The discussion here relates to the winding down of fossil fuels. Arguably, the most high-profile use of the term was in the concluding statement for COP26. The draft statement included the phrase “phase-out” in relation to the global use of coal.

India pushed for, and was successful in, a change of words to “phase down” coal use. As an interesting aside, at COP27 India has pushed for agreement on the “phase down” of all fossil fuel use, which Saudi Arabia appears less keen on.

The two phrases relate to two different pathways, with the implication being that the paths converge on the same destination, such as ‘net zero by 2050’. In this case there can only be any interest in comparing them if the nature of the journey would be qualitatively different. Or, if the implication of convergence turned out not to be true. Let’s explore this.

We should first define our terms. In the absence of a commonly-held definition, we at Thinking Ahead suggest we define ‘phase out’ to mean the progressive reduction over successive periods to the point where no further usage occurs.

In contrast, ‘phase down’ will also mean a progressive reduction over successive periods, but to a level that is deemed acceptable to continue into the indefinite future. In other words, ‘phase out’ gets to net zero by 2050 by contributing absolute zero (annual) emissions from fossil fuels, while ‘phase down’ requires the simultaneous building up of carbon capture and storage (CCS) to a level that offsets the continuing ‘phase down’ emissions.

We can now consider the two scenarios introduced above. The first is that the down and the out pathways converge on net zero annual emissions by 2050. From the construction of this scenario there is no meaningful difference between the pathways in terms of their impact on the climate. Instead, the difference will be seen in the mix of energy types and, possibly, in the quantity of energy supplied. The phase out path means that the energy mix in 2050 will not contain any energy derived from the burning of coal, oil or gas. In turn, this would have big implications for certain sectors where electrification is less straightforward (eg shipping, trucking, flying, high-temperature manufacturing). The quantity of energy supplied in 2050 will directly depend on the rate of investment in new (non-carbon) energy generation between now and then.

The phase down path means that we will still be burning fossil fuels as part of our energy mix in 2050. Again, from the construction of this scenario the amount of fossil fuel (and, by extension, the total amount of energy) will depend on the rate of investment in, and the efficiency of, CCS. The amount of energy can be further boosted by also investing in non-carbon energy if there are sufficient funds. This path gives us greater scope to continue benefiting from the hard-to-electrify sectors.

The second scenario is that the pathways actually diverge. Phase out still gets us to zero absolute emissions in 2050, but it gives us the headache of finding substitutes for the hard-to-electrify services we currently enjoy. It could also result in a fall in the total amount of energy supplied, which would be an aberration in a historical context. This would imply some form of energy rationing, which is a difficult proposition for those of us in the global north to wrap our heads around.

The divergence, therefore, comes from the phase down path. We will either default on the phasing down (nobody likes energy rationing, so we keep on burning fossil fuels), and/or we will discover that CCS is more difficult, more expensive, or less efficient than we hoped – and therefore we will do less of it. In this scenario, ‘phase down’ does not get to net zero by 2050.

Why might CCS disappoint? First there is the technological angle. Every successful new technology takes a number of decades to mature. Solar electricity took 40 years to become price competitive with fossil fuels. CCS has only 25 years to show it can be successful, and to mature and scale.

Second, there is the physics. Capturing carbon from the air, compressing it and pumping it underground takes energy[1]. Why dig up more natural ecosystems to find the materials, to build new energy generating capacity, to power CCS when it would be simpler, cheaper and more efficient to burn less fossil fuel instead?

Third, there is the biology, or the human domination of natural ecosystems. It would be nice if the so-called ‘nature-based solutions’ could do the heavy lifting of carbon removal for us. Unfortunately that ship has sailed. The atmosphere enjoyed 10,000 years of stability in the run up to the industrial revolution. The concentration of carbon dioxide didn’t vary much from 280 parts per million (ppm).

In 2022 the concentration passed 420ppm. In other words, while nature has done its best, it was not able to offset the light economic activity of one billion people, let alone the heavy economic activity of eight billion people now. Tropical rainforests are transitioning from carbon sinks to sources, and permafrost has started to melt, releasing long-stored greenhouse gases. Against these considerations, how much confidence should we have in the effectiveness of CCS?

In this piece we have considered phase down vs phase out at the very highest level. A proper consideration would require a much longer piece and a breath-taking amount of complex detail.

