alternative investments by pension schemes: avoiding the legal pitfalls€¦ · full of hidden...

10 May 2017

Alternative investments by pension schemes:

avoiding the legal pitfalls

Alternatives – An Introduction Tim Gardener Partner – Aon Hewitt Investment Consulting

3

Agenda

1. A Short History of the UK DB Pension Fund Asset Allocation

2. Why Alternatives? (including the Cynics Explanation)

3. What Alternatives can add to Portfolio Design

4

Average Pension Fund 1976

Asset Class 1976 (%)

UK Equity* 57

Overseas Equity* 4

UK Gilts 25

UK Property 9

Cash 5

Life was so simple then….

*61% Equity

5



Asset Class 1976

(%)

1996

(%)

Equity* UK 57 55

US 0 3

Europe 0 9

Japan 0 3

Asia Pac 0 5

Other 4 1

Bonds UK FI 25 8

UK IL N/A 4

Overseas 0 4

Property 9 2

Cash 5 6

Life was so simple then…. but getting less so ………..

*61% Equity

*76% Equity

Asset Class 1976 (%)

UK Equity* 57

Overseas Equity* 4

UK Gilts 25

UK Property 9

Cash 5

6

…….and now life is anything but simple

Asset Class 1976

(%)

1996

(%)

2016

(%)

Equity UK 57 55 15

Overseas 4 21 26

Bonds UK FI 25 8 17

ILG N/A 4 9

Overseas 0 4 5

Property 5 6 1

Property 9 2 8 Alternatives 9

Equity Allocation: 61% 76% 41%

7

Why Alternatives? (incl. the Cynics Explanation)

8

Just some of the Alternatives

Duis rutrum

massa quis

sem placerat,

doodio pellen.

Duis rutrum

massa quis

sem placerat,

doodio pellen.

Social housing. Real estate

debt

Infrastructure

debt Agriculture Woodlands. Private Equity

Commercial

Property

Insurance

Linked

Securities

Hedge Funds

Direct Lending

Infrastructure

Diversified

Growth Funds

Commodities

Absolute

Return Bond

Funds

Emerging

market debt

Securitised

Debt

High Yield

Venture Capital

9

Whatever happened to the KISS principle?

Compared to mainstream assets alternative asset types can be:

Lacking in transparency

Illiquid or semi-liquid

Difficult to access

Expensive to manage

Comparatively lightly regulated – still in ‘caveat emptor’ land

Full of hidden costs

10

Private equity - examples of practices where Enforcement Actions were taken by

SEC (in US)

1. Undisclosed fees – monitoring agreement. Private equity firm charges companies it invests in

a ‘monitoring’ fee (ten year contract, say) which it ‘accelerates’ if company sold. Not disclosed to

investors,

2. Expense shifting. If a deal doesn’t go ahead then the expenses (due diligence, etc.) should be

allocated to those who would have benefited from the deal. In at least one case the expenses were

all allocated to the investors although the private equity firm would also have had an interest had the

deal gone through

11

Conventional wisdom

“Diversification reduces risk”

“Harvest illiquidity premium”

“Uncorrelated returns reduce volatility”

“Lower volatility”

“Low yields on conventional debt”

“Low returns on mainstream equities”

Alternatives – Why?

12

The Cynics View

“We need to innovate”

“Everyone else is doing it”

“My client expects me to come up with new

ideas"

DB has been a supply led business

Rear view mirror investing


13

Conventional View

“Diversification reduces risk”

“Harvest illiquidity premium”

“Uncorrelated returns reduce volatility”

“Lower volatility”

“Low yields on conventional debt”

“Low returns on mainstream equities”

Cynics View

“We need to innovate”

“Everyone else is doing it”

“My client expects me to come up with new

ideas"

DB has been a supply led business

Rear view mirror investing


14

Making sense of alternative investments

15

Three broad categories

Real Assets Alternative

Debt

Absolute

Return

16

Real assets – enhancing the growth portfolio

Examples: Real estate, private equity, infrastructure,

woodlands, etc.

Common Characteristic: Ownership/part ownership

Raison d’ être: Real growth, alternative to equities

Reference portfolio enhancement: Increased return, reduced

volatility, (lower price volatility and/or follows different cycles),

diversification

Biggest single risk: Asset becomes worthless

Real Assets

17

Alternative debt – enhancing yield and providing cash flow

Examples: Direct Lending, real estate debt, infrastructure debt

Common Characteristic: Debt either fixed or floating rate

Raison d’ être: Yield enhancement

Reference portfolio enhancement: Increased return, enhanced

yield, diversification

Biggest single risk: Default, investor misunderstands level of

security

Alternative

Debt

18

Absolute return – uncorrelated return reducing volatility and/or protecting the

downside

Examples: Hedge funds, absolute return bond funds

Common Characteristic: Investing in ‘skill’

Raison d’ être: Uncorrelated return – protection in falling

markets

Reference portfolio enhancement: Improves return/volatility

characteristics of growth portfolio

Biggest single risks: Leverage, ‘skill’ is illusory

Absolute

Return

19

Alternative investment and how it should be done – outcome investing

At a high level decide on: 1. The outcomes needed -e.g. growth, income, source of cash, hedging liabilities, etc.

