Sometimes a company’s best investments aren’t in businesses or financial markets. When Jack Coates took over management of the pension plan for US forest products firm Weyerhaeuser in 1985, he was returning to full-time work after the company let him pursue a PhD while working part-time in his international treasury position. That investment was to pay off handsomely. His research led him to understand how alternative investments could be relevant to the challenge he saw before the Weyerhaeuser pension plan, which was under-funded and needed to generate higher returns without incurring too much downside volatility.
He returned with a plan to allocate substantially all of the fund’s assets in opportunistic alternative investments, overlaid with derivatives that created a proxy for a standard 60/40 portfolio exposure. It was one of the earliest examples of portable alpha. Senior management liked the idea, and the rest is history: from 1985 to 2010, the Weyerhaeuser pension assets delivered an annualised return of 15.3%.
Fifteen years into that history, Weyerhaeuser entered into a joint venture with Morgan Stanley and formed Morgan Stanley Alternative Investment Partners (AIP) to provide alternatives solutions for institutional investors. In 2005 the bank took full ownership of the business. By the end of 2010 it was managing more than $20bn, but its goals still reflect Coates’ at Weyerhaeuser - to make the return potential of market inefficiencies available to institutional investors, structured in a way that makes sense in their specific context.
Three-quarters of that $20bn comes from institutional investors, and 38% of that is from pension funds in Europe and North America. Many face challenges similar to the ones Coates had at Weyerhaeuser - the need to generate higher returns in a context of maturing liabilities and regulatory constraints that militate against taking risk. This is why Jacques Chappuis, head of AIP, thinks of these mature pension markets as “in many ways ideal” for his business.
“Sovereign wealth funds are important to us because they are building up large portfolios of alternative investments and allocating huge amounts of capital to strategies where we excel,” he says. “But the conversation is different; they tend to ask us about where they can be opportunistic with all of their dry powder, for example. While some pension fund clients have a similar ‘opportunistic’ bucket, the typical conversation there begins with understanding the constraints related to their liability profile - and I think we shine in these situations precisely because of our customised approach.”
Customised solutions make up about two-thirds of assets. Chappuis wants to grow that, as he sees bespoke as the best way for investors with such complex needs to engage most fully with AIP’s capabilities - and, crucially, to break free of the ‘buckets’ approach to alternatives.
“The reason buckets exist is that, historically, you really were dealing with just a few asset classes - equities, credit, real estate, commodities - and these were long-only and not really deviating too much from benchmarks,” he says. “But once you start moving into alternatives, there’s no longer a convenient bucket that defines that risk very well. Portfolio construction is really just a process of comparisons. But how do I compare investing in a distressed credit hedge fund with buying a building in midtown Manhattan?”
In ‘diversified alternatives’, AIP helps clients to think holistically - across alternatives but also across alternatives and their core portfolio - essentially by characterising all investments according to how they package beta, alpha and liquidity risk together. That means that an investor whose liability profile allows it to take some illiquidity risk will tend to get more illiquid assets in its alternatives solution from AIP, for example. But if it has a high-equity allocation in its core portfolio, that risk might be taken more in distressed debt hedge funds than in private equity.
Similarly, one European pension fund client found itself with a four-manager, 16-fund private equity programme which was swamping its target alternatives allocation. It wanted 7% in private equity, but its invested and outstanding commitments already amounted to 11%. AIP took over responsibility for capital calls and distributions, and refashioned the underlying exposures, vintage diversification and overall size of allocation through a programme of fund run-offs, all without recourse to secondary market sales. But it also created a ‘completion portfolio’ of other alternatives to complement the new private equity strategy and integrated the reporting for the entire package.
AIP’s approach to private equity exemplifies the flexibility it brings, which enables it to work both with investors that have long-established legacy private equity commitments, but also with those just starting out. Its pooled programme - focused on mid-market, early venture, emerging markets, secondaries, distressed and special situations (everything from aircraft leasing to pharmaceutical royalties) - looks designed to diversify against a standard LBO-focused portfolio. On the other hand, it is perfectly good as a standalone - a recent Preqin study showed AIP to be one of only two funds of funds providers to have launched only top-quartile products.
AIP offers sophisticated solutions for newbies with a clean slate in the asset class; it has modelled a series of different commitment programmes designed to show the trade-off between vintage-year diversification and the speed at which one can reach a target allocation, for example. At the same time, it advises a super-sophisticated US pension plan on co-investment opportunities coming from its multi-billion dollar direct private equity portfolio. “We’ve generated top-quartile single-manager private equity returns out of their own co-investment deal flow, net of our fees,” says Chappuis.
If that is the level of customisation that AIP can provide in beta-dominated areas like real estate and private equity - where investor choice is limited - the flexibility available in its hedge fund solutions is almost boundless. Moreover, while its private equity solutions only become truly cost-effective for commitments starting at about $100m (€79m), Chappuis says that hedge fund packages can start at as little as $25m.
As we have seen, these alpha strategies can be deployed as part of a standard diversified fund of funds, or as completion portfolios to complement other alternatives or core long-only exposures. But, as is evident in the tilt towards niche strategies in the private equity pooled programme, the spirit of AIP is in opportunistically exploiting market inefficiencies and cycles.
This culture is typified in the single-strategy funds of funds it has launched, particularly the one dedicated to distressed hedge funds secondaries. Taking commitments from clients like a private equity partnership, it draws down capital as and when opportunities arise. Alongside this programme sits, among other offerings, a global macro strategy (dynamically allocating between several discretionary and systematic styles) and a distressed credit strategy. “One thing Jack Coates did very well was to be opportunistic with strategy allocations over time,” says Chappuis.
And that is not the only way in which the original DNA of Jack Coates’ philosophy lives on in AIP. The beauty of alternatives, when used well as a source of asymmetric risk, is that they can enable pension funds to adopt anti-cyclical investment strategies that do not disrupt compliance with pro-cyclical regulation or accounting constraints. Weyerhaueser, after using hedge fund strategies to regain full-funded status, was able to take on more illiquidity, boosting its real estate and private equity investments and riding the market up through the 1990s, for example.
“In the same way, we might advise a fund that moves towards a better-funded status to take on more illiquidity, and we would consider implementing a plan that would do that as funding status reaches certain trigger points,” says Chappuis.
It is an approach to alternatives that is refreshing in its recognition of the pressures and constraints faced by a UK corporate pension scheme working to a ‘flight plan’, a Dutch scheme struggling with its DNB-imposed Recovery Plan, or a Danish scheme grappling with its solvency requirements. With its roots in the pension fund world, Morgan Stanley AIP speaks a pension fund language to address pension fund challenges.