PGGM, the asset manager for €237.8 billion PFZW, the Netherland’s healthcare pension fund, invests around 30 per cent of PFZW’s assets in fixed income with another 10 per cent allocated to liquid corporate credits. Portfolio manager Wilfried Bolt tells Top1000funds.com how the end of quantitative easing (QE) has changed PGGM’s hedging strategy and prompted a keen focus on liquidity. He also explains the rationale behind managing more of the corporate bond allocation in house.

Hedging the risk

Today’s new economic regime of higher interest rates has impacted PGGM’s hedging strategy, a carefully choreographed approach designed to keep PFZW’s coverage ratio stable by matching its liabilities and assets daily.

“We invest in long-term maturities with typical maturities of 20- to 30-years but could include up to 100-year maturities,” explains Bolt, who has been at PGGM for 13 years. “Fixed income is the cornerstone of the investment portfolio. The required investment returns are typically calculated versus the risk-free rate, so we only invest in government and SSA bonds with a minimum AA-rating.”

The end of central bank bond buying program means the yield curve is finally starting to steepen again. It is a reversal of a trend dating from 2014 when curves first began to flatten off the back of massive European Central Bank intervention that continued up until last year when the ECB stopped re-investing part of their asset purchases.

“In our strategy we have been anticipating this steepening,” says Bolt. “The inverted 10- to 30-year swap curve means our preference when it comes to hedge duration has focused on these middle maturities rather than longer-dated maturities, ever since 2022.”

The end of QE has also turned PGGM’s focus to liquidity – namely ensuring the continued ability to buy and sell bonds now that the liquidity central banks injected into the market is over. “The ability to access bonds as collateral for central-clearing activities under our derivatives operations has become more prominent on our radar,” he reflects.

Similarly, he says liquidity is also becoming much more important for other market participants, visible in corporate and sovereigns increasing benchmark issue sizes or tapping existing bonds. “This is one of the effects of reduced intervention by central banks that can be observed over the last years,” he says.

Swaps v bonds

In another trend, the disappearance of QE is impacting the yield differential between swaps and bonds, which PGGM manages in one integrated mandate. It has created a window of opportunity to either pick bonds when the team think they are attractively priced or buy swaps if they expect swap spreads to tighten.

“Scarcity of safe bonds was a remarkable phenomenon in 2022, making them extremely expensive versus swaps. Consequently, most of our hedging since then has been executed via swaps. It’s resulted in quite a large net liquidity position to potentially invest in bonds when swap spreads reach a level we deem attractive enough [to invest more in bonds]”

Now that central banks have switched to tightening mode, private investors must absorb huge supply. “As in 2023 we don’t see any hint these amounts cannot be absorbed by the market, however the time when bonds underperform swaps could continue potentially further into 2024,” he predicts.

Bolt reflects that a hard landing could bring more demand for government debt (also more supply) if investors switch out of riskier assets into safe havens once again. It could also see central banks re-emerging as buyers of sovereign bonds. In another scenario, a softer landing would have more ambiguous implications. It could see demand for the safest havens and less demand for smaller issuers, for example. “In both cases, we expect more demand for short-dated government bonds than the ones further out on the maturity spectrum.”

Shaking up corporate credit

PGGM is also changing its approach to corporate credit, covering a wider range of segments in-house. This includes US dollar-denominated corporate bonds, but also in-house coverage of high yield companies, both in the US as well as Europe.

“Taking a global approach makes a lot of sense.,” he says. “We believe covering the entire corporate credit universe, both across currencies and countries as well as across rating segments, allows teams to better take advantage of inefficiencies between the pricing of individual segments. Overall allocations to credit as an asset class have remained stable recently.”

Although he says the corporate bond market is “in relatively good shape,” he flags areas where those inefficiencies and risks are starting to manifest. Namely real estate companies, a segment with large corporate bond exposure and most exposed to the rapid increase in interest rates.

“We have had concerns about both valuations and corporate governance in some real estate firms, especially in Scandinavia. Investor appetite for bonds from such companies quickly dried up, resulting in a significant underperformance especially in so called hybrid instruments.” Going forward he expects the market to start differentiating between the different issuers much more.

