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Impact Investing

IPE special report May 2018

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Beyond Excel spreadsheets

Pension funds are increasingly turning to custodians for help in dealing with the complexities of investing in illiquid alternatives asset classes, writes Anthony Harrington

Alternative assets – generally taken to mean any investable asset apart from  stocks, bonds and cash – are not new to securities services providers. But when you add in asset classes that are fundamentally illiquid, such as infrastructure projects, corporate loans by so-called shadow banking entities, commercial property or private equity investments, there are particular challenges and some unique opportunities for service providers to add value – if they can generate sufficient returns. 

Mark Schoen, the head of solutions for asset owners at BNP Paribas, says that pension funds and life companies are increasing their allocation to alternatives and this is leading some of them to look to their custodians for help. “We used to see large pension schemes with funds allocated to direct investment in properties, for example, managing those investments through their own in-house administration departments. Now, as they increase the allocation and the range of alternatives they are investing in, it is becoming exponentially more complex to manage internally,” he says. 

Allocations to derivatives, distressed debt and hedge funds with redemption restrictions, add to the complexity. “A few years ago you could perhaps manage with an Excel spreadsheet. Now you need the proper IT tools to support any significant allocation to alternatives,” he says.

Two of the main challenges to administering the more illiquid alternative investments are pricing and managing cash flows. A private equity investment will generally involve funds being committed for a five to seven-year period. Classic IT systems designed to support bond and equity investments are not going to cope. “You are going to want to track your commitments, payments made, and so on. The choice for investing institutions, be they pension funds or life companies, is either to build a specialist tool themselves or to go to a custodian who can provide an illiquid assets administration service,” Schoen says. 

Part of the value an experienced custodian adds is to help the client with performance measurement. This involves identifying the returns achieved and looking at how to normalise that with the rest of the client’s portfolio of investments. Schoen accepts that an investment in a private equity fund, for example, might look quite opaque. However, the custodian can look through the investment, identifying the various areas of exposure, such as the geographic and sector exposure of individual investments. This service saves the client from unwittingly running elevated levels of risk in any specific dimension. 

Robert Wagstaff, head of UK sales and relationship management at BNY Mellon Corporate Trust, says collateralised loan transactions have surged in popularity as an asset class in recent years. “The market stopped with the financial crash, but we have seen a switch into these assets on an unleveraged basis by pension funds and insurance companies. What we bring to the table with OTC [over-the-counter] asset classes that are traded on a paper basis through some 300 agent banks around the world, is the ability to present the client with clean, verifiable data that can go direct into their systems,” he says. 

At a glance 

• Custodians are seeking to help pension funds to invest in alternative assets.
• Pricing and managing cash flows are particular challenges for illiquid assets.
• Competition in custody and administration is becoming more intense.

The register of investors in a client’s alternatives portfolio will be held by agent banks around the world, usually in the jurisdiction of the borrower. Wagstaff says these agent banks will have a wide range of different systems, which translates into a huge variety in the format and availability of the data. “We model all assets from the underlying credit agreement for the instrument, creating a ‘Security Master’ on a global platform that we use to reconcile daily to the agent bank. We process some 70,000 notices every month and around 150,000 at the end of each quarter on behalf of our clients,” he says. 

A large client with a strategy of investing in infrastructure debt, for example, might allocate €500m to invest for a 20-year term, with the investments spread across Europe and the rest of the world. The client will be looking for a yield premium for investing in illiquid assets and it will need an agreed methodology for holding and valuing those investments. “Pricing can be a huge challenge and the pricing methodology needs to be very clear for each asset type in the illiquid assets portfolio. Where there is a challenge to pricing, since we hold the books and records of the asset and aggregate the pricing sources, we can track back to the original agreed pricing method to clarify the methodology,” Wagstaff says.

Another wrinkle in administering an illiquid assets portfolio is that these assets do not always have predictable interest rate cycles. “With an infrastructure investment, if the borrower gets into distress, they may well go back to the syndicate of investors and renegotiate the deal, with consequent changes to the interest, so you need a bespoke OTC platform to handle these assets,” Wagstaff says. “The same is true to handle bespoke pricing models for illiquid assets. We will independently model the credit agreement that the investor is getting into, to make sure the agent bank is doing things in accordance with the documentation and to enable our client’s asset manager to do forward projections on the asset.” 

Wagstaff adds that, prior to the 2008 financial crisis, monoline insurers (insurance entities that guaranteed municipal and project debt) made infrastructure investment more attractive by providing a ‘wrapper’ that guaranteed the bond on the project. If the original consortium failed, the idea was that the monoline would step in and run the project. Most monolines did not survive the crash, but there have been signs that they could be coming back into play. In 2012, for example, Assured Guarantee, which is listed on the New York Stock Exchange, guaranteed the first infrastructure bond transaction in Europe since the crisis – a £100m (€142m) contract at Worcestershire Royal Hospital in the UK.

Robert Wagstaff

At the time, Nick Proud, UK chief executive of Assured Guarantee, one of the two US monolines that did survive, pointed out  that his company guaranteed £6bn in European infrastructure bonds in the decade prior to 2008. “We are now in a position to guarantee pension funds and life assurers considering UK infrastructure projects,” he said. If monolines do return, this will certainly help to increase the attractiveness of the asset class, Wagstaff notes, which in turn will mean more business for the custodians.

BNY Mellon is particularly strong in providing services to the collateralised loan obligation (CLO) market, where it has €300bn of assets under custody across 1,200-1,400 portfolios. This is not something that any competitor can build in a day, he says. With such a scale, it is likely that BNY Mellon will have several clients invested in the same asset, which generates efficiencies from existing activities with the relevant agent banks. However, there is competition in the sector. “We are seeing the traditional custody competitors who did not have the pedigree in the CLO market that we did, coming into this market with offerings now. We are in a very-low-yield environment and CLOs are attractive as an asset class, so they have become a focus for custody banks looking to offer a service on illiquid assets,” he says. 

Competition across all areas of custody and administration of alternative assets is only going to get more intense as institutional investors explore the various illiquid and alternative asset types. One of the difficulties service providers face, however, is that providing bespoke services in areas such as pricing and compliance monitoring, tends to be people-intensive. With margins falling and salaries rising, people-intensive operations tend to be difficult areas to be in for the long term. 

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