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Impact Investing

IPE special report May 2018

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Risk managers lift the lid

As pension funds move further into alternative investments, so risk management grows in importance. Who better, therefore, to tackle the subject than the heads of risk at the two biggest Dutch fund ABP and PGGM and the City of New York. The combination of American, European and public and private sectors was bound to raise different concerns, and so it did. When the three sat down to discuss the subject at conference in Paris recently, they faced a full and eager audience with plenty of questions.
Claire Dobie, head of risk at Barclays Global Investors, chaired the meeting and opened by asking them what the greatest threats were, what gave them sleepless nights. Wouter Peters is PGGM’s head of risk and therefore has to oversee e50bn in funds. His most pressing issue is the synchronisation of risk and portfolio management. “To achieve this everyone needs to understand what he or she is doing … communication is the most difficult point not just internally but also with external managers,” he said.
Harris Lirtzman, director of risk at the City of New York, seconded this concern, ironically, as a side effect of technological development. “Risk management has reached critical mass in the States and I expect in Europe as well … we’re about to experience a period of rapid innovation, both technologically and structurally, in terms of what’s available and how it’s done. This is the good news.
“On the flip side, what scares me is that in two or three years’ time we may wind up with an almost unimaginable tower of Babel, where money managers are unable to communicate to plan sponsors their positions and prices, their concentrations of risk, and fundamental information about their portfolios in a way that will be meaningful.”
As if this wasn’t enough the move into alternative investments and high yield is producing further risk. City of New York is investing in a broad spectrum of sectors, including private equity, mezzanine financing and hedge funds. Given the novelty of these investments, Lirtzman said that, from an operational risk perspective, there are chinks in the due diligence process and this needs particular attention given the investments’ long-term nature. “If you don’t get it right at the beginning you really have a problem.”
Thijs Coenen, ABP’s head of risk, spoke of both his young son and alternative investments as sources of sleepless nights. Like City of New York, ABP is into private equity, venture capital and structured financing, investments Coenen described as almost impossible from a risk management perspective. “We are doing our best to take these assets into our standard framework but these assets are very difficult to include in our risk management scheme,” he said.
The three then moved from self-assessment to their risk criteria when choosing money managers. According to Peters, PGGM employs portfolio exposure limits and has started to use investment-tracking error. “We also look at how is risk management is integrated in the investment process? Where does it come in? Does it come in at looking at each individual security, does it come in at the portfolio construction process or does it come in at both sides?” The fund requires monthly reports and visits the mangers more than three times a year.
At the City of New York, Lirtzman is more concerned with compliance and trade processing. The fund’s risk control vis à vis external managers is done via position-based guidelines. The fund has established a system to monitor compliance through its custodian that allows it to identify on a next-day, post-trade basis any deviations from the guidelines.
He also expressed an interest in money managers’ assessments of new products. “We are pitched new products all the time, some of which are marginally beyond our investment policy, some of which are big jumps. Not all our managers are able to articulate a fully conceived process by which they have arrived at this decision to present us with a new product,” he said.
The guidelines at ABP are more stringent. Potential managers need to be able to produce a SAS 70 statement, the US document confirming an adequate administrative process – without one you can forget about winning a mandate, says Coenen – the UK equivalent, a FRAG 21, and a statement from an external auditor. ABP then does its own internal audit and commissions an external auditor to look at the manager (ABP picks up the bill for this.) The fund also uses its own risk management scheme to monitor progress and it demands monthly and quarterly reports.
All of this produces a mountain of data, a point picked up by Lirtzman who admitted the same problem. “We are getting data dumps under the guise of risk management and so we are required as end-users to turn the data into something that is useful.” A lack of resources means Lirtzman is asking more of his custodians. ABP’s Coenen said the mass of data was a problem too and that this is forcing change: “We are evaluating our custody policy and what we are going to require from our custodians with respect to day to day information.” Coenen said ABP employs about four or five custodians at the moment but that this would fall. “We think it’s natural that the custodian provide a client with accurate and timely data,” he said, adding that those who couldn’t would fall by the wayside. Without specifics, he said ABP will cut its custodians to just two.
Here Lirtzman got fired up about the future of custodians. “It seems strange a person can get heated discussing his custodian, so I’ll try to restrain myself,” he began. Apologising to that section of the conference, Askari – wholly owned by State Street Bank, itself a major custodian – he got into his stride. “There was until recently in the US, and maybe here, a presumption that the custodian has the position and the prices, therefore it should do risk management. I don’t think so. Some custodians should do risk management. But any presumption has been rapidly eroded. There are some that will a good job and there are some that have done. There are others that haven’t and they are going to be run out of the business in the next two or three years. They will be forced back to the low margin precincts of core custodial accounting.”
There’s what Lirtzman calls a democratisation of data under way that is liberating the custodian’s monopoly on risk management. He drew attention to an earlier e-commerce presentation at the conference and said the internet was threatening custodians. “Over the next two to three years we’re going to see an emergence of a whole variety of alternatives and people are going to have to earn a place at the table,” he said.
The panel discussion closed by coming full circle to the most pressing source of risk, alternative investments, and where the pension funds are heading with risk management. PGGM’s Peters said his fund has about 5% in private equity, commodities, structured finance and long and short positions. PGGM is developing risk management internally, as it allows him to check the portfolio’s components in greater detail if need be. The fund is also moving towards a risk budgeting approach. Nevertheless, there was a feeling during the discussion that risk budgeting produces a lot of talk but precious little action, a point reiterated by Lirtzman.
City of New York has 3% of its assets in alternative investments, predominantly private equity. Any new proposal to the firm goes directly to a third-party due diligence manager. If it passes this stage it goes to the chief investment officer and then to the city’s five separate boards. Nevertheless, Lirtzman still has concerns about the due diligence but he says that, although attractive, risk budgeting isn’t imminent. “I think it’ll be a very long time before we enter into a formal risk budgeting process and I don’t think many plan sponsors in the US are moving in that direction,” he said.
Coenen says alternative investment is now part of ABP’s strategic investment plan but that it has to pass a severe due diligence process. “We have a fairly long check list … once you’ve signed an agreement, you’re locked in for 10 years,” he said. Despite alternative investments being relatively new ground, Coenen finished optimistically saying alternatives are sound if chosen carefully. “They are a long-term investment. Maybe it’s very high risk in the short term but we think that in the long term, five to 10 years say, they really become a low risk potential.”

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