Another segment of the market attracting his attention is high yield, especially in the US. High yield spreads still trade at comparatively tight levels versus their investment grade peers, while the ability of a lot of these companies to access the bond market has been hampered.

“With a sizeable amount of refinancing coming up in the next two years, it is likely that companies will need to pay significantly more for funding than what they were used to in the past years of low interest rates, thereby reducing profitability, leading to a normalization of spreads.”

Geopolitics in the bond market

That global approach and managing the allocation in house also helps navigate the impact of geopolitics playing out in the bond market. For example, he describes “excessive demand in euro markets” for scarce, safe, German government debt up until 2022. Since then, the pressure on German bonds has started to alleviate creating tighter spreads for other European sovereign bonds.

Still, he notes that the impact of geopolitics on the investment grade credit market has been surprisingly small. Mostly because the market has been more preoccupied with the path of interest rates on both sides of the Atlantic, pricing in aggressive rate cutting cycles for this year, despite pushback from various central banks. “The interplay between economic activity and inflation numbers seems more on the minds of investors than the various geopolitical risks that are present.”

Integrating sustainability

PFZW invests at least 5 per cent of the fixed income portfolio in bonds that contribute towards achieving the SDGs. But progress moving from investing in specific named SDG issuance to analysing sovereigns on an issuer level, is slow.

“In 2023 we started to calculate financed emissions for investing in sovereign bonds via PCAF’s updated standard but a more complete 3D assessment of our sovereign bonds, potentially as a tool to have a more meaningful exchange with the sovereigns we invest in, is still a work in progress,” he says. Moreover, green and social bond frameworks and initiatives to standardize sustainability-related bond issuances are only effective if multiple, large investors pool their weight and voice.

Still, outside the SDG bond programme, the team are making progress integrating PFZW’s sustainability goals via a carbon reduction pathway and an emerging 3D-investment framework that evaluates risk, return and sustainability of an investment.

It is also getting easier to integrating 3D investments in corporate bonds. For example, the team now measure the sustainability of individual business models and the sustainability targets that a company has put in place. PGGM is also prepared to buy labelled bonds from companies including companies that are ‘transitioning’ if they have presented a credible path to future sustainability.

He concludes that PGGM is more prepared to get increasingly tough on corporates. “If companies fail to deliver on such promises, we have no hesitation in divesting from them. We have become much more selective deciding which companies we engage with, based on where we think we can have a good chance of success. This more selective approach has helped to improve the success rate of our engagement efforts.”

Norges Bank Investment Management, manager of Norway’s sovereign wealth fund, has committed to measuring investee companies’ nature-related risks in its giant portfolio and publishing its own exposure using the Task Force on Nature-related Financial Disclosures (TNFD) framework.

As has sister investor Norway’s KLP, Sweden’s $79 billion AP7 and London-based LGPS CIV, one of eight LGPS asset pools, together comprising a handful of key investors signing up as early adopters of the TNFD recommendations. A process that will increase engagement by asset owners with investee companies and begin to change how financial markets value, price, and approach nature-related risk.

“We will identify those corporates most at risk, using the TNFD to target engagement with companies that we have most exposure to, most influence on and pose the biggest risk on our portfolio,” confirms Jacqueline Jackson, chief sustainability officer at London CIV.

TNFD disclosure recommendations are structured around four pillars (governance, strategy, risk & impact, metrics & targets) consistent with the Task Force on Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB). The framework includes 14 recommended disclosures covering nature-related dependencies, impacts, risks, and opportunities. Since its launch last year, 320 companies, financial institutions and service providers have signalled they will integrate them into their reporting.

The challenge of Measuring intangibLes

Investors adopting the framework face a number of challenges. Unlike climate change where they have been able to focus on reducing emissions in their holdings, nature is complex, intangible, and diverse, making it difficult to hone on a single issue – despite the framework highlighting core global indicators.

“By no means do we yet have a perfect KPI or indicators since there will be no single KPI for biodiversity due to its complexity,” says Flora Gaber, manager, ESG analysis at AP7, already integrating nature and biodiversity loss in its active ownership; conducting TNFD analysis and planning to issue a brief TNFD chapter in its annual report. “The issue of metrics and indicators, as well as targets, will probably be revised many times over in the next few years.”