2. The balance between the sub-portfolios (growth, income, etc.) etc.

3. The reference portfolio for each sub- portfolio.

Example:

Strategy

Growth

Income

Hedging

Cash

Ref: Global

equities Ref: Scheme

liabilities

Ref: Inv.

grade credit

20

Conclusion

Investing in Alternatives can lead to:

– Better outcomes

– More certainty of achieving a desired outcome

– Reduced risk during the ‘journey’

But:

– Look very carefully at the ‘small print’

– Be wary of fashion and supply led advice

– Understand how your provider is making (so much) money

“If you've been playing poker for half an hour and you still don't know who the patsy

is, you're the patsy” – Warren Buffet

21

Disclaimer

This document and any enclosures or attachments are prepared on the understanding that it is solely for the benefit of the

addressee(s). Unless we provide express prior written consent, no part of this document should be reproduced, distributed or

communicated to anyone else and, in providing this document, we do not accept or assume any responsibility for any other purpose

or to anyone other than the addressee(s) of this document.

Notwithstanding the level of skill and care used in conducting due diligence into any organisation that is the subject of a rating in this

document, it is not always possible to detect the negligence, fraud, or other misconduct of the organisation being assessed or any

weaknesses in that organisation's systems and controls or operations.

This document and any due diligence conducted is based upon information available to us at the date of this document and takes no

account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties

(including those that are the subject of due diligence) and therefore no warranty or guarantee of accuracy or completeness is

provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by third parties

(including those that are the subject of due diligence). This document is not intended by us to form a basis of any decision by any

third party to do or omit to do anything.

Any opinions or assumptions in this document have been derived by us through a blend of economic theory, historical analysis and/or

other sources. Any opinion or assumption may contain elements of subjective judgement and are not intended to imply, nor should be

interpreted as conveying, any form of guarantee or assurance by us of any future performance. Views are derived from our research

process and it should be noted in particular that we cannot research legal, regulatory, administrative or accounting procedures and

accordingly make no warranty and accept no responsibility for consequences arising from relying on this document in this regard.

Calculations may be derived from our proprietary models in use at that time. Models may be based on historical analysis of data and

other methodologies and we may have incorporated their subjective judgement to complement such data as is available. It should be

noted that models may change over time and they should not be relied upon to capture future uncertainty or events.

22

Aon Hewitt Limited

Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority.

Registered in England & Wales No. 4396810

Registered office:

The Aon Centre | The Leadenhall Building | 122 Leadenhall Street | London | EC3V 4AN

To protect the confidential and proprietary information included in this material, it may not be disclosed or provided to any

third parties without the prior written consent of Aon Hewitt Limited.

Aon Hewitt Limited does not accept or assume any responsibility for any consequences arising from any person, other

than the intended recipient, using or relying on this material.

Copyright © 2017 Aon Hewitt Limited. All rights reserved.

Ed Harris and Amran Hanif

Trends in Limited Partnership investment strategies

Hogan Lovells | 24

Typical Private Fund / Limited Partnership (LP) Structure

Trends in LP investment strategies

Investment

Manager

General

Partner

Limited

Partnership

Investors

(Limited

Partners)

Portfolio

| 25 Hogan Lovells

• Continuing downward pressure

– Smaller number of fund managers can resist this

– Negotiation focussing on detail, not just %

– Management fee offsets

• Discounts

– Early bird discounts remain common, as do fee rebates, particularly for cornerstones/large investors

– Loyalty discounts

– Group discounts

• Timing of fees starting, stepping-down and stopping

• Regulatory scrutiny

Management Fees


| 26 Hogan Lovells

• LP rights

– to suspend or end the investment period

– remove/replace the manager

– wind-up/terminate the fund

• Manager removal

– No fault and for cause

– Possibility of cure

• Key person

Governance: LP rights


Hogan Lovells | 27

Limitation of liability

– Commitment v assets of scheme

– No personal liability for trustees

Reporting requirements

– More detailed and more frequent

– Greater accountability on cost

– Communicate what you actually need

End of Life Solutions

– US$600 million in funds of pre 2007/8 vintage

– Historically under thought and under negotiated


Hogan Lovells | 28

Co-investments

– Part of most private equity deals, either pre signing or post closing syndication

– Process now streamlined and element of competitive tension with potential co-investors

– Co-investors often a mix of current and prospective LPs

– Push back from GPs on no fees/carry?

