Thales ups alts for predictable cash flows

New investments included private debt and unlevered infrastructure equity mandates, as trustees look to reduce risk while maintaining the current level of expected return.

The changes fall in line with the continued appetite among institutional investors for diversification into lower risk alternative asset classes.

You need to take care that the lack of flexibility you have in investing in an illiquid security is not going to cause you cash flow problems

Greg Fedorenko, Redington

Mercer’s European Asset Allocation Survey 2018 found that the proportion of European schemes allocating to private debt increased from 7 per cent to 11 per cent over the year to June.

Meanwhile, 45 per cent of European pension funds have an allocation to real assets, such as infrastructure, property and natural resources.

Alterations to the £2.5bn Thales UK Pension Scheme’s investment policy over the year to December 2017 “have resulted in a reduction in the scheme’s allocation to listed equities and an increase in the allocation to more predictable cash flows”, according to the fund’s latest annual report.

Thales trims equities

In December 2017 the scheme appointed Highbridge Capital Management to manage a £60m private debt mandate, to be funded by a reduction in the scheme’s equity allocation.

This mandate draws down over time and capital calls will be funded from the scheme’s “drawdown portfolio”.

This portfolio, managed by Allianz Global Investors, is structured as a short-dated credit mandate, and will be used “to fund mandates which draw down their capital commitments over the next few years”, according to the scheme.

The scheme divested £120m from a global equity fund in December last year to fund this drawdown portfolio.

Greg Fedorenko, senior vice president of manager research at consultancy Redington, said private debt can be attractive because of its ability to provide a combination of higher returns and lower risk.

“The main advantages of private debt include typically greater security,” he said, adding that bespoke protection structures might involve taking possession of physical assets if the borrower gets into difficulties.

As a result, private debt investors can often get better recovery rates while taking companies through restructuring than unsecured creditors in the public market.

Illiquidity can lead to cash flow issues

Fedorenko noted that managers also have more of an influence on the outcome, giving investors better protection: “In private transactions there can also be fewer people round the table in a restructuring scenario than in large public companies.”

Other advantages include being able to charge borrowers a higher rate for financing than is the case in public markets, as “private investors can often move faster to offer more certainty to companies who want to borrow money than would be the case if they had to go down the route of a public bond issue”.

Despite its advantages, the illiquid nature of the asset class can pose a problem to more mature pension funds, which are increasingly turning cash flow negative.

“You need to take care that the lack of flexibility you have in investing in an illiquid security is not going to cause you cash flow problems, as you can’t sell the assets to meet cash flow needs with the same speed as would be the case for a liquid position like an equity,” Fedorenko noted.

Private debt past its best?

Intertrust’s 2018 global private debt market survey found that 59 per cent of investors believe private debt funds will be attractive to private sector pension plans.

But experts noted that now is not necessarily the best time to be investing in the asset class.

Kevin Frisby, partner at consultancy LCP, said that the cash flows from asset classes Thales has recently invested in are indeed higher and more predictable.

However, private debt currently “looks a little bit past its best”, he said. “There has been a lot of money attracted to the market and… we’re just getting the sense that some of the better opportunities have now gone”.

Frisby noted that while the market is not completely barren, it is a little less attractive than it was before.

Those who have already made a commitment or have already made some investments should not worry, but for schemes thinking about it today, and comparing it with some other opportunities, “then they ought to think carefully”, he said.

Ben Gold, head of investment, Leeds at XPS Pensions, agreed. “It’s not as good a time as it has been,” he said. With more investors attracted to the asset class, this has driven yields down.

However, private debt is an “eminently sensible strategic holding” and while returns may currently be lower than they used to be, “they’re still pretty attractive”, he added.

Scheme targets infra equity

In December, the Thales pension fund also committed £60m to an unlevered infrastructure equity fund managed by Aviva Investors. The mandate, which draws down over time, will be funded on an ad-hoc basis as the scheme receives capital calls.

In general, infrastructure equity is leveraged, and seen as riskier than debt. A paper by consultancy EY explains that equity normally accounts for between 10 and 20 per cent of the capital structure, with investors receiving remaining cash flows after debt investors have been paid.

However, Aviva’s strategy buys whole projects without using third-party debt tranches, according to its website, leading to an unleveraged exposure.

Gold said schemes’ investments will usually last for the duration of the project’s development, and it will then typically be sold to another party to then run it on an ongoing basis.

“You expect it to generate quite high levels of return because you’re taking the risk that something goes wrong with building that infrastructure,” Gold said.

Brownfield or greenfield?

Whether a pension fund invests in infrastructure equity or infrastructure debt really depends on its risk appetite and return objectives, Fedorenko said.

Infrastructure equity funds “can range between highly leveraged, private equity style vehicles targeting low-teens net returns, and much more conservative approaches involving ownership of projects outright, where the underlying value is closely tied to a government-guaranteed revenue stream such as a feed-in tariff,” he said.

Infrastructure debt can cover a range of different approaches but generally involves a lower level of return for a lower level of risk, Fedorenko added.

David Morton, head of DB investment solutions at consultancy Hymans Robertson, said that brownfield infrastructure tends to be a good fit for pension funds.

Once an infrastructure asset is in place and operational, it is referred to as brownfield.

“You’re buying into established infrastructure, which is either very close to or already producing a yield that you can then rely on to meet your benefit payments,” Morton said.

When it comes to greenfield infrastructure, to build up a good portfolio “you need to have a longer time horizon, to be able to invest for that length of time and to manage the risk”, he said.

For schemes who are thinking about cash flow, or cash flow-driven investing, they tend to look more at brownfield opportunities, according to Brown.

UK pension fund exposure to infrastructure is likely to increase over time, said Anish Butani, director, private markets at bfinance.

“This is reflective of the emerging role of infrastructure as a credible complement to real estate within the alternatives/real asset portfolio and greater awareness of what infrastructure can bring to the portfolio,” he said.

He noted that measures such as UK Local Government Pension Scheme pooling have been designed to allow such investors to have greater scale to invest in the infrastructure sector, like their Australian and Canadian counterparts.

Distributing share classes can prove useful

After reviewing its cash flow profile, the Thales scheme trustees agreed to collect income from investments where possible.

For investments in pooled funds, this meant moving to an income distributing share class where this was available.

“A process has also been put in place to sweep income from the scheme’s segregated mandates with Majedie [Asset Management] and Allianz GI,” the report states.

Units in pooled funds typically come in one of two share classes, usually referred to as accumulating and distributing share classes.

The distributing class means that if the underlying assets produce income, such as dividends on UK equities or coupons on bonds, they are paid out on a regular basis – perhaps quarterly – to investors.

“I personally prefer distributing share classes in general, because you then receive the cash without incurring any transaction costs. Normally if you want cash to meet benefit payments, you have to sell your units in the fund and incur some costs,” Morton noted.

The scheme also authorised the use of repurchase agreements and total return swaps to finance short-term cash requirements, up to a maximum of £15m per quarter, within the scheme’s liability-drive investment portfolios.

CDI has grown in popularity over the past few years, as schemes look to ensure they can meet their benefit payments.

“That is often interpreted as needing to move into income-generating assets like private debt or infrastructure,” said Brown.

But he said that an alternative way is to use repurchase agreements and swaps within an LDI portfolio to release cash.

“Those are highly liquid markets where the transaction costs are very low, so I find that that is quite a useful way of generating cash for unexpected needs,” Morton said.