“Since there is no common indicator for nature like emissions, our approach will vary depending on the company and sector,” Gjermund Grimsby, KLP’s deputy vice president, corporate responsibility, tells Top1000funds.com. “By identifying the key impacts, dependencies, and risks of different sectors, we can find appropriate indicators to evaluate and track companies. We will start with key sectors in our portfolio that we know have material impacts on nature and biodiversity, namely agriculture, aquaculture and fisheries, forestry and paper production, mining and metals, and oil and gas.”

Nature-related impacts and dependencies are also difficult to quantify (particularly for large investors with a diversified portfolio) because they are often localised. “Nature degradation is a global challenge but impacts and dependencies on ecosystems are very often localised, and may even vary depending on the season,” explains Snorre Gjerde, lead investment stewardship manager, NBIM,  an active contributor throughout the design and development of the TNFD. “Take for instance the example of water withdrawal: the impact can be considerably higher if the withdrawal takes place in a water-stressed ecosystem during dry season, versus in another location or even just at a different time of year.”

The localised element – in contrast to a universal carbon footprint – also makes accessing data particularly difficult. “You need to understand where a company has its assets, and the value of nature in this location, as well as its condition and whether it is degraded or not. In certain sectors, assessing a company’s value chain has more relevance. For instance, consider the beef supply chain in the retail sector,” suggests AP7’s Gaber.

But investors also note that access to data is getting easier. New reporting frameworks are emerging and technologies such as satellite imaging and remote sensing are producing unseen information on the state of the world’s ecosystems and natural resources. Data providers are also jumping on board.

“Geo-specific data is a top priority for most data providers, so hopefully this won’t remain a challenge for long,” says KLP’s Grimsby who suggests asset owners looking to get started focus first on the type of information they can easily assess, such as whether the portfolio company at risk has biodiversity on its agenda.

“Qualitative analysis can also provide valuable insights into key impacts and risks and serve as a starting point for integrating nature related risks in risk management and governance,” he suggests. “Like with climate risk, we expect quantifying nature risk in monetary terms will improve over time. Building on experiences from climate risk is valuable, so we try to integrate work on climate and nature instead of having two separate work streams,” he adds that KLP is currently building out capacity and knowledge so that as with climate risk the pension fund will ultimately integrate nature risk in ordinary risk management and governance structures.

A milestone in cooperation

And despite its “tricky” and “extensive” reporting, commentators believe that TNFD integration is easier than it looks given its many comparisons with climate disclosures and the fact investors that are reducing emissions in their portfolio will be familiar with the process. “Carbon reporting has been around for a long time and the accounting principles and available data is a lot stronger. In the early days, climate reporting was complex compared to traditional accounting methods, but the market had to tackle climate metrics, and the same will happen with nature-related risks,” predicts CIV’s Jackson.

Moreover, some investors have already engaged on nature because of its interdependence with the transition. NBIM already combines climate and nature in its engagement with food production and consumer goods groups, mining and extractive industries, for example. “This sector is key to obtaining the minerals and metals needed for the transition, but at the same time it is important to ensure that these can be produced in a responsible manner, with appropriate mitigation of significant environmental and social impacts of company operations,” says Gjerde.

“Climate change and nature loss are deeply intertwined global issues: climate change can cause nature loss, and conversely nature can provide climate change mitigation solutions. We encourage our investee companies to consider the toolkit for their own risk management and reporting efforts. As a global investor, it is particularly encouraging for us to see the broad mix of industries and geographies represented among the early adopters, including many of our portfolio companies,” he continues.

CIV’s Jackson also notes a willingness amongst investee companies to adopt the framework, something she links to acute awareness of the vulnerability of supply chains. “As investors we have diversified risk, but supply chain disruption has a massive impact for an individual company, many of which have already felt the reality of managing these issues and a drop in profits and rising costs.”

TNFD’s similarities with other frameworks also signposts a welcome coming together of shared standards in the regulatory landscape.

The International Sustainable Standards Board (ISSB) will be a global baseline of sustainability information, and the TNFD framework is already referenced by the ISSB, and other standard-setters such as the GRI.

“It has been very important for us that the TNFD framework has been designed to have a high level of interoperability with emerging global sustainability standards to ensure consistent and comparable information to financial markets, and to facilitate ease of application for report preparers, as opposed to causing fragmentation,” concludes Gjerde.