For me, however, the primary importance lies in the high-level abstract realm. The choice of phase down or phase out will reveal our underlying values and beliefs. It is, pretty much, an ideological choice. In the run up to COP26 Greta Thunberg wrote that “we now have to choose between saving the living planet or saving our unsustainable way of life[2]”.

It is my argument that phase out is a choice to save the living planet, while phase down is an attempt to save our unsustainable way of life.

Tim Hodgson is co-founder of the Thinking Ahead Institute.

[1] Currently 2,000 kWhours per ton of CO2, according to James Dyke in We Need to Stop Pretending we can Limit Global Warming to 1.5°C, Byline Times (bylinetimes.com), 6 July 2022.
[2] There are no real climate leaders yet – who will step up at Cop26?, The Guardian, 21 Oct 2021

For pension funds with a large roster of external managers, balancing the integration of top-down strategy with managers’ bottom-up implementation is one of the most challenging tasks for CIOs.

The key, says Mark Walker, CIO of Coal Pension Trustees Services Limited (CPT), which oversees around £21 billion in assets on behalf of beneficiaries in two schemes from the UK’s legacy coal industry, is to ensure external managers truly understand the strategic reasons and goals for the allocation. It’s  a process that is more complex, and goes much deeper, than a mandate’s label or just trying to beat a performance benchmark.

Four years ago, CPT introduced short duration, higher yield, external bond mandates for one of its two pension schemes. Working in combination with other assets, the idea was that if the pension fund needed to meet future cash flows three or four years down the line, it could run off those mandates. The managers wouldn’t buy any more bonds and when they got to maturity, the proceeds would be collected and used to pay benefits.

In a classic, top-down strategy, the allocation was crafted to meet cash flows at the pension fund where up to 10 per cent of assets under management may need to be sold to pay benefits in a given year, explains Walker. It was only on closer examination of the portfolio he noticed that one of mandates had a bond with a maturity of 2054.

“This clearly didn’t link to our top-down strategy – it wasn’t going to mature for another 30-odd years!” he says.

Recalling initial discussions with managers around structuring the higher yield bond mandate, Walker cited conversations around timing cashflows out, diversification and manager flexibility around adjusting the duration or managing credit risk. Yet behind these discussions, it was also key that the manager understood the strategic, top-down resonance of the portfolio in the context of the pension scheme’s cash-flow priorities and that not implementing it correctly, held consequences for strategy. Even so, a rouge bond slipped into the portfolio.

Aligning top-down strategy and bottom-up implementation can only be achieved if external managers truly understand asset owners key purpose, Walker continues. For CPT’s two pension funds, that purpose is paying pensions against the backdrop of a huge pay-out ratio (no new money has come into the schemes for the last 30 years) pegged to RPI, meaning that if inflation is much higher than expected, the schemes must generate more returns.

It’s a cash flow focus that means every external manager must understand the importance to the pension schemes of selling an asset well (divesting is just as important as investing) alongside growing the assets to generate returns given that the more income the schemes can collect, the less they have to sell.

“Our starting point with managers has to be about ensuring they understand the liability characteristics of the schemes and the importance of making payments out of the scheme – our purpose is to provide benefits to members, and our payments are much higher than most.”

Property and ships

Top down, bottom-up alignment is a particular headache in the UK property allocation. The schemes’ property managers don’t just need to understand the importance of controlling fees and costs given the impact on vital rental income coming into the pension funds. Other factors are coming into play like the rise in capital expenditure to repurpose UK buildings in line with new environmental and energy efficiency rules, and the impact on cash flows ahead.

“You could argue this kind of expenditure is a bottom-up issue,” reflects Walker. “But it really makes us evaluate the place of property in our portfolio and the value from spending money on a property versus selling the property and committing capital elsewhere. Blending top down and bottom up in a segregated property mandate involves so many different factors. You think you’ve connected the two, and then you discover you haven’t.”

Similar themes have guided the rationale to sell ships, despite ownership of 50-odd ocean-faring vessels across both schemes earning double digit IRRs over the years and comprising one of the best-performing allocations last year alongside private debt and macro hedge funds.

“It has been a good time to sell some of our ships, not least because of increasing costs around environmental standards. Fitting sulphur filters to some of our ships was costly, and more environmental regulation is coming,” he says.

Successful alignment also requires the schemes’ external managers feed-up and share any information that supports top-down strategy. Witness another anecdote from the front line. When flicking through a report from one of the schemes’ global equity managers, Walker noticed the average dividend yield for the stocks in their portfolio was 1.4 per cent – but share buybacks had been at the level of 2.5 per cent over the year.

Since every ounce of income is collected and used to pay benefits, the fact not all the cash flows from companies in the portfolio was being paid out in dividends, but being used, instead, to buy back shares, would have hit the schemes’ all important cash flows.

“It was a facet of the stocks the mandate was invested in, but it impacted the income we received,” he says. “It was a useful piece of market information. Things might happen at a market or stock level that we will then need to think about at on a mandate, cash flow or strategy level.”

Manager shake-up

The quest for alignment with third party managers has resulted in a shake-up of the manager roster in recent years as Walker seeks to buid relationships with a smaller number of bigger names. Many managers have fallen away naturally, like long-term private equity or special situations managers where the investment is realised. Elsewhere, mandates have been consolidated or changes in the value of the asset class has led to fewer managers required.

However, Walker has also reduced the number of manager relationships by asking 25-odd existing managers and some potential new names to come up with ways to work more closely with the schemes, emphasizing their particular needs around high cash flow requirements and high returns, as well as key investment themes like climate and technology. Walker was looking for managers prepared to leverage their resources and help the pension schemes form macro views, access liquid growth opportunities, better structure the equity portfolio or manage climate risk without losing returns.

As a consequence CPT, on behalf of the schemes, now has four strategic providers and around 15 core managers (plus a further 10-15 core private equity managers).

“We are not completely closed to new managers, but the bar for others is higher now because we generally look to our core and strategic managers first if we want to do something new.”

Assets have also flowed to these managers. “Over the last 12-18 months, our percentage of assets with these managers has gone up. We’ve seen our number of legacy managers go down, and the value of assets go up with strategic managers.”

China

Now both pension funds are also revaluating their approach to China. The schemes first invested in Chinese private equity around ten years ago; an active, onshore public equity allocation followed, and together with a small exposure to Chinese fixed income and stocks held by global managers, onshore and offshore exposure to China is around 6 per cent in one of the pension funds.

“We’ve had some great investments, but the risks are increasing,” says Walker.

For example, some of the China portfolios increasingly drag on the Trustees’ climate and wider ESG metrics, and the geopolitics have got more complicated.

“In the past we’ve been relatively bullish on China, but the risk and complexity are increasing, and although we are not exiting, we are reviewing our exposure and I expect it will come down.” For now, he has no short-term plans to put new money into private equity and is likely to re-evaluate positions in public equity too. Still, he’s mindful of the potential short-term benefits to Chinese equities as China opens up after COVID.

The allocation to China sits in a wider equity allocation, divided three ways between Europe, US and Asia. Allocations include small cap and climate and healthcare allocations. Although he is positive on equities in the long run, he expects more downside in the short-term.

“The key issue for us is if they fall we don’t sell them because this is a permanent capital loss,” he says.

Outlook

With no LDI strategy, very few gilts or typical rebalancing requirements, the pension schemes escaped the worst of UK bond market volatility last year. However, the secondary impact from forced sellers as UK pension funds sold assets to meet margin calls did buffet the portfolios, impacting prices of assets the schemes had planned to sell and the balance between buyers and sellers at the time.

“Whilst we still have high return targets, much of our strategy is actually about what we have to sell. We have around 50 per cent of the portfolio in illiquid assets, and don’t want to or need to be a forced seller,” says Walker, who adds that sterling’s weakness has actually helped the pension funds. Many of the two funds overseas assets are unhedged and have seen their value go up. However this has increased illiquidity given the unhedged US private equity allocation went up in value, but the hedged public equity allocation fell.

Looking out on the best income-generating assets ahead, rising bond yields bode well.

“It’s easier to get income now – bonds are paying higher income, much more than they were 12-18 months ago.” However, he’s already feeling some impact from lower distributions in private equity and expects worse ahead.

“We still received hundreds of million in distributions from private equity and special situations debt last year. In private equity alone, we saw around £400 million in distributions last year but that was still less than expected.”

Price discovery in the illiquid allocation is also difficult.

“Private equity has not revalued down as quickly as public equity so understanding the value and a true price, rather than just a latest valuation, is a challenge.”

 

The idea that the ESG movement is impeding a successful response to the climate emergency sounds like a paradox. But John Skjervem, CIO at $43.2 billion Utah Retirement Systems (URS), believes today’s seemingly unanimous embrace of ESG investment and ESG groupthink is actually jeopardizing real transition solutions.

