’.

SL Capital Partners’ McKellar agrees going the fund-of-funds route is something local authorities should approach with their eyes open.

“It is important to note that the fund-of-funds route of investing in private equity is not appropriate for all local authority pension funds. However, for those who are looking for a general exposure to the asset class due to the smaller size of their potential allocation, an experienced fund-of-funds manager can offer a high level of access, performance and the overall management of the programme.

“In addition, larger plans

can use fund-of-funds for specific strategies or geographies that are hard to cover with limited resources. In such cases, fund-of-fund managers can be the ‘eyes and ears’ for pension funds.

“We are encouraged by the continued acceptance that fund-of-funds are seen as a valid partner with local authority pension funds. It is critical that fund-of-funds continue to deliver value for the fees incurred, and that managers continue to develop their investment strategies, portfolio monitoring and reporting to be state of the art.”

The survey also asked about more esoteric issues such as governance and socially responsible investing – where interest among local authority pension funds has waned since the early part of the century, especially as returns did not match up to expectation.

Asked about whether SRI or ESG ideals impinge on investment decisions in private equity, it was clear they generally are not a high priority with around half – 46% – considering this not to be important, a fifth going the other way and a third sat plumb in the middle.

Balanced viewsSimilarly most local authority pension scheme managers did not believe private equity investment managers placed SRI or ESG factors high in the criteria when considering making an investment. Around a third felt negatively on this issue, half were on the fence and around a fifth took the view that, yes, this was something taken seriously.

The number of fund managers a pension scheme employs and the number of funds in which it invests has clear governance implications for officers’ managing investment for their authorities.

This survey was sponsored by SL Capital Partners. Questions were drafted jointly by LGC and SL Capital Partners. The report was independently written and edited.

Custody, monitoring and accounting are all matters that have to be taken into consideration and the manpower implications of keeping on top of all these issues.

Respondents were therefore asked how much work investments in private equity funds created, how expensive it was and how burdensome on an in-house investment team it was to manage and monitor the investment.

There was little consensus on how onerous it was to monitor private equity funds; however, 7% did say they thought it very burdensome.

Similarly there was little consensus on fee levels, with more than 55% of the sample ambivalent and the balance spread on either side of the mean. Restrictions on private equity investments were not seen as very burdensome, with almost 90% arguing this was not an issue.

Similarly management of cash flows relating to private equity was not generally seen as burdensome, nor was reporting to trustees.

Liquidity, too, was not thought to be an issue, although this might change with the implementation of the ‘new’ local authority scheme in 2014.

Finally, respondents were asked how they rated their investment experience when using consultants to advise on sectors to invest in with private equity. The majority,

74%, reported their experience as either average or poor.

However, when asked about performance, 33% said those recommended either outperformed or were good, with 50% saying performance was average and 17% poor.

Overall, what should local authority pension fund managers be taking away from all this? On balance the case for investing in private equity does appear to rest on the economics of recovery.

Actual returns experienced by 68% of the sample rated average or above, so investment in private equity would seem to meet expectations, although it remains to be seen whether the expectation of a return between 11% and 20% over five years from the present will be met.

From the sample in this survey there does not appear to be an overwhelming desire to invest in the sector, although more than 50% do believe now is a good time to invest.

OpportunityPerhaps more positively, the diversity of response appears to back the view that individual schemes are constantly considering ways of improving investment performance.

Clearly, too, overall investment returns for the local government pension scheme are critical and the need to improve paramount.

The need to diversify into higher yielding asset classes is proven but if the implementation of the ‘new’ scheme pushes funds up the maturity curve in 2014 the question is will they be able to do so or will they have to move towards investment in liability matching assets? l Tony Charlwood is an independent financial services adviser

‘‘ Larger plans can use fund-of-funds for specific strategies or geographies that are hard to cover with limited resources


While most people would admit economics

forms an essential ingredient of effective investment decision-making, many would also acknowledge it can be difficult to predict the investment repercussions of a sharp rise in inflation or an unanticipated fall in GDP.

This article aims to simplify this conundrum.

Let us begin with the data itself. First, the compilation methodology of economic data can vary from country to country. CPI (Consumer Price Index) is a good example of this. Around the world, different governments use different baskets of goods, and different weights, to measure inflation.