The commodities sector is at the heart of the energy transition, impacting both the coming structural decline of fossil fuels and the demand for the new economy critical materials. There is also the delicate matter of future nature-based land-use and food production conflicts facing investors and soft commodity driven deforestation, other potential clouds on their net-zero commitments.

The reality is that many investors are reluctant to talk openly about commodities because of the negative perceptions of the sector. To date, the commodities narrative has been mostly characterised by high emitting energy production from fossil fuel companies and mining companies that are misaligned with a sustainable future & their negative climate lobbying activities, which are still to be effectively curbed by those very same investors.

References to the role of commodities also often brings visions of irresponsible corporations and nations with issues beyond their environmental impact, including poor human rights records and a sometimes-dubious influence on some governments. In some cases, the list of broader ESG issues associated with commodity production reads like a list of investor red flags. If the global commodities sector were a single business, the CEO would be straight on the phone to Saatchi and Saatchi for an urgent rebranding.

Fossil fuels to critical materials–a rebalancing in indices

Investors increasingly recognize that the future of the energy transition and in turn emissions outcomes relies on the rapidly shifting balance in commodities trading from fossil fuels to critical minerals including metals, many of them in key transition sectors. Copper, cobalt, lithium and others are already exploding but their demand is not yet represented in the fossil fuel laden commodities indices that investors overwhelmingly use.

To better reflect this inexorable trend, Dutch giant APG is looking to launch a new forward-looking commodities index that will be constructed based on the future demand for these commodities rather than their historical counterparts, a move that will help shift some of the existing negative perceptions.

As any investor will tell you, exposure to futures indices is not the driver of change that many think they are. Nothing can alter fundamental economics more than early-stage investment, R&D, pro-active policy designed to accelerate commercialization and regulation to advantage the new over the old. Further complicating indices as a lever is that investors’ existing underlying exposure to commodities is often whispered in quiet corridors, blamed on supply chains where their influence is thin or on mining monoliths that no investor can afford not to hold in their portfolio. This has limited the opportunity for open debate.

However, with the development of these new forward-looking indices, investors can acknowledge their positive expectations of the new commodities exposure and then start the difficult discussions necessary to explore the social and environmental downsides. This can be far easier at the commodities level than at the company level, which often degenerates into a complex jurisdictional or commodity divestment discussion that shuts doors rather than opens them.

As the Inevitable Policy Response (IPR) shows in its 2023 Forecast Policy Scenario, most residual emissions by 2050 will be in Emerging Markets and Developing Economies (EDMEs). The transition will reflect a rapid transformation in those economies even though it is too slow to save us from a significant overshoot past 1.5C. Embedded in this inevitable future is the change in the commodities landscape that mirrors the change in the economies that produce the new materials.

To understand how the future will unfold, the history of commodities is worth recalling as the significance of the primary commodity sector in any national economy generally declines as the process of economic development improves in that country. Nations start by digging up their land for resource wealth or utilizing land in some productive way and a tipping point arrives when the benefits of this activity create a secondary manufacturing and service economy which fuel property and other booms to even the global playing field.

For example, the USA’s reliance on the primary sector for GDP contribution was around a quarter at the turn of the 20th century but had shrunk to just 5% by 1960 once Henry Ford and a couple of technology fueled world wars had washed through. History may well repeat itself regarding the new commodities, many of which will be produced in developing nations and some of which will send you scurrying towards an Atlas.

The Coming Commodities Shifts

Understanding how commodity shifts will manifest during the energy transition is vital for investors both at a sector and at a jurisdictional level with complex geo-politics. It is easy to point at investments in certain sovereign states in the most difficult and controversial of commodity producing destinations. China’s desire to influence nations in Africa is well documented and investors need only peek at their Sovereign and Corporate Debt portfolios to see that broader ESG issues are inherent in their investments.

Some commodities are already a major story in themselves with Cobalt in the Democratic Republic of the Congo (DRC) being the most recognised example, the country languishing 136th in The Economists Global Democratic Index out of 167 countries. When, in comparison, Zimbabwe and Burkina Faso are deemed some of the more stable areas to mine commodities in comparison, you have an industry facing difficult challenges.  Rare earth mining is also beset by some prickly ESG issues in some jurisdictions.