Divestment doesn’t work, he says, and Scope 3 reporting regulations portend a legal and bureaucratic morass that will stymie both economic growth and the pace of meaningful emissions reduction. Moreover, current (and, he says, largely narrative-based) ESG initiatives threaten pension plans’ long-term financial security and, in turn, their capacity to finance energy transition technologies.

“Now completely politicized, ESG is a waste of time,” says Skjervem, a self-confessed ESG apostate, speaking in a rare interview since he joined URS in November 2021 to work alongside State Treasurer Marlo Oaks, a prominent ESG critic.

Amongst the climate change cacophony, calls for divestment worry him most. Take one of URS’s best performing allocations: a 5 per cent strategic commitment to energy, mining, and infrastructure, most of which resides in direct oil and gas investments URS has made in the wake of other institutional investors’ exodus from fossil fuels.

Direct relationships with management teams and operating groups have allowed URS to make cost-saving investments and escape the co-mingled fund structures in which general partners add value and then quickly exit. Now URS can match investment duration with its long-term return and asset allocation objectives.

“We’ll hold these hydrocarbon assets for a decade or more,” he says, flying in the face of calls on pension funds to divest fossil fuels. “We earn great returns while also doing our part to maintain America’s access to cheap, reliable power and fortify its geopolitical position through domestic energy independence.”

Just as important, the unashamedly “fabulously successful” portfolio (boosted by the sharp appreciation in energy prices) has helped fund multiple investments in renewables and several separate commitments to “moon-shot” energy technologies like fusion. “From a place of humility, not ideology, we are deliberately allocating across a mosaic of energy investments because we don’t know exactly how the transition will evolve and play out,” says Skjervem.

He also points out the integral role natural gas plays in weaning economic activity off coal and providing backup power to the intermittent supply profile of wind and solar. “The reality is, we need aggressive investment in oil and gas to provide cheap reliable energy so plans like ours can remain fully funded and provide the risk capital needed to invest in transition technologies like renewables, modular fission, hydrogen and fusion.” He continues, “the energy transition is not an ‘either/or’ proposition, it’s a ‘both/and’ proposition.”

Fossil fuel divestment doesn’t only cause investors to miss out on returns – of which last year was a particularly good example – and plough more money into emerging climate solutions. Divestment is also disingenuous.

In an increasingly pervasive argument, Skjervem says divestment doesn’t work because selling hydrocarbon assets just means they’ll likely end up in the hands of other, less altruistic investors who are less knowledgeable and less concerned about sustainability. “Engine No.1 would not have prevailed if CalSTRS had divested,” he says, referring to the proxy battle investors forced on US oil giant Exxon.

Divestment is also flawed because if successful, it would raise the cost of capital for fossil fuel companies, resulting in fewer projects and less long-term capital investment, he continues.

“Constraining supply raises prices, and higher energy prices are essentially a tax borne mostly by the poor and working class who generally cannot work from home and for whom purchasing an EV is entirely cost prohibitive,” he says, warming to his theme. “Living in the Bay Area during summer power outages, the cause of which was at least partly the State of California decommissioning some natural gas-fired powered plants, I anecdotally observed the immediate activation of diesel-powered generators in affluent areas while poor neighborhoods suffered through extended heatwaves without any air conditioning. The hypocrisy is appalling.”

“At URS we know the energy transition is an imperative, but we also refuse to make investments or promote policies like divestment that shift transition costs disproportionally to the poorest members of society, undermine the economic progress of our state, and compromise the geopolitical security of the US,” he surmises.

Perhaps the aspect of divestment that frustrates him most is that the climate emergency looms ever closer, but clamours for hydrocarbon divestment only squander valuable time, throwing sand in the gears of efforts to find real solutions. “Proponents of divestment are wasting time and diverting valuable resources from serious people making equally serious investments across the energy transition spectrum. This misguided activism is just getting in the way.”

Governance, Governance, Governance

Skjervem, who was CIO at Oregon State Treasury between 2012 and 2020, cites the URS governance model as support for his team’s bold fossil fuel investments. Specifically, the URS board addresses investment matters in executive session which limits the “political grandstanding and virtue signalling” Skjervem says is commonplace at many US public plan board meetings.