– Impacts of GP removal


| 29 Hogan Lovells

Secondaries (sales by investors)

– Well established, liquid market with heavily intermediated processes

– Less bank and state sales and more LPs managing their portfolios

– Pricing, terms and execution very competitive and increased use of leverage to make returns

– Deferred consideration


Hogan Lovells | 30

Other

– "Alternative secondaries"

– GP or tail end solutions (e.g. liquidity for LPs, reset carry for team or end life funds)

– Increased number of deal by deal funds

– Single LP funds

– Acquisitions of PE funds or fund of funds


Ed Harris and Amran Hanif

Trends in Limited Partnership investment strategies

Jeremy Pickles

Hedge fund investment

| 33 Hogan Lovells

• Overview

– Scope of legal review and negotiation points

– Headline features

• What is a hedge fund?

– No formal definition

– Typical characteristics include: target absolute returns, unconstrained management style, "open-ended", performance fee to incentivise skill-based manager, domiciled offshore

• Market background

– High profile articles on pension funds reallocating away from hedge funds and poor performance in the hedge fund sector

– Reality is more nuanced


| 34 Hogan Lovells

• Typical structure

– Offshore company

– Can be tiered ("master-feeder")

• Key documents

– Private Placement Memorandum (or PPM)

– Articles (or equivalent)

– Application Form

• Scope of legal review

– Generally tougher to negotiate changes to key fund terms

– but opportunities for side letters have increased in recent years

Hedge fund paperwork

Hogan Lovells | 35

• Top 5 headline features:

– Arguably weak governance

– Constraints on liquidity

– Unconstrained investment strategies

– Lack of transparency/information rights

– High fees

Headline features

Hogan Lovells | 36

• Arguably weak governance

– Quality of oversight provided by board

– Trend for more independence

– Limited voting rights (changes of class rights)

– But redemption rights

• Constraints on liquidity

– Periodic liquidity, but

– Lock-ins

– Redemption gates

– Suspensions

– "Redemption shares" (or fast pay/slow pay)

– "Side pockets"

Headline features (cont.)

Hogan Lovells | 37

• Unconstrained investment strategies

– Broad and flexible: potential for "style drift"

– Powers to make illiquid investments

• Lack of transparency/information rights

– Information essential for exercising governance rights

– Trend to more disclosure, particularly expenses and conflicts

• Fees

– Management fee

– Downwards pressure on fees in general

– Concern re "asset gathering"

– Performance fee

– High water marks and resets

– Increasing complexity (e.g. benchmarks)

Headline features (cont.)

Jeremy Pickles


John Condliffe and Elliot Weston

Investing in residential property

| 40 Hogan Lovells

• Our recent experience

• A growing market

• Direct and indirect investment

• Jargon busting

• Core real estate and tax issues of which to be aware

• Case study – build to rent on brownfield site

Residential property

| 41 Hogan Lovells

• Four times as many private rented schemes were under construction or in the pipeline at the end of 2016 as were built in the previous seven years in total. (Molior (2016) Q3 PRS Research)

• As at Q3 2016, there were 8,257 PRS units that had been completed since 2009, 8,799 under construction, and 23,022 in the planning pipeline. (Molior (2016) Q3 PRS Research)

• Around £3.1bn of student housing stock was traded in 2016 and £5.1bn in 2015. (C&W UK student accommodation report 2016/17)

• Number of purpose built student beds for the 2016/2017 academic year has reached 568,000, an increase of 5.4% on 2015/2016. (C&W UK student accommodation report 2016/17)

A growing market

Hogan Lovells | 42

• The Guardian, 5 May 2017

• Highly regulated sector, expert knowledge and advice is key.