However few investors can afford to be without Cobalt in their portfolios whether they like it or not. Nothing short of total auto and battery divestment is required for an investor to look clean if they want to keep the DRC out of portfolios. This reflects how tightly integrated the world’s supply chains have become.

If no investor can look you in the eye and say they are totally clean on myriad ESG issues it further highlights that the real issue is about how to influence the future of commodities as transition shapes new demand, rather than how to avoid them. This is the debate that the APG indices can help promote whilst simultaneously advancing financial returns.

Once agriculture and nature – based commodities join the picture and you accept that the 1.5C overshoot is a coming reality, then investors may be forced into a new approach to commodities. Conflicts between bioenergy and food production are looming in future decades (an emerging issue the just released IPR Land Use & Bioenergy Outlooks both explore) with forestry playing a critical role in carbon removals to redress the temperature outcome towards the end of this century.

The emissions debate for investors is reaching a stage where difficult investment issues like commodities impacts can’t be avoided either in debate or implementation. The most obvious of these is the Net Zero alignment over reliance on Scope 1 and 2 emissions to make any sense. Scope 3 (with upstream supply chains being prevalent) is gradually being recognised as being essential to any logical framework for analysing emissions and pathways for reductions.

Like Scope 3 emissions, commodity exposure is also unavoidable for investors, even those committed to do the right thing on climate, just transition and stewardship. Divestment hasn’t worked as a theory of change and for large investors never could work once Scope 3 emissions were accounted for.

Investors should treat commodities in the same way, realising they are an inherent part of any portfolio and thus it is better to try to manage the inherent ESG issues as best they can whilst supporting the development of the critical minerals that the transition so desperately needs.

Within that framework, a new commodities index would not only be a tool to manage climate-related risks within a commodity futures portfolio but would help drive this new narrative which in turn can influence positive capital allocations towards these commodities.

Given that the Inevitable Policy Response has shown that investment in developing and emerging economies is the key to minimising an overshoot past 1.5C, and that many of these new transition commodities are in developing economies, the intersection of these two themes is a great opportunity for leading investors.

 Julian Poulter is a partner of Energy Transition Advisers (ETA) and head of investor relations at the Inevitable Policy Response (IPR). The views expressed in this article are personal and do not necessarily represent the views of IPR.

 

The €15 billion ($16.1 billion) Ireland Strategic Investment Fund (ISIF) is finding compelling investment opportunities in the energy transition and is successfully drawing in additional investment to finance Ireland’s net zero commitments.

By targeting “climate positive” investments which support Ireland’s transition (outlined in the government’s Climate Action Plan) as a key investment theme, the fund is investing in both sustainable infrastructure and new technologies, and in business models to support the long-term transition. In 2021 ISIF committed €1 billion in climate projects over a five-year period of which it has already invested over €600 million.

The strategy runs in parallel with a divestment programme dating from 2018 when Ireland became one of the first countries in the world to sell out of fossil fuel companies. It  currently has a list of some 200 companies in which it won’t invest as part of that strategy.

When ISIF was established at the end of 2014 from the remnants of the National Pensions Reserve Fund, the sovereign development fund was tasked with attracting €1 million in co-investments across the portfolio for every €1 million invested. Today, typically around €1.6 million in co-investment is ploughed into projects for every €1 million the fund puts in itself, so that since inception ISIF has committed €6.5 billion across 188 investments that have unlocked some €10.2 billion of co-investment commitments.

“It’s positive for our investees and for the wider Irish economy,” says ISIF senior investment director Brian O’Connor, who leads the fund’s investments in indigenous businesses as one of four investment themes that sits alongside climate, housing, and food and agriculture set out in a 2022 framework that shapes the €8.7 billion discretionary portfolio.

The remaining assets (€6.3 billion) lie in directed portfolios held separately and under direction from the Ministry of Finance.  The discretionary portfolio targets returns in excess of the five-year rolling cost of government debt (2.8 per cent) over the long term, and assets are divided into equity (€3.4 billion), fixed income (€1.6 billion), real assets (€1.2 billion), absolute return (€1.4 billion) and cash and equivalent (€1.1 billion).