The URS model has not only enabled staff to quietly profit from fossil fuel investments while many other public funds bow to divestment pressures. Skjervem says it also shields the entire programme from politics and “non-fiduciary” influences, allowing the team to focus exclusively on hunting for the best risk-adjusted returns without interruption or interference.

“Why do endowments outperform?” he asks. “Because they are opaque. You can’t dial into or attend Stanford’s or Yale’s investment committee meetings.”

Take the URS venture capital allocation for example, a particularly attractive element of the programme’s portfolio construction. Skjervem attributes the celebrated allocation and its impressive manager roster (on par with top endowments and mostly unprecedented among public funds) to the fund’s governance structure which allows VCs to pitch in privacy, protect their IP and stay under the media radar.

Together with enduring Board support (which often wanes at larger funds due to the negligible performance impact of typically small VC investments), he says the URS model has a distinct competitive advantage. “Allowing public comment and opinion on potential investment opportunities is not conducive to attracting high quality VC partners, but in our construct, general partners can be confident they’ll be insulated from the counter-productive elements that quickly emerge with public participation and transparency.”

The seven-member URS board, comprised of five professional investors and two participant representatives, sets asset allocation policy, the actuarial rate of return and employers’ legally compelled contribution rates. The only politician on the Board is the state treasurer, and all implementation and manager selection decisions are delegated to URS investment staff.

URS has an internal audit team that monitors investment process compliance as well as external auditors who review its financials and file reports with the Retirement and Independent Entities Committee of the Utah State Legislature, thereby ensuring multiple layers of accountability.

Skjervem believes this combination of delegated investment authority and multi-level fiduciary oversight is the programme’s “secret sauce” and manifests as excellence in both portfolio construction and team culture, which has enabled the easiest transition to a new role of his career.

So far, he hasn’t had to “put out fires”, “push boulders uphill” or any other metaphor for difficult and complex change management. In fact, he says the most important aspect of his job is keeping a steady hand on the tiller, a thinly veiled tribute to previous CIO Bruce Cundick who over a two decade span assembled “a terrifically dedicated and talented staff who have expertly capitalized on the program’s structural advantages to create a truly world-class investment portfolio.”

Smaller Managers

Nor could he find anything to change in the 15 per cent allocation URS has to hedge funds, a large commitment for a fund its size. This corner of the portfolio, where he particularly enjoys getting under the hood, has proved truly unique. Steeling for change when he took the helm, the hedge fund allocation has, in fact, produced the holy grail of low correlation and statistically significant alpha despite challenging markets.

It has also withstood rigorous empirical analysis and stress testing. “If I think back to the hedge fund portfolios I’ve been responsible for in previous roles, I wouldn’t have had the same success URS has enjoyed.” He attributes this success to Board support (as with the VC allocation) and a carefully cultivated list of around 30 smaller managers.

Rather than invest with the usual suspects, URS positions itself as the largest LP in the relationship rather than one of many. Other contributing factors he cites include ensuring the allocation is well-resourced internally and invested globally rather than with a US bias.

He was similarly circumspect regarding URS’s 12 per cent private equity allocation, especially coming from Oregon. That pioneering investor has a private equity portfolio that dates from 1981 and a pacing model that requires annual commitments of $3.5 billion allocated among the biggest PE firms. He quickly learnt that different principles govern the URS allocation.

Once again, URS plays to its strengths in terms of preferential access, and favours partnerships with smaller, lesser-known managers, made possible by bitesize annual commitments totalling around $1 billion. “There are many benefits to being smaller,” he says.

As the conversation draws to a close, he returns to his conviction that ESG is now hindering the energy transition, diverting valuable resources and time from the important task at hand. “We’re trying to figure out who’s doing it right in terms of both commercial viability and environmental sustainability, and if you’re not doing that, you are part of the problem.”

For all his talk of not changing anything, and the portfolio only needing a minor tweak here or there if at all, Skjervem is putting his mark on URS.

Hit by last year’s unusual correlation between equities and bonds, and in a bid to avoid higher long-term inflation, Switzerland’s €45.6 billion Publica kick-starts a new strategic asset allocation that will reduce the bond allocation and result in a search for new managers.

“The most difficult part of last year was the lack of diversification between fixed income and equity caused by the increase in (real) interest rates. This meant that not only the fixed income part of the portfolio suffered from a market value perspective, but also equity. This kind of equity-fixed income correction happens 2-4 times every hundred years,” said Stefan Beiner head of asset management at Switzerland’s largest pension fund, CHF44 billion (€45.6 billion) Publica.