But…

Hogan Lovells | 43

• Some of you may already have invested in residential property, either directly or indirectly

• The issues we will talk about are relevant whether you invest indirectly or directly (albeit once removed if you invest indirectly)

• If there are any differences in impact we will highlight them

• In either case we want to tell you some of the key issues and drivers so that you know what questions to ask when deciding what funds or sectors to invest in

Direct or indirect investment

| 44 Hogan Lovells

• AST – Assured Shorthold Tenancy – underpins BTR and PRS

• B2R/BTR – build to rent – newly constructed purpose built private rented block intended to be owned by a

single landlord

• BTS – build to sell

• DMR – Discount Market Rent – agreed with the local planning authority

• Enfranchisement – acquisition of the freehold by residential long leaseholders

• Golden Brick – sale of newly built residential accommodation is zero rated for VAT purposes if the sale is

by the person constructing and construction has got past "golden brick stage"

• HMOs – Houses in Multiple Occupation – particularly relevant to student accommodation sector. Landlords

who let houses or flats to groups of students are likely to face extra regulation if property deemed to be an HMO

Jargon busting

| 45 Hogan Lovells

• MDR – Multiple Dwellings Relief – for SDLT purposes

• PBSA – Purpose Built Student Accommodation

• PD right – right for Permitted Development of existing buildings to residential, which does not require

planning consent

• PRS – Private Rented (or Residential) Sector – accommodation that is privately owned and let

• RSLs – Registered Social Landlords – relevant for affordable housing requirement

• SDLT – Stamp Duty Land Tax – a tax on a land transaction

• TDS – Tenancy Deposit Scheme – a regulated and compulsory scheme for holding tenants' security deposits

• TOGC – Transfer Of a Going Concern for VAT purposes, for example, on a sale of a let property

Jargon busting continued

Hogan Lovells | 46

Tax Real estate

Drivers

• It is where people live

• So statutory protection for home owners and residential tenants is woven through all the legislation

• Similar statutory provisions for owners or occupiers of commercial property generally do not exist

• Sales of new residential properties can be zero rated for VAT purposes

• Landlords suffer irrecoverable VAT on letting residential property

• SDLT rates are higher than for commercial property but MDR can apply to reduce the SDLT cost for acquisitions of multiple flats or houses

| 47 Hogan Lovells

• Enfranchisement – rights of qualifying long leaseholders to acquire the freehold and any intermediate leases

• Lease extension – rights of qualifying long leaseholders to extend their leases by 50 years (houses) or 90 years (flats)

• Right of first refusal – triggered by disposal by landlord

• Ground rents – recent publicity and case law

Key real estate issues

Build to Sell

Hogan Lovells | 48

• Underpinned by Assured Shorthold Tenancies

• Management is key – experienced property managers

• Power of attorney for signing ASTs

• Tenancy Deposit Scheme

• Right to Rent

• Policy on length of term of ASTs


Build to Rent/Private Residential Sector

Hogan Lovells | 49

• Name of landlord

• Timing of delivery, particularly on development

• Licensing and HMOs

• Non term time income - planning restrictions

• Nomination agreements


Student accommodation

Hogan Lovells | 50

• Variety of senior market offerings, often with different issues:

– Retirement flats – usually let or sold to individual owners

– Care homes – run by a care home operator

– Extra care facilities (with nursing or long-term specialist care)

– Retirement villages combining some of all of these, often with shared communal facilities

• CQC registration

• Age restrictions

• Service charge consultation

• Other fees


Care homes / Retirement living

| 51 Hogan Lovells

• Sales: trading v investment

• Self-invested pension funds and residential property

• VAT recovery

• SDLT cost

Tax considerations

Tax considerations for pension funds

| 52 Hogan Lovells

• Brownfield site

• Used to be offices and factory

• Forward funding of a developer by an investor

• Land owned by a third party, land value significant proportion of end value

• Knock down and rebuild

• Golden brick

• VAT on land and construction cost

Build to Rent

Case study

John Condliffe and Elliot Weston

Investing in residential property

Coffee

Paul Mullen and Jo Robinson

Direct lending

| 56 Hogan Lovells

• Background

– low interest rate environment

– increased regulation of the Banks post financial crisis

• Debt funds established to lend directly to borrowers in Europe (more mature market in US)

• Pitch by direct lenders

– flexible approach to lending

– streamlined decision making

– investment professionals with bank lending experience

• Non-rated, illiquid assets

• Less volatility than other asset classes

• Floating rate instruments

• Income producing rather than capital growth

What is direct lending?

| 57 Hogan Lovells

• Generally secured debt on Loan Market Association (LMA) terms

• Senior Debt

• Unitranche

• Subordinated Debt (second lien, mezzanine, PIK)

• Equity co-invest

• Regulatory position determined by jurisdiction of borrower

How are direct lending transactions structured?

| 58 Hogan Lovells

• Drawdown structures

• Default rates/past performance

• Reporting

• IRR – asset level/fund level

• Leverage?

• Management fees

• Hedging policy

• Internal governance

• Independent diligence

Considerations for investing in direct lending funds

Hogan Lovells | 59

Active Direct Lenders in Europe

Paul Mullen and Jo Robinson

Direct lending

Philip Brown

Investing in infrastructure

| 62 Hogan Lovells

• Spanish Funeral Business for sale – Infrastructure funds expected to bid.