This makes a global comparison from one country to the next a less than precise science. It is also not uncommon to find governments making changes to the basket.

In January 2011, for example, China’s CPI rose to 4.9%, much less than the consensus expectation of 5.4%. Yet the response in the Asian markets was muted because, in fact, the lower figure reflected a previously announced change in the weight of items included in the CPI basket calculation.

‘Know the methodology’ becomes a key criterion to successfully interpreting releases of economic data.

Second, an accurate idea of

Are we clear on that?Before we can predict the impact of changes in indices we need to be sure of some fundamentals. KAREN SHACKLETON provides a little clarity

where the economy lies can take time to unfold.

In the US, for example, media attention usually focuses on the first GDP release, a month after quarter end. Yet this can be quite different from subsequent reports because it is missing some trade and business inventory information.

The second report comes out two months after quarter end and the final report is released the month after that.

Compare the information in the three reports in Q3 2011, for example. The first said GDP was growing at 2.5%, the second reduced this to 2% and the final report reduced it further to 1.8%. Such large differences could have a dramatic impact on the investment decisions taken in response to the data.

Ambivalent forecastsThen there is the problem of forecasting that ‘already somewhat unreliable data’, ahead of the announcement.

The Citigroup Economic Surprise Index measures whether actual economic data is better or worse than economists’ forecasts, the ‘forecast’ being the consensus view as measured by Bloomberg.

Positive levels of the index indicate that economic releases have, on balance, beaten the consensus forecast (economists are under-estimating the numbers). Measures below zero show occasions when

▼

the forecasts were better than the actual numbers (economists were over-optimistic).

The index for the US market over the past five years is shown above.

As economic releases begin to beat forecasts (above zero), economists gradually begin to take a more optimistic view with their next set of predictions, until it gets to a point where they become too optimistic and then the trend begins to revert to below zero again.

We are currently in an environment where forecasts are significantly lower than actual figures (almost one of

the highest points on the graph since 2007).

Yet in June 2011 it was –117, the lowest since 2009, showing a significant swing in sentiment (from optimism to pessimism) in just nine months.

Reflection and predictionOne way to assess how good an individual investment manager is at economic forecasting is to explore whether or not they reflect on what they said previously and compare it to what actually happened.

Of course, an economist is much more inclined to do this if he or she gets it right

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AfricaBrazil China Mexico Korea

Source: Gerstein Fisher

Correlations between stock indices and GDP movements

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Index for the US market over past 5 yearsSource: Bloomberg

The Citigroup Economic Surprise Index


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coMMent KEvin CuLLEn Client relationship manager – local authorities, SSgA

With growth rates in developed markets stagnant, emerging markets continue to draw attention as a promising potential source of growth for investment portfolios. There would certainly appear to be ample reason to consider this asset class as a key element of a diversified investment portfolio. While emerging market equities represent about 13% of the world’s global investable equity market capitalisation, the average pension fund around the world only has about 6% of their equities in emerging markets.

It’s not just EM equities that offer opportunities for investors. Options include local currency debt, hard currency debt, private equity, real estate, and absolute return strategies. With nominal yields on a local currency emerging debt roughly about 6% now, for example, and yields in the UK at a 300-year low, the former presents a compelling candidate for investing.

So what’s driving the case for EM? One of the most surprising features of the sector has been its resilience in the face of the global financial crisis. Overall, emerging markets are being lauded for much lower debt-to-GDP ratios than in the developed markets, greater fiscal flexibility in the event of a further shock hitting the

world economy, and banking systems that are often in much better shape than those in the developed markets. So, the long-term case for investing in emerging markets has actually been enhanced since the crisis. Even in the short term, emerging markets are growing four times as fast as developed markets. Powerful forces in demographics, urbanisation, productivity increases and technology transfer are not going to change any time soon – if anything, they are likely to accelerate.

Clearly investors need to consider their attitude to risk – emerging market equities are typically more volatile than developed markets – and macroeconomic factors like commodity prices or the slope of the yield curve are essential factors. From there investors must decide on their tactical asset allocation between active, passive and advanced beta strategies, such as minimum variance portfolios or managed volatility, and appropriate risk management.