O’Connor says businesses and projects IDSF invests in must meet a double bottom-line, targeting both returns and supporting economic activity and employment in Ireland.

Scaling local businesses

O’Connor’s team oversees a portfolio of Irish businesses that spans investments in growth equity, private equity and private credit, managed by a range of Irish and international fund managers – the ISIF mandate to invest in the Irish economy allows scope to invest globally if there’s a benefit to support economic activity and employment in Ireland. The team also manages many of ISIF’s co-investments with fund partners and investments are roughly split 65:35 between fund and direct investment, respectively.

The ability to invest with global fund managers if it supports economic activity and employment in Ireland is vital in the fund’s ability to diversify outside Ireland’s small market. “Finding enough opportunity in the Irish economy is a challenge,” O’Connor says.

The fund does its best to invest broadly across many sectors and applies a portfolio approach to achieve a level of diversification across the risk it’s taking and the sectors it’s exposed to as it seeks to get its risk-adjusted returns right.

Investing across the capital structure

Diversity also comes with ISIF’s ability to invest at any point of the capital structure where the team use different instruments to best suit the investee. The fund can be flexible where many other investors can’t be, and is able to offer an alternative to low-risk bank funding or to private equity hunting double-digit returns, often over a three-five-year time horizon. The flexible approach plays an important role supporting an ecosystem of firms at whatever stage they are in their growth journey.

“We can provide debt at one end of the risk spectrum and equity at the other – and anything in between, whether it’s mezzanine finance, hybrid debt/equity instruments, venture capital, growth capital or private equity,” O’ Connor says.

“We aim to ensure the right mix across the capital structure. When co-investing in businesses, ISIF equity gives firms an ability to prioritise longer-term growth knowing that ISIF is not necessarily optimising to a short or medium-term exit timeframe.”

ISIF’s role of catalyst and its ability to attract co-investment capital into the economy is another central pillar. ISIF considers every investment on its ability to promote “economic additionality”, namely, benefits to gross value added (the value producers add to the goods and services they buy), while avoiding “dead weight”, meaning the economic benefits created from an investment would have been achieved in any event; and “displacement”, where the investment would simply substitute existing economic activity.

For example, avoiding dead weight means ISIF won’t invest in sectors that are already served by private-sector investors or by lenders to such an extent that ISIF’s involvement won’t make a difference. Instead, it looks to target important gaps that other investors and lenders aren’t filling.

“We do not alter our investment strategy materially based on market cycles,” O”Connor says.

O’Connor concludes with a nod to how ISIF capital has led to a new generation of international Irish companies.

“Many Irish companies have expanded to international markets in recent years,” he says. “The key is to help these types of companies by continuing to back their ambitions to grow over the medium and longer term and support them with access to funding via the co-investment partnerships.”

 

 

As the Netherland’s overhaul of its €1.45 trillion ($1.6 trillion) pension sector, Europe’s largest, gathers pace the country’s pension funds must shift from defined benefit to defined contribution.

Asset owners are beginning to adjust their hedging policies and asset mix to prepare for a new world that replaces retirement income promises for members with a different system that bases pension payouts on contributions and investment returns, dependent on the vicissitudes of financial markets.

“Pension funds are really busy with the transition from DB to DC. Everyone is preparing for a different asset mix in the new DC system and beginning to incorporate a different approach to interest rate hedging that has always been a very prominent element of risk management in the Netherlands,” explains Xander den Uyl, somewhat of an identity in the Dutch pension landscape. He is now a trustee at €1 billion Pensioenfonds Recreatie, a pension fund for employees in the Netherland’s recreational sector that is at the forefront of a transition that is being closely watched by governments around the world, mindful of the need to reform their own pension systems as aging populations increase.

“Recreatie is really leading the pack in its approach to the reform process and sees a clear future. It’s a nice atmosphere,” reflects den Uyl, who has just taken up the role after a 12-year stint on the board at €9 billion PWRI and who was also a board member at the giant ABP until May 2023, and had been its previous deputy chair.

Rush to hedge

The reforms promise profound implications for Dutch funds’ hedging strategies; the extent to which hedging will remain active and dynamic or shift to shorter duration swaps, and the suitability of LDI strategies in the long-term.

