At Brightwell, which manages the assets of the £47 billion ($62 billion) British Telecom Pension Scheme (BTPS) one of the largest private sector DB schemes in the UK, liability-driven investment (LDI) is managed in-house, but cashflow-driven investment (CDI) for client funds is managed externally.
In contrast to many other UK pension schemes or asset managers, Brightwell believes that the credit collateralisation of LDI exposures and cashflow management is possible without all the relevant assets sitting with the same manager.
The two-pronged approach requires a sophisticated set up, technology and position level data sharing, says Wyn Francis, executive director and CIO in Brightwell’s latest newsletter.
“It is a received wisdom in the industry to combine LDI and credit under one roof for credit collateralisation and holistic cashflow management,” Francis says.
“However, this can result in manager concentration as the majority of a scheme’s portfolio sits with a single investment manager. The usual argument is that this is the only way to use credit as collateral for LDI and manage the operational requirements of cashflow management. At Brightwell, we strongly disagree with this approach.”
LDI and CDI
LDI is best described as a fancy name for a structured set of derivatives exposed to, in this case, the price of gilts. The idea is that pension funds buy these derivatives to protect them against yields going down, as this leads their liabilities to go up – when their liabilities are going up, they also have an asset that is posting them collateral. When yields fall, LDI funds receive margin but in the reverse scenario when yields rise (like they did in the UK’s gilt crisis in 2022) pension funds must post more collateral in-line with calls from their investment banks.
CDI, in contrast, matches fund income to scheme cashflows as they fall due and is an alternative to a traditional growth-and-matching investment strategy.
Since the LDI crisis, many pension funds have run their LDI and CDI allocations with one manager in a combined portfolio. The approach, Francis says, is a consequence of pension funds struggling to manage their collateral (bonds) during the LDI crisis because it was not easily accessible for their LDI managers. Some funds were unable to get cash fast enough to meet increasingly urgent collateral demands.
“One of the issues was that managing collateral was very difficult because their collateral pools were not in the same place, or the place that LDI managers needed it to be. Communication between LDI and CDI managers was challenged,” says Francis, who adds that under Brightwell’s approach, the internal team also have full cashflow visibility of the CDI assets.
Splitting up the allocation between in house and external managers brings a range of benefits. For example, the strategy allows pension fund clients to benefit by exposure to their preferred credit manager, gaining exposure to niche or best in class managers. Clients also retain the flexibility to change managers if performance drops or their requirements change.
It also avoids manager concentration, another problem during the LDI crisis when some investment managers were unable to service all their clients equally. Brightwell argues its approach reduces pension funds’ reliance on a single manager, often running many mandates to similar objectives, potentially creating operational and market risks.
Francis says Brightwell likes to build long-term relationships with managers, treating them as trusted advisors. But it also seeks to limit the number of managers it works with, to ensure a diversity in approach and portfolios.
“We like [managers] to be able to move across from public to private credit and make that value decision for us,” Francis says.
“It is unlikely that a good LDI manager is also the best-in-class credit manager. Managing LDI and credit under one roof to deliver CDI not only means potentially forgoing the returns that a credit specialist could offer and, as such, a loss of value, but also the loss of future flexibility.”
Putting the plumbing in place
Francis explains that the strategy has involved working closely with asset managers and custodians to make sure “the plumbing is in place”, including daily data on the bonds managers hold, and which ones are ring-fenced for collateral purposes.
“It requires communication with managers and the custodian whereby managers inform us of any bonds they want to sell out of, and new bonds coming into the portfolio,” Francis says.
He says Brightwell has built and uses a hybrid platform that allows it to manage LDI and CDI as one portfolio without directly managing corporate bonds.
“We believe that we are uniquely positioned as a fiduciary manager who only manages LDI, overlays and longevity risk in-house,” he says.
“We do not have proprietary funds or strategies to allocate to and as such do not compete with other asset managers. Other asset managers see us as investors and there is a mutual desire to co-operate. Close collaboration between all parties is vital for managing LDI and CDI under separate roofs.”