So there are a number of facets to this opportunity, and investor focus shouldn’t be solely on equities. But a little bit of planning and analysis can create significant investor benefits in terms of a broadly diversified long-term investment programme.

Emerging benefits

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Are we clear on that? most of the time. But trustees who implement a disciplined, rolling quarterly cycle of ‘reflection and prediction in equal measure’ will develop a rigorous and objective methodology for assessing the quality of their economist’s input to the investment approach.

Key elements to such a cycle might include:l Reviewing forecasts from previous periodsl Analysing actual economic releases during the past quarter and comparingwith forecastsl Challenging the manager where there are significant deviationsl Requesting and discussing forecasts for next periodsl Clarifying the anticipated impact on the portfolio.

It is natural to expect there to be a fairly direct link between the economy and stock market performance. Yet US investment firm Gerstein Fisher analysed this relationship for eight markets from 1993 to 2010, with unexpected results (left).

They concluded the correlation between economic growth and stock market performance was surprisingly tenuous, and in China and Korea, over the period analysed, it was actually negative. China’s economy, for example, grew by nearly 16% per annum (in nominal, US-dollar terms) but the equity market fell by 2.25% per annum over the 18-year period.

Gerstein Fisher put forward several possible reasons for this unexpected relationship, including:l Expected economic growth is already discounted in current prices.l Globalisation of companies is breaking down the relationship between the domestic economy and its stock market. For example, S&P 500 companies are often global businesses that just

happen to be listed on the US stock exchange.

Trustees can challenge their economists by asking them to confirm and clarify the expected relationship between forecasted economic data and the underlying stock or bond markets, as well as the likely sensitivity, or the magnitude of the impact, of those different indicators.

By forcing the economist to make a direct link between the economic data and the underlying investments, trustees will be left with a much clearer picture of how their portfolio will be affected in different scenarios.

DisenfranchisingMany investment managers dilute their economist’s skill by developing an unclear investment process that leaves the economic input disengaged from final stock selection in the portfolio.

A full understanding of a fund manager’s investment process is essential, and of how the economic views are taken into account in the decision making.

This takes trustee and adviser time and effort; it requires a good deal of transparency by the manager and demands ongoing monitoring and challenge.

Some of the common pitfalls in decision-making include tactical overlays (overlaying the strategic view set by the economist with short-term fears), ‘top-down’ versus ‘bottom-up’ methodologies interfering with each other (a lack of clarity in approach), and portfolio construction (which stocks and how much?).

Such pitfalls ultimately dampen performance opportunities with mediocre results ensuing. But that is a topic for another time...l Karen Shackleton is managing director, AllenbridgeEpic investment Advisers

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Correlations between stock indices and GDP movements

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Index for the US market over past 5 yearsSource: Bloomberg

The Citigroup Economic Surprise Index


With the reputation of bankers currently

almost on a par with that of politicians you may wonder why, as both leader of Cambridgeshire County Council and now non-executive of our new joint venture Cambridge & Counties Bank, I have decided to become both.

The answer is simple: it gave the council a real chance to use a modest investment from the Cambridgeshire Local Government Pension Fund to bring a good return for our pensioners and provide a boost to business.

By pairing with Trinity Hall, a college of Cambridge University, we have been able to bring together hundreds of years of experience to launch a traditional bank, one not based on a bonus culture or casino-like investments but one that will make loans available to help grow and support small businesses.

When we launched the Cambridge & Counties Bank in June, Mark Hoban, financial secretary to the Treasury, said: “I’m pleased to support a new bank that will focus on lending to the SMEs that make up such a vital part of the UK economy. The government remains committed to fostering more diversity in the banking sector, so we need new banks to enter the market to provide consumers and businesses with greater choice.”

Banking on historyA county council and a historic centre of learning might seem unlikely partners to set up a bank. NICK CLARKE explains the origins and ambitions of the country’s latest lender

The role of a pension fund, of course, is primarily to get a good return for its members and reduce any burden that could fall on taxpayers.

At the same time, the creation of the bank has offered an ideal opportunity to help enterprising small and medium-sized businesses.