Many Dutch funds have dynamic asset and liability management strategies where a matching and return portfolio, and an interest-rate hedging strategy, all move in line with funding ratios. An investment approach that has been encouraged by strict regulation steering funds to focus on short term stability and guarantees rather than tilt towards risk-taking and long-term returns, but which has also thrived in a low interest rate world.

den Uyl predicts that more funds will seek to hedge interest rate risk in the next few years ahead of the 2028 reform deadline. It could lead to a short-term spike in demand (in 2026 and 2027 particularly) for hedging as funds scramble to de-risk.

Most funds have a relatively high solvency rate because of the rise in interest rates, a position they want to preserve before they transition into the new system, he explains. “Funds are thinking about increasing their hedging position in the short-term because if interest rates go down, their healthy solvency ratio is threatened.”

But from 2028 and beyond, the strategy for long-term hedging will increasingly shift to demand for short-term hedging strategies. The reduction in the duration of their hedging portfolios over time will see more selling of long duration and more buying short duration, he says.

“Less demand for long-duration hedges will have some price effect on rates,” he predicts.

As a regulator, the Netherland’s Central Bank, (DNB) is hesitant to speculate how pension reform will impact asset mixes and hedging strategies, mindful that portfolio composition will only become apparent when pension funds migrate to the new system.

Still, DNB’s Chris Sondervan, a supervisor of specialist financial risk, acknowledges an important change of the new pension system will include an increased emphasis on robust risk preference surveys.

“Pension funds will have a good understanding of their participants’ risk appetite in their investment portfolios and are obliged to have an asset allocation that fits with the corresponding risk appetite,” he says.

Under this new, participant-specific risk umbrella, interest rate risk will be better allocated to reflect respective risk preferences.

“For example, young generations have a long horizon and are, therefore, more likely to hedge against long term interest rate risk, while old generations prefer to hedge short term interest rate risk. The current pension scheme does not take these differences into account, while the new pension scheme allows for tailor made interest rate hedging strategies,” he says.

Changing the asset mix

It’s may not just be hedging strategies that change. Changes to pension funds’ asset mix are also on the horizon. Many funds, particularly with younger beneficiaries, may begin to beef up their allocation to equities and reduce their exposure to fixed income.

“Of course, this will depend on the risk preference of members but there is a feeling that the asset mix amongst Dutch pension funds will become riskier,” says den Uyl, who welcomes a change that will see a shift from “overdone” hedging strategies, often at the expense of returns. Reform heralds the dawn of a healthier system that will see pension funds invest more not just in equity but real estate and alternatives, he adds.

More communication with beneficiaries

Under the reforms, pension funds will choose between two different types of DC schemes, either a “solidarity contract” where the fund decides on the investment mix or a “flexible contract” where the member can choose their own [investment mix].

It means the new regulation will see a sharp uptick in compulsory communication with beneficiaries. “This will be an important part of the work of trustees and boards,” says den Uyl.

There is a possibility heightened communication could have consequences for ESG integration. Although many Dutch funds have integrated sustainability off the back of pressure from their beneficiaries, the success of far-right leader Geert Wilders in recent Dutch elections and who has a hostile stance on attempts to cut carbon emissions, could signpost a population beginning to cool on sustainable investment.

den Uyl believes by focusing on the sustainability message, beneficiaries are unlikely to request changes in sustainable investment, even if the Netherlands political landscape shifts to the right.

“There will be even more communication with members around responsible investment in the new system, but members are pushing for sustainable investment, and I don’t see that changing very much and I don’t see the transition to a new system stopping the focus on sustainable investment.

Although not every political party is committed to reducing the impact of climate change, members understand that a sustainable return requires a sustainable world.”

Still, he does warn that if pension returns start to fall, priorities may shift. “If returns drop, the conversation could change,” he concludes.

 

At $26.4 billion and 28 per cent of Oregon Public Employees Retirement Fund’s total assets under the management, the pension fund’s private equity allocation is at the very top end of its target range.

Not only is the exposure stubbornly high, lacklustre M&A deals and “anaemic” exit activity; a slowdown in fundraising and deployment and market volatility creating benchmarking havoc have also conspired to cause consternation for the Oregon Investment Council (OIC).