Hit by both falls in equity and bonds, the fund has just posted a -9.6 per cent loss for the last year, although direct real estate had a positive impact on the portfolio. Bonds had the largest adverse effect in 2022, followed by equities where the six main regions Publica invests all posted losses. Pacific ex-Japan did best in the faltering equity allocation – and US equities worst.

Despite last year’s poor results, Beiner predicts that rising interest rates will support the portfolio in the long run. “Our expected return from our SAA at the end of 2021 was 2 per cent. This has now risen to around 3.5 per cent for the next ten years.” Still, he remains pessimistic regarding short-term performance.

“Although the long-term expected return has increased, it doesn’t mean we expect a strong performance in 2023. As well as our SAA, we have a tactical process that looks at the next 3-9 months. Here, personally, I am still quite pessimistic, particularly because of corporate earnings risks.” 

New SAA

Beiner’s focus in 2023 is implementing a new strategic asset allocation, designed to increase exposure to real assets and support diversification. In times of high inflation and volatility, assets that are closest to the real economy do best, he says.

The new SAA will shave 14 per cent off the fixed income allocation. In turn leading to a 5 per cent increase to public equity (there will be no search process; the fund will just allocate to existing public equity managers) 9 per cent will be placed in real assets  and 3 per cent in international real estate. Here the team will begin a hunt for new managers, most likely one Asian and one Canadian-focused manager, “We will do the FRP process this year,” he says.

Publica also plans to increase exposure to Swiss real estate, but this will be internally managed. A final 1 per cent will be invested in precious metals – gold and silver.

In a new strategy, Publica will build a new allocation to private infrastructure equity. “Private infrastructure equity is a new allocation for us. As a first step, we will invest in open ended funds and finalize the RFP process to find the right partners in the next few months.”  

The new SSA will be implemented over the next four years in a bid to benefit and time from price corrections in asset prices. If prices correct faster, the process will speed up. “We decided to implement our new SAA over four years in a rules-based manner to diversify the adjustments on the time axes due to the high volatility. If there is a larger equity price correction, we will speed up the build-up process.”  

Publica is divided into a closed and open fund. The closed pension plans, which have a 10 per cent allocation to equities, recorded a performance of -8.0 per cent, while the open pension plans which includes active members and which allocate some 25 per cent of their assets to equities, posted -9.7 per cent. The consolidated funded ratio across all pension plans is estimated at 96.7 per cent.

Analysis back in 2021 showed that inflation was very likely to be higher in the next ten years than it had been in the preceding decade. Since real assets tend to outperform nominal assets in an inflationary environment, Publica’s Board of Directors decided to reduce the relatively high weighting of bonds in favour of higher weightings of real assets and listed equities, states a press release.

 

Since joining $233.5 billion New York City Retirement Systems (NYCRS) six months ago, CIO and Deputy Comptroller for Asset Management Steven Meier has spent the bulk of his time getting under the hood of the private markets allocation, engaging with business partners and meeting some of the best minds in the industry to discuss the private equity, infrastructure, and credit allocations.

It makes the recent amendment to so-called basket clause legislation that will now allow pension funds in the state to increase their allocations to private markets to 35 per cent of assets under management (up 10 per cent) particularly timely. More so given it also coincides with NYCRS approaching a scheduled review of its large and complex asset allocation across the five different plans with trustees and consultants.

“We will revisit our asset allocation strategy in coming months to rethink asset allocation decisions,” says Meier in an interview with Top1000Funds.com. “And since basket clause legislation has now been approved, we will discuss with our boards whether to increase our allocation to private assets. It’s time to revaluate our asset allocation studies across the plans and cascade these decisions into our investment policy statement.”

Private equity

Still, any GP bonanza comes in the context of today’s market headwinds. In private equity, where NYCRS currently has around 100 direct relationships (it doesn’t invest in any fund of funds) he still expects solid returns but not on the same level as recent years. Moreover, until rates come down, his focus is on private equity investment structured with more equity and less leverage. “We will see more equity in deals with the expectation that as rates come down, leverage will be added on these opportunities down the road.”

Elsewhere, he anticipates less exits as investors sit tight and avoid selling into a distressed market, something that is made easier by NYCRS long-term approach where strategies are typically 11-12 years, and sometimes longer. “GPs that manage on our behalf don’t have to sell into weakness,” he says. It means a lower level of distributions ahead since NYCRS is unable to lean in and lean out of the asset class. Continued capital calls will have a negative impact on cash flow, he says.