Analysis of industry data by Cambridge & Counties Bank has revealed that in the second half of 2011 more than 60,000 loan and overdraft applications from SMEs – worth as much as £3bn – were rejected by banks.

Poor relationshipsResearch has also revealed that 47% of businesses believe their relationship with their main business bank is only average or bad.

Investing pension funds or public authority money into banks is not a new idea, but it is an attractive one and we believe we are breaking new ground with ours.

Banking on history

Cambridge & Counties Bank has a strong management team. It is led by chief executive Gary Wilkinson, who has held a number of senior roles in the banking and building society sectors.

Assets from a former bank have been bought for the new venture, which will concentrate on secured lending to SMEs.

Investment in the bank we believe brings good returns for the pension fund, which has more than 170 member organisations, so reducing any potential long-term burden on the taxpayer.

By launching the bank, we have been able to show that Cambridgeshire is open for business and will provide financial support to help small and medium-sized businesses grow, as well as create jobs at a time when it is harder to secure funding.

To be issued with a banking licence, Cambridge & Counties Bank has had to be formally authorised by the

▼

FSA. In addition, each of the directors of the bank has been authorised by the FSA as an approved person to carry out the controlled function of a board director.

Paul ffolkes Davis, bursar and steward of Trinity Hall, says: “We regard Cambridge & Counties Bank as an unprecedented opportunity to marry a strong investment promising good returns with support for small businesses at a time they need it most.

“While the traditional high-street banks are preoccupied with their legacy problems, which are having a negative impact on their lending, Cambridge & Counties Bank has no past and is looking forward to a successful future.

“While the outlook for higher education funding looks ever more challenging, this investment is also intended to strengthen the college’s endowment returns in order to secure our world-class teaching and research for coming generations of Cambridge students.”

Cambridge & Counties Bank will provide SMEs with loans secured against commercial property as well as a highly competitive deposit account. It will also offer secured pension scheme lending and has plans to launch professions’ financing, as well as other competitive savings accounts.● Nick Clarke is leader of Cambridgeshire CC


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coMMent ALex CArpenter Managing director, UK prime clients Blackrock

Local authorities’ pension schemes have long seen commercial property as a diversifying return driver but little more. While they have traditionally had higher exposure to property than their private sector counterparts, allocations remain typically limited in scope.

Yet today property is a multi-faceted asset class, capable of satisfying a multitude of investment needs. For schemes looking to protect liabilities or to grow their assets, property has evolved to perform an abundance of roles in a multi-asset portfolio.

From use as an index-linked bond proxy to highly leveraged development plays, property now covers the full spectrum of investment profiles.

An attractive return profileTraditionally, pension schemes expect property returns, which combine regular income with the potential for capital growth, to sit between equities and bonds, a view supported by current forecasts.

However, if the initial credit crunch badly affected property markets – in the UK alone, aggregate valuations fell by 44% – prime markets have rebounded since then to near pre-crisis levels, with initial yields of below 5% in some areas.

The return profile of a property investment will largely depend on the

investor’s route to market. For example, local authority schemes can opt to access the listed sector by investing in property investment trusts (REITs – real estate investment trusts), which trade on the stock market.

While they offer property-like returns, REITs also exhibit similar volatility to other equity holdings.

Alternatively, schemes may favour an unlisted approach, accessing property returns without equity market volatility in exchange for lower liquidity.

Schemes can also opt to invest higher up an asset’s capital structure through an investment in property debt.

Regardless of the chosen route, investment committees need to be comfortable with the illiquidity and potential volatility associated with property investing and understand how difficult it can be to time the market.

Traditional core property has widely been regarded as a loose inflation hedge. However, the increasing prevalence of index-linked occupational leases (tied to RPI or CPI), particularly in the retail sector, allows investors to focus their investment on assets that offer a much more effective hedge for their liabilities.

Combined with the long-dated nature of property returns and the yield pick-up offered by property investments over index-linked gilts, this means

pension schemes can effectively diversify some of their inflation risk management at significantly lower cost.

Moving further up the risk curve, UK core markets continue to offer long-term, sustainable cash flows. Core investments are typically represented by stabilised, income-producing properties. While the UK remains a challenging economic environment, UK property is set to remain robust. Based on analysis using models from Property Market Analysis, BlackRock estimates total returns from the sector of 6.8% per annum over the next five years.

