Real Assets: Real challenges
Frances Hudson outlines just how many obstacles lie between pension funds and investment in European real assets, and calls for further debt and securitisation to open up the market
Real asset investment has historically proved challenging for institutional investors. Many of the obstacles fall into three types – transparency (or lack thereof), liquidity and risk. Clearly risk can be a function of both lack of transparency and liquidity, but there are also ‘real risks’ – those encountered when owning or trading a real asset.
Transparency presents various issues for institutions. First, is that of valuation versus transacted prices. Some markets have frequent indicators of prices linked to transactions, engendering confidence, whereas in others, even large markets such as the US, not all assets are externally valued, or valuations are infrequent, often not even quarterly.
Transparency also relates to trading information – who are the main buyers, what are they buying? With many of these issues unresolved, it is no surprise that real assets are still typically a domestically-biased asset class.
In terms of liquidity, the complex nature of real assets such as infrastructure, real estate, forestry and farmland means investment activity is rarely a desktop exercise. Local contacts, operators, contractors and agents remain critical to the transaction and operating process – again supporting a local bias to institutional investment.
To meet the major challenge of quantifying ‘real risks’ across a range of instruments and markets, in order to move from single country to global exposures, new analytical tools have been developed. For instance, Standard Life Investments’ Real Estate team utilise a ‘Global Real Estate Implementation Risk’ score, by which returns can be adjusted for local political, ownership, tax, transparency and liquidity risks.
Size and maturity also matter, both of investor and investment. One may have a favourable view of UK forestry as an asset class, but small trades and exceptionally low trading volume preclude funds larger than £300m (€377m). In infrastructure, huge projects attract a lot of interest and competitive bids from the largest players, including experienced investors such as Canadian and Australian pension funds and global infrastructure banks. Mid-market brownfield opportunities are also available for appropriately-sized investors wishing to avoid both the front-loaded construction risks attached to infrastructure projects and the early period when returns are limited. Co-investment also provides a route into some projects.
More diverse access through debt and securitisation
The securities markets remain underdeveloped in Europe relative to the US. This is partly a consequence of Europe’s over-reliance on bank financing. Banks, collateralised mortgage-backed securities (CMBS), insurance companies, federal and state government and mortgage REITs all played a part in financing US real estate. Since the financial crisis, the CMBS market has remained open for business in the US, whereas, in Europe, there have been some tentative signs of life only in the past year. What we have witnessed is a growing IPO market in Europe and also significant volumes of bond issuance.
For infrastructure, another factor is the varying involvement of national governments. The categorisation of infrastructure as ‘strategic’ has not always been limited to social entities and interaction has been anything but ‘arm’s length’. The changing regulatory framework and risk transfer associated with government-supported projects has limited the attractiveness of some related equity investments. The determination of regulated prices in energy and utilities via complex formulae can be off-putting while, elsewhere, the prospect of windfall taxes has loomed large. Hence, as illiquid credit markets develop and become more structured, there is more analytical interest. For instance, credit rating agencies have now published detailed guidance on their criteria for assessing a range of infrastructure assets.
The overall context can be seen from OECD statistics – pension funds allocate between 12-15% to alternative investments which results, for example, in just 1% of their total assets invested in unlisted infrastructure. Responses from the FT/Towers Watson 2014 Global Alternatives Survey indicate that pension funds, and particularly insurers, are among the more enthusiastic investors in illiquid credit. However, as a proportion of assets allocated to all forms of alternatives, their commitments are modest compared with exposure to, say, direct real estate.
In terms of market growth, in 2013 and 2014 there has been a significant pick-up in real estate debt issuance in Europe (circa $4.5bn, €3.5bn) representing around 50% of global activity. The first generation of European infrastructure funds are now maturing and being liquidated, releasing assets back to the market which can then be repackaged into equity and debt tranches. For institutional investors, this provides opportunities to invest at a brownfield stage. However, the markets do not seem to be keeping up with investor interest. Anecdotally, there is at least €20bn of dry powder waiting to be deployed in European infrastructure.
It is difficult to reach general conclusions about the health of real asset bond markets, as they differ substantially. The market for private loans in Europe is at a nascent stage; infrastructure bonds relating to US power projects carry high levels of default risk associated with construction; secondary markets are still illiquid and each issue requires careful bottom-up analysis.
Supportive political rhetoric is growing, particularly for infrastructure, but the arguments also apply to other real assets. In its 2013 Green Paper and 2014 Supplement, the European Commission acknowledges the problems caused by historic dependence on bank financing in Europe in the last cycle and aims to diversify the sources of funding for long-term financing by ‘fostering’ non-bank financial involvement, particularly by institutional investors. This is likely to have been spurred on by the realisation that, even if governments carry out these massive long-term projects, there is a liability mismatch – government tenures tend to be 4-5 years, projects can take more than 10 times as long. Also, in straitened times many government balance sheets and budgets cannot easily afford or sustain the commitment.
The Solvency II regulation for insurers is supposed to “repeal certain investment obstacles, particularly for less liquid asset classes” but still requires application of the prudent-person principle, whereby they “properly identify, measure, monitor, manage, control and report” the associated risks – no small task.
Both occupational and personal pension funds are seen as having the “capacity to be patient investors” and would be attracted by potential for diversification and higher returns. This conveniently ignores the role of leverage in the historic performance of many alternative investments. While the EC’s comments include somewhat blithe assumptions about the ability and willingness of institutional investors to participate fully, the markets are evolving in this direction. With tightly regulated banks reducing lending related to real assets, the capital markets are becoming a key source of funding. Equally clearly, this marries with investor appetite for yield, which is typically high and sustainable from real assets.
It is easy for politicians to talk up real assets, emphasising the need to develop debt and securitisation markets on the one hand, while decrying an equity gap in the overly debt-financed European economy on the other. For investors in real assets, a pragmatic diversified risk approach to real assets may include adopting a domestic or home-region equity orientation balanced by global debt exposure.
Frances Hudson is global thematic strategist at Standard Life Investments