• Interests in entities that own or operate physical, tangible assets that provide essential services to society.

• Key characteristics:

– monopolistic or quasi monopolistic, high barriers to entry

– long term investments: yields returns when the asset is operating

• Which asset types will suit your fund?

What are infrastructure investments?

| 63 Hogan Lovells

• PPP/PFI

• Regulated assets

• Assets with a stable government subsidy

• Demand-based assets

• Corporate (contracted) assets

• Non-core (trading companies with some infra characteristics)

What are the different types of infrastructure?

LOWER

RISK AND

RETURNS

HIGHER

Hogan Lovells | 64

A. "operating infrastructure projects that have been developed PFI/PPP or similar procurement models"

B. " Environmental Infrastructure projects that have the benefit of long-term contracts or stable regulatory frameworks"

C. "infrastructure assets which the Directors believe have high barriers to entry and are expected to generate an attractive total

rate of return over the whole life of the investment"

Investment Strategy?

Hogan Lovells | 65

• Common risks

– Construction risk

– Concentration risk

– Operating track record

– Geo-political risk

– Reputational risk

• What asset types will the fund manager buy?

• Management incentives: Alignment?

• So…. are Funeral Parlours infra investments?

Other considerations

Philip Brown

Investing in infrastructure

Faye Jarvis

EMIR: where are we now?

Hogan Lovells | 68

• European Markets Infrastructure Regulation (EMIR) introduced in response to the financial crisis

• Designed to improve the stability of the over-the-counter (OTC) derivative market

Background to EMIR

"OTC derivative contracts lack transparency as they are privately negotiated contracts and any information concerning them is usually only available to the contracting parties. They create a complex web of interdependence which can make it difficult to identify the nature and level of risks involved. The financial crisis has demonstrated that such characteristics increase uncertainty in times of market stress and, accordingly, pose risks to financial stability. This Regulation lays down conditions for mitigating those risks and improving the transparency of derivative contracts."

Hogan Lovells | 69

• New rules for OTC derivatives that are not cleared, eg, portfolio reconciliation

• New reporting requirements – have to report OTC derivatives to trade repositories

• Requirement to clear OTC derivatives through central counterparties (CCPs)

EMIR – key requirements

Hogan Lovells | 70

• Parties to an OTC derivative transaction required to clear it through a CCP

– clearing commenced in 2016

• CCPs require parties to post collateral – mainly as cash – to cover the potential losses in the event of a counterparty default

• Problem – pension schemes don't hold large amounts of cash

Clearing and the problem for pension schemes

Hogan Lovells | 71

• Pension schemes granted an exemption (initially to 2015) as it was recognised that in order to clear trades pension schemes would need to divest assets in order to meet the requirement to post cash as collateral, which could have a negative impact on members

• Exemption is only in respect of "OTC derivative contracts that are objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements" ie, it applies at transaction level not scheme level

• Exemption just been extended to 2020

The (temporary) solution

Hogan Lovells | 72

• Pension schemes have to represent to counterparties that the exemption applies

• The Occupational Pension Scheme (Investment) Regulations 2005 specify the basis on which pension schemes can invest in derivatives

• Concern that some trades would be permitted under the Investment Regulations but fall outside of the exemption

Action point: discuss with Investment Managers whether all trades will qualify for the exemption

So there's nothing to do until 2020 … right?

Faye Jarvis

EMIR: where are we now?

"Hogan Lovells" or the "firm" is an international legal practice that includes Hogan Lovells International LLP, Hogan Lovells US LLP and their affiliated businesses.

The word “partner” is used to describe a partner or member of Hogan Lovells International LLP, Hogan Lovells US LLP or

any of their affiliated entities or any employee or consultant with equivalent standing.. Certain individuals, who are designated as partners, but who are not members of Hogan Lovells International LLP, do not hold qualifications equivalent

to members.

For more information about Hogan Lovells, the partners and their qualifications, see www.hoganlovells.com.

Where case studies are included, results achieved do not guarantee similar outcomes for other clients. Attorney advertising. Images of people may feature current or former lawyers and employees at Hogan Lovells or models not

connected with the firm.

© Hogan Lovells 2017. All rights reserved

www.hoganlovells.com

Hogan Lovells | 75

@HLpensions

Follow us on Twitter!

@HLfunds

@HLRealEstate

10 May 2017

Alternative investments by pension schemes:

avoiding the legal pitfalls

alternative investments by pension schemes: avoiding the legal pitfalls€¦ · full of hidden...

Documents