Widening opportunitiesLooking ahead, high-yield mezzanine debt opportunities also present pension schemes with attractive risk-adjusted return potential as well as significant downside protection. We believe the market dynamics across

Europe have created a unique investment opportunity to earn up to 9 to 12% annual total returns, with a typical current income yield component of 7 to 9%.

With the equity component providing downside protection, the most critical risk in a mezzanine investment is a severe market downturn, which would increase levels of default. However, at this stage we do not view such a scenario as likely.

Mezzanine investors must also ensure that transactions are underwritten by best-in-class underwriters with a strong focus on timing and exit strategies.

In conclusion, forward-thinking investors no longer regard property as simply another return diversifier. The universe of investment opportunities that property offers has expanded, creating a broad toolkit to help local authority pension schemes meet a range of challenges.

Commercial property: more than just a risk diversifier

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Three key quesTionsl Investment expectations What risk/return characteristics are we expecting from our property allocation? What do we want to achieve? What is our illiquidity tolerance?l Management Do we want to manage our property allocation directly or do we prefer employing a specialist manager?l expertise If the latter, does our manager have the breadth of expertise required to manage our allocation across the property investment spectrum?


1


▼

Howard Pearce has been head of the Environment Agency’s two LGPS

pension funds for the past 10 years. Together they have liabilities of £3bn, assets of £2bn, and 42,000 members across England and Wales.

What attracted you to the Environment Agency?I was brought up in Sale in Cheshire. As a boy I wanted to play football for Manchester United and clean up the polluted River Mersey so I could use it for fishing or boating. I went to Liverpool University and, when not playing football, got a degree in zoology and the Ellis Prize for my dissertation (on how to improve the freshwater ecology for the largest tributary of the Mersey).

This led to a postgraduate studentship with the Welsh Water Authority, which led to me becoming deputy editor of a weekly journal for the Water Research Centre. I then got a job to develop all the water bodies in the Lee Valley Park, became national countryside and water sport adviser for the Sports Council, then in 1989 I was appointed head of corporate planning for the National Rivers Authority, which was enlarged into the Environment Agency in 1996.

In 2002 our director of finance asked me if I could develop a long-term funding solution for the Closed Fund and to use my financial and environmental acumen to

Environment’s steady playerHe never achieved his ambition to play for Manchester United, but the Environment Agency’s Howard Pearce is spot on target when it comes to long-term investment

develop a long-term financially robust and environmentally responsible strategy for the Active Fund. So there has been a common thread throughout my career, a focus on long-term business planning, funding, financial investment and achievement reporting.

What’s a typical week?Spending two to three days with my team in our Bristol office, one to two days attending meetings in London, and a day working from home to catch up after being out of the office. I try to get to the gym and swim.

I also spend time preparing for our quarterly Pensions Committee and Investment and Benefits subgroups. I am a member of the LGPS Policy Review Group and UK Institutional Investors Group on Climate Change.

What is the EA’s pension fund investment strategy? How has this changed?Our long-term investment strategy for the residual assets of our legacy Closed Fund is to invest in very long dated gilts up to the time they will fund the tail of liabilities in around 30 years. The Closed Fund has been the top performing fund in the LGPS for the past two years.

For our Active Fund we consider we have a fiduciary duty to avoid financially material environmental risks (for example climate change) that could reduce our returns

and to seek out financially material environmental opportunities (for example low carbon technology) that will increase our returns.

Our Active Fund is relatively immature. But over the past 10 years we have progressively de-risked its investment strategy by reducing equity exposure and diversified our investments, a process we will continue.

As at 31 March the fund has nearly £250m invested in green technology, or around 13%. By 2015 around 25% of the fund will be invested in

the green economy for long-term returns.

The current market volatility and low gilt yields is causing us some angst, not least because they may distort the 2013 triennial valuation.

Consequently we have agreed a new investment strategy and asset allocation. This includes a mandate in low volatility global equities and diversifying our asset allocation into ‘real’ assets. We are going to need to make our assets work harder.

I explain in more detail the thinking behind our investment strategy overleaf.

