Small pension funds may not have the clout to build internal teams, invest directly or use the weight of their capital to influence manager fees, but they do have one distinct advantage.
“Bigger funds can’t invest in niche strategies because they can’t put enough money to work [in them],” Mark Hedges, chief investment officer of the £5.4 billion ($7.1 billion) Nationwide Pension Fund, explains. “It forces them into the mainstream; whereas we can find opportunities that are more boutique, and much more focused.”
At Nationwide, a closed scheme for 30,000 employees of the UK’s largest building society, Hedges has built a nimble and opportunistic alternatives portfolio that makes a virtue of its relatively small size.
Those boutique, focused opportunities are often complex and exist in small markets where there is less competition and investments are specialist but also repeatable. Nationwide’s recent £300 million investment in a private-credit fund specialising in small loans to corporations in the latter stages of growth is a typical example.
“These companies have a 10-year track record, but banks won’t lend to them because they are still in their growth phase,” Hedges says. And because few investors venture into these markets, participating can lead to proprietary arrangements where the fund ends up dealing directly with entrepreneurs and family businesses.
Straight into private markets
Hedges joined Nationwide 38 years ago, straight out of university, as a trainee manager in a building society branch.
“It was in the days when a branch manager was actually quite senior,” he reminisces. “We used to approve all the mortgages and run the branch’s own balance sheet, so we were in charge of all the arrears.”
He became CIO of the pension fund in 2011 and prioritised building the allocation to private markets from the start, funded by a gradual reduction in the public-equity portfolio.
Along with private credit – the target of much of his current investment focus – private equity, real estate, real-estate debt and infrastructure equity all come under the private markets umbrella. Although private equity and infrastructure count for the biggest allocations, Hedges’ mantra is flexibility and opportunistic investment, with allocations happily oscillating between 7 per cent and 3 per cent, rather than being fixed buckets.
“We are not beholden to 5 per cent here and there; it is much more fluid,” he says. “We think, ‘Where are the best opportunities at the moment? What are asset prices for new acquisitions? Is this a good time to be investing?’ ”
As an example, he is especially picky about anything in private equity and infrastructure at the moment.
“We have had good distributions this year, and we suspect that if people are buying assets at these prices, it may prove very difficult to generate the same kind of returns when they come to crystalise them in five years’ time.”
He would, however, like more exposure to small- and mid-cap companies in Europe and Asia.
“We don’t tend to look at individual country funds in emerging markets,” he says. “We are short on the industrials and manufacturing side. We’ve got consumer and retail exposure in Asia. We’ve also got infrastructure and real estate, but we are missing an allocation to a [small- and mid-cap] buyout fund.”
Patience is a virtue
Just because there is a gap in the fund’s exposure, doesn’t mean Nationwide will definitely be investing to fill it. Even if it does, it may not be any time soon. Patience is fundamental to successful investment in alternatives. It took the pension fund five years to find and invest in an Asian real-estate fund, following years of in-depth research and due diligence to get comfortable.
“We’d rather have a gap than rush,” he says. “It took us 10 years to build the [alternatives] portfolio from 0-20 per cent of assets. It is all about trying to find the right things at the right time.”
To put this in context, Hedges estimates that two to three opportunities land on the small investment team’s desk every day, yet he commits to only four of five funds a year. Due diligence, and choosing and managing relationships in the private allocation, are still the biggest parts of the job. It’s fortunate for Hedges that private markets is also the part he finds most thrilling.
“A big chunk of my time is spent on private markets because we see this as the value-creation piece to drive down the deficit [which Hedges believes is about £250 million, down from £600 million in 2016] and facilitate de-risking of the fund over time,” he says. “We learn a great deal from talking to fund managers about how they think about making money and their investment approaches. It is about buying into their thought processes and their view of the world.”
Meanwhile, the rest of his time is portioned to tasks such as reporting to trustees, working with consultants, and managing the cash and hedging elements of the portfolio.
Worth the cost
Investing in private markets comes with a cost Hedges thinks is wholly worth it, and best evaluated based on the net return.
“Yes I am paying a lot of money in fees, but if returns deliver 6-7 per cent more than public equity, in net terms, I am better off being in private markets,” he argues. Moreover, he is pragmatic about Nationwide’s limited ability as the UK’s 70th biggest pension fund to negotiate and influence pricing.
“We are not a CalPERS [California Public Employees’ Retirement System] or a major Canadian fund. We are a small UK pension fund.”
Private assets are classified as either capital-growth or income-producing investments, with about two-thirds now allocated to the former and one-third to the latter. However, as the funding position improves, that balance will shift in favour of income-producing assets, which will include core property and more private credit.
Under Hedges’ stewardship, the fund has pared down its equity allocation from 70 per cent to today’s 15 per cent, and four-fifths of that remaining equity is in passive strategies, with the active allocation run by three emerging-markets managers. This, together with a 10 per cent allocation to credit and the 20 per cent allocation to private markets, gives Nationwide an overall 45 per cent return-seeking allocation. The remainder is in matching assets, primarily UK gilts, where the fund uses swaps to improve the overall hedging of the liabilities, but complemented by exposure to alternative matching assets, including long-dated property and ground rents. He also likes infrastructure debt and social housing debt for the link to inflation they give this part of the portfolio. It is not “a perfect hedge” but he says the fund is still “relatively young” and is not cashflow negative.
“All that hedging is costly, and we don’t have to be perfectly hedged because, at this point, it is not necessary to match cash flows perfectly.”
Hedges says he has a “nicely placed portfolio” ahead of his prediction that asset prices will either fall or remain stagnant in coming months.
“Equities grew 20 per cent last year,” he says. “Will they grow the same? I suspect not. In credit, we want to be short duration because if there is a correction, we can then re-invest, although taking this view it does mean we could underperform targets.”