Smaller managers

At the moment, NYCRS’ size means it’s rarely worth conducting costly and time-consuming due diligence on deals that only ever result in a small investment. “Our size can be a hindrance,” he says. “When it comes to looking at smaller deals, it is a question of resource allocation and one of our priorities is increasing how nimble we are.”

However, re-evaluation of the portfolio, GP relationships and asset allocation levels, could open the door to smaller GPs investing on behalf of the smaller pension funds under NYCRS umbrella. “We could look at smaller deals for some of the pension funds for whom small would be a better fit. This would expand the opportunity set and give us better diversification.”

Manager selection involves a rigorous due diligence of the strengths and quality of the offering around ESG, compliance, risk, operations, and legal considerations. And quantifying the risks associated with climate change in portfolio construction is increasingly centre stage. In real estate this involves assessing areas prone to flooding or fire, for example.

He adds that NYCRS is prepared to support smaller GPs integrate ESG over the course of the relationship – it doesn’t all have to be in place from the get-go. “They don’t have to be there on day one; we can look at [integration] and measure it over time,” he says.

In contrast to private equity, Meier believes private credit could benefit from a tailwind from several factors. Fed policy and tightening financial conditions has pushed yields to 4-8 per cent depending on the Sovereign, or if an asset is investment grade or high yield. “Defensively positioned private credit strategies and opportunistic credit strategies in the private space should all do well. It’s a better time to be a fixed income investor now than a few years ago,” he says.

Public markets

NYCRS ability to invest more in private markets will act as a counterweight to ongoing travails in public equity. Meier believes public equity will remain buffeted by the impact of low interest rates through the pandemic pulling forward returns, and says that US equities are most vulnerable to headline risk. He flags the risk of  a decline in corporate earnings, the impact of which is unclear given how much is already priced into the market. Sticky inflation will also dent public equity where he is concerned by inflationary geopolitical trends around re-shoring, inflationary pressure in the transition and shortfalls in the labour market.

“The labour force participation rate is low on a combination of demographics, baby boomers retiring and stifled immigration. We haven’t replenished the labour force and may see wage price pressures that are inflationary. I grew up in 1970s and remember a time when inflation was higher and stickier, and I think about this in the context of the asset allocation and what to reasonably expect for performance.”

He also has half an eye on another market shock. Crypto’s collapse and sharp falls in the UK bond market are the only major fallouts from the policy response so far, and more could lie ahead. “When the Fed raises rates this aggressively, something usually breaks,” he concludes.

The world faces a set of risks that feel both wholly new and eerily familiar. The Global Risks Report 2023 explores some of the most severe risks we may face over the next decade. As we stand on the edge of a low-growth and low-cooperation era, tougher trade-offs risk eroding climate action, human development and future resilience.

The war in Ukraine has disrupted the return to a ‘new normal’ following the COVID-19 pandemic, according to this year’s WEF Global Risks Report.

The 2022-2023 Global Risks Perception Survey (GRPS) identified the energy supply crisis, the cost-of-living crisis, rising inflation, the food supply crisis, and cyberattacks on critical infrastructure as among the top risks with the most significant potential global impact in 2023.

It also flagged concerns over the failure to meet net zero targets, the weaponization of economic policy, the weakening of human rights, the debt crisis, and the failure of non-food supply chains.

The report states that all the current risks are converging to shape a unique, uncertain, and turbulent decade to come.

Respondents to the GRPS (more than 1,200 experts across academia, business, government, the international community, and civil society) see the path to 2025 dominated by social and environmental risks, driven by underlying geopolitical and economic trends.

Respondents expect the cost-of-living crisis, the economic down-turn, geo-economic warfare, the climate action hiatus, and societal polarisation to play out over the next two years.

They will also have ramifications for the next ten years. Some respondents felt optimistic about the outlook for the world in the long term, predicting limited volatility with a relative – and potentially renewed – stability over the next ten years. Yet, over half expect progressive tipping points and persistent crises leading to catastrophic outcomes or consistent volatility over the next ten years.

‘Global risk’ is defined as the possibility of an event or condition occurring that would negatively impact a significant proportion of global GDP, population, or natural resources.

The report explains that some of the current global risks are close to a tipping point and understanding them is vital to shaping a more secure future.