“We are still in a phase of markets digesting what has been a wild ride since COVID,” said Michael Langdon, director of private markets at OIC, who charted how unprecedented stimulus in 2020 led to record deal activity; inflation and tightening ensued, and now a disconnect between private equity and volatile public markets continues to thwart performance.

Bias to larger funds but smaller funds do best

In its Annual Review of the asset class, the private markets team told the investment council that OPERF’s large program is skewed to allocating to larger funds – yet smaller funds have significantly outperformed. The team have now begun a “manager by manager” analysis to dig down into “why this has happened” although they noted “actual, crystalized IRR” confirming smaller fund outperformance, remains unproven.

The size of the program means OPERF can only access a narrow selection of the manager universe because small managers can’t take large commitments. Of the 5000-odd funds in the asset class composite from 2013-2022, only 352 raised $3 billion plus of committed capital – during the same time period 50 per cent of OPERF fund investments by count and 71 per cent by commitment went to funds with $3 billion or more of total commitments.

Positively, large commitments enable OIC to negotiate more favourable fees.

Cash flow negative

In another challenge, the slowdown in distributions means the private equity allocation has turned cash flow negative for the first time in a decade. In 2023, the portfolio processed capital calls of $2.9 billion and distributions of $2.4 billion leaving net contributions of $518 million.

“2023 was the portfolio’s first negative cash flow year since the GFC,” state board documents.

Moreover, it’s difficult for LPs to model how fast distributions will show up to ease the crunch of negative cash flows. “We control what we commit, but we can’t control how fast managers invest,” the board heard.

The team has also been unable to use the secondary market to pull forward distributions because of challenges around execution. Still, looking ahead, improved pricing in the public market will feed into the secondary market, helping OPERF generate more strategic liquidity.

Pacing and fewer GP relationships

OPEF has a strict private equity pacing commitment of $2.5 billion total annually. But this has also caused challenges to appear in the portfolio because it has led to an underweight in vintages that have performed well. It has created a drag on OPERF’s relative performance due to the strong, early performance from recent vintage years where OPERF is underweight, say board documents.

Around 60 per cent of OPERF’s fund investments in mature vintages are ranked below median as compared to other funds pursuing a similar strategy in the same vintage.  “Fund size continues to have an outsized impact on quartile rankings, particularly with respect to OPERF’s core allocation to North America buyout funds,” say board statements.

The pension fund will keep its pacing range of between $2-3.5 billion while there is a slowdown in distributions.

OPERF is currently “lighter” than it wants with some 30 GPs on its roster rather than a preferred 40. In a catch-22, the team will only add managers as the pacing allows, and given the team will stick with the existing roster unless “the manager gives reason not to reup” it means scant opportunity for new GPs. Since 2015 the program has sharpened manager selection, reducing the number of managers from 70.

The OPERF portfolio has buyout, venture and growth equity. An overweight to buyout and North America has served the fund well. In contrast, the struggle to retain the target weight to venture has been a detractor. In another trend, the investment team expect to tilt more to developed markets in America and Europe because of the challenging geopolitical landscape.

Shifting dynamics

The board heard how the dynamics behind private equity are changing. Since 1981 – when Oregon was one of the first US pension funds to invest in private equity – interest rates have steadily fallen. It means rates have been falling for the entire time the fund has invested in private equity, bolstering the allocation as well as bidding up all risk assets.

The new interest rate environment means that fundamentals and earnings growth will now be the most important contributors to returns in excess of the market. Moreover, if returns are muted on a real basis by inflation, every single basis point is important.

Other market trends include inflated valuations in the tech sector. GPs hunting for capital for their next fund are under pressure from LPs to sell assets but because valuations remain inflated, buyers are cautious. Still, technology is unaffected by cyclical ups and downs. In contrast, PE opportunities in healthcare and services are buffeted more by macro trends, while investors in consumer brands do best focused on the luxury segment and from digitization trends.

The current market is also characterised by an uptick in demand for and availability of leverage from direct lenders.

The board heard concerns about the rising cost of leverage, with the team counselling on the importance of paying close attention to OPERF’s ability to serve the cost of leverage so as not to impact cash flows. Many GPs didn’t hedge interest rate exposure heading into rising rates and worryingly, a fair amount of debt has come due, requiring refinancing across the capital structure.