How does good environmental governance equate with investment and financial performance?Well governed companies that manage their financially material ESG risks that could impact on shareholder value will over time produce more sustainable returns compared to poorly governed

‘‘ More companies are realising there are fi nancial advantages from using resources, energy, packaging and so on more effi ciently


comment ViCki Bakhshi associate director, Gsi

In 2011, for the first time, global net new expenditure on renewable energy exceeded fossil fuel plants. Clean energy has moved definitively from niche to mainstream. Yet some ‘green’ investors have not reaped the benefits; the WilderHill New Energy Global Innovation index fell 40% last year, dramatically underperforming the benchmark markets.

This apparent contradiction is the product of a particular set of circumstances: massive investment in renewable energy has led to tumbling prices and overcapacity, and a shake-out is under way. This short-term situation should not obscure the long-term investment opportunity; 138 governments worldwide have a climate change policy in place, motivated not just by the desire to cut emissions, but also by the promise of greater energy security and competitive advantage.

There are three ways investors can harness the opportunities while protecting against risk:l Get wise to policy risk. Governments are looking to cut costs, and renewable energy subsidies are a tempting target. Investors should be wary of promised returns heavily reliant on vulnerable subsidies, particularly as there are many opportunities that are economic in their own

right. Asset owners should press their fund managers on how they are identifying climate policy risk.l Take a broad interpretation. Climate change investing does not equal renewable energy investing. Energy efficiency is an attractive area, offering savings in both carbon and money. Climate change also exacerbates existing stresses in the world’s natural resources, reinforcing the investment case for companies offering better management of water, air and land.l Invest across asset classes. While equity markets still offer the broadest range of investment options, opportunities in other asset classes are expanding. Private equity investment in renewable energy remains robust, holding up in 2011 despite falling public market valuations. In credit markets, a growing range of ‘green bonds’ are on offer. And many investors are looking at infrastructure, which in the UK is receiving a boost with initiatives such as the Green Investment Bank aimed at reducing the risk profile for investors.

Climate change, energy and resource scarcity are a powerful nexus of issues with significant growth potential; they merit a place as a core part of a balanced portfolio.

Don’t be greenly naive

COLUMN sPONsORED aND sUPPLiED BY F&C assEt MaNaGEMENt. WWW.FaNDC.COM

Environment’s steady player

companies, and so are a better long-term investment.

More companies are realising there are financial opportunities from conserving natural resources, energy, packaging and so on more efficiently, which gives them competitive advantage.

What would you identify as the key challenges facing pension fund managers? Even with a move to a CARE scheme in 2014 because the LGPS is the largest occupational pension scheme in the UK it will almost inevitably come under pressure from people with ‘pensions envy’ and by employers and employees with ‘pension apathy’ because of negative media coverage.

LGPS pension managers need continually to highlight to their employer and fund members the importance of saving for 20 to 30 years of life or longer in retirement; the LGPS is a very good scheme;

the higher cost (25% of pay) it would require to get the same pension benefits from a DC scheme; and they would need to make difficult investment decisions themselves.

If you could travel back in time and meet yourself at the start of your career, what advice would you give?Practise your football skills to ensure you are spotted by a Manchester United talent scout. More seriously, I would say consider becoming an actuary, chartered financial analyst or pensions lawyer, to deal with the increasingly complex world of pensions, funding and investments.

More generally, for those thinking about a career in the LGPS, ensure you have knowledge, understanding and experience in public sector pension scheme governance, benefits administration, responsible investment, marketing, and e-communications.

Also focus on long-term strategic performance drivers and not short-term episodic or cyclical events.

What do you think will be the main issues for the LGPS over the next 5 to 10 years?Communicating and implementing the new LGPS, training new committee members, funding historic liabilities, retaining fund members in the new LGPS and finding high yielding sustainable investments in what will probably be a volatile and low-growth world – and above all keeping paying future pensions.l howard Pearce is head of environment finance and pension fund management at the Environment agency

xx Local Government Chronicle xx Month 2012 LGCplus.com

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LGCplus.com22 LGC Finance 6 September 2012

The Environment Agency’s Active Fund has nearly 22,000 members and assets of almost £1.9bn. It was the first fund in the LGPS to join the United Nations Principles of Responsible Investment in 2006. It was the first UK pension fund to produce a Responsible Investment Review in 2009.

The fund’s 2012 Annual Report and Financial Statements show its investment performance was +5.1%, almost double the average (+2.6%) of the other 89 LGPS funds. Over the past three years its annualised performance was +16.1%, or 1.6 points more than the 14.5% average of the others.

The environmental footprint of the fund’s active equity investments was 6% less, and carbon footprint 25% less, than the market benchmark. The active bond portfolio performed even better with an environmental footprint 23% better than its benchmark and 30% more efficient for carbon.

Future objectivesThe fund’s future investment objectives are to aim to be at least 100% funded, to continue to de-risk where possible, and to maintain its reputation as a financially and environmentally responsible investor. The fund considers it has a fiduciary duty to take account of financially material environmental risks and opportunities that could affect its current and future investment returns, such as climate change.

The fund’s new investment

Securing returnsMore flexible asset allocation, broader investments and a goal of improved returns from across the portfolio are the Environment Agency’s new strategy, explains HOWARD PEARCE

strategy is designed to improve its risk-adjusted returns, enhance diversification, make as effective use as possible of its assets, provide flexibility to meet the challenges of difficult economic conditions, and strengthen the fund’s commitment as a long-term responsible investor.

The aim is to improve the fund’s funding position and so avoid increased employer costs. It will also reduce the fund’s vulnerability to climate change.

To achieve this, the Pension Committee has decided to: ● adopt a more flexible approach to the fund’s asset allocation;● target a broader and better

Private Equity

Public Equity

Forestry / Farmland

Infrastructure

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Corporate Bonds

Index Linked Gilts

201420120

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‘‘ The aim is to improve the fund’s funding position and so avoid increased employer costs. It will also reduce the vulnerability to climate change

spread of investments, including an increased allocation to real assets;● seek to improve risk adjusted returns from across the portfolio.

It has set a framework for asset allocation with acceptable ranges. This includes reducing the fund’s passively managed public equities and gilts, increasing actively managed corporate bonds and increasing alternative investments, particularly real assets.

Over the next two years the fund plans to reduce its public equities (63% to 50% but, within this, increase actively managed emerging equities from 4.5% to 10%), reduce index linked gilts (13.5% to 5%), maintain private equity (5%), increase corporate bonds (13.5% to 28%), and increase alternative ‘real asset’ investments (5% to 12%) via sustainable property (5%), and infrastructure (3.5%), and farmland/forestry (3.5%).

This asset allocation change will also help the fund to move towards its target that by 2015 25% of the fund will be invested in the ‘green’ economy. As at 31 March, the

▼fund has nearly £250m invested in clean technology, or around 13% of the fund.

The long-term investment objective is to aim to be 100% funded on an ongoing basis by 2031 (which implies a return target of 3.3% pa over gilts – over the medium to long term).

The risk objective is to limit the likelihood of a fall in funding to <80% in the 2013, 2016 and 2019 valuations. These objectives will be reviewed annually and strengthened if market conditions make this possible.

To manage financial risk the following ranges are designed to limit asset allocations. In addition, a likely future ‘direction’ of strategy is indicated from this asset allocation for the following next one to two years – though this will be subject to annual review.

Allocations and flexibilityClimate change is likely to create a more uncertain investment environment in the next 20-30 years. The fund has undertaken a climate change scenarios analysis of the new investment strategy based on current and potential future asset allocation.

Reduction of equity risk, a continued focus on ESG analysis and sustainably themed equities, and diversification of the fund’s investments into new asset classes (infrastructure, timberland and farmland), are viewed positively in respect of reducing climate change risks to the fund.

Target allocations for 2013 and 2014


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ALAM

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coMMent ALAstAir Mundy Head of contrarian team and portfolio manager investec Asset Management

It is always good to have lots of new buy ideas but markets are rarely that compliant. The current volatility in equity markets has generated more stocks than normal for potential analysis.

However, our dealing activity levels remain fairly low as a number of these companies have unsound business models, unattractive balance sheets or valuations which discount a recovery in earnings (and sometimes all three).

We have therefore added few new UK listed stocks to the portfolios in recent times. Fortunately, we are still comfortable with the shares we hold, and in many cases have held them for a number of years.

Avoiding value trapsEven our relentless focus on value can be of limited protection if a company not only fails to recover, but even sees its operating performance deteriorate further.

If this is purely a matter of timing, then we have the patience – and the company hopefully the balance sheet – to ride it out. However, there is always the risk that such a deterioration will lead to a cascade through our risk factors, from a scenario we at first thought to be only specific, to one that is more structural. This puts greater strain on the balance sheet,

which in turn destroys our margin of safety. This is our definition of a value trap.

How do we try to avoid value traps?

First of all, our focus on particularly out of favour stocks means there will already have been a significant deterioration in the company’s share price and operating performance, and a corresponding decline in investor sentiment. There will already have been a stream of news flow which may help us assess the likelihood of the company being in genuinely permanent decline.

We consider capacity and market share changes within the company’s industry that may help signal the potential for recovery, taking particular care in areas where these metrics can change rapidly.

Finally, our ever present focus on balance sheets and valuation should provide some buffer against those companies that fail to turn themselves around. A compelling valuation alone, however, will not trigger a purchase if we believe structural and balance sheet risks prevail.

Of course, we will still make a number of unsuccessful stock picks, but as long as we have stuck to our methodology there may be little we can learn from them.

Being totally focused on our processes allows us to be

more relaxed about the outcomes – the world is an uncertain place, some investments simply do not work out.

The correct blend of stock opportunitiesWe are patient investors and our average holding period is five years. Within the portfolio we strive to ensure we have exposure to a number of companies across a number of industries which have moved out of favour at different times for different reasons.

This determines that we will typically have a mix of defensive holdings (for example our pharmaceutical companies and holding in Unilever fit this bill) and more cyclical companies (for example our holdings in Signet Jewellers and Travis Perkins).

Some of these cyclicals have generated very good returns for us over the past three years.

Long-term outperformance by focusing on out-of-favour stocksTo us, it is essential we do something different from the herd. Our contrarian investment philosophy focuses on out-of-favour stocks which other investors believe are going to fall even further out of favour, yet which we believe are significantly undervalued.

We do this for four simple reasons.

First, despite the fact that this approach has worked for many investors over many decades, it still remains a well-kept secret. In other words, there continue to be rewards for consistently investing in out-of-favour stocks.

Second, it is scalable. By this we mean we are able to manage a lot of money without fear of detriment or dilution to the portfolio. This is because when we are buying a stock it is very out of favour and hence there’s a lot of stock available; if the stock subsequently rises, when we are selling it there is great demand as it is back in favour.

Third, it is hard to replicate. Despite the evidence that it is good to buy low and sell high, people still prefer to buy high and then try to sell even higher. The reason for this is that buying low is very uncomfortable. You feel very lonely. It’s a bit like eating a meal in a restaurant on your own.

Finally, we are emotionally suited to it. It’s part of our DNA to be more interested in buying a share as it falls in price, even (or perhaps especially) when things get a bit crazy at the bottom of the market. In both 2003 and 2008 we kept our contrarian nerve and were handsomely rewarded. l For more information, please contact us on 0207 597 1926.

When being out of favour spells success…

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This communicaTion is direcTed only aT invesTmenT professionals. iT should noT be disTribuTed To, or relied on by privaTe cusTomers. The value of investments can fall as well as rise and losses may be made. Telephone calls may be recorded for training and quality assurance purposes. *Source: Investec Asset Management as at 30.06.12. Issued by Investec Asset Management, August 2012.

Emerging markets. They’ve always looked good to usThat’s why we’ve invested more than half of the $95bn funds

that we manage in emerging markets*. As the only truly global asset

manager with roots firmly in Africa, Investec Asset Management is

uniquely equipped to understand emerging markets, offering access to

investors through a range of forward-thinking equity, debt, currency,

emerging market multi-asset and frontier strategies.

Contact us on +44 (0)20 7597 1926,

email [email protected] or visit

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C31199.004_AM_emerging markets_LGC_Aug12_297x210_v2.indd 1 24/08/2012 16:48