SAN FRANCISCO -- Dick Picket, senior investment officer for fixed income at the San Francisco City & County Employees' Retirement System, believes the best way to boost yield is by diversifying beyond traditional bond investments.
One strategy that has been extremely successful for the system has been the addition of a commercial lending program, which now stands at $300 million, or 3%of total assets. Mr. Picket said he expects "returns north of 10%" The $10 billion system securitized $100 million of the loans at the end of March, and is looking for new loans, Mr. Picket said.
San Francisco is only the second public pension fund known to securitize its loans. The State of Connecticut Retirement & Trust Funds, Hartford, securitized $200 million of loans in June 1993..
The commercial lending program at San Francisco, which is invested in a mix of commercial loans and commercial mortgage-backed securities, is part of the fund's fixed-income portfolio. "It offers a way to diversify, because fixed income is not correlated with real estate risk," said Frank Blaschka, principal at The Townsend Group, real estate consultants to the pension fund.
Initially, AEW Capital Management, Boston, and Schroder Mortgage Associates, St. Louis (now Conning Asset Management) each were given $75 million to invest in 1995. Another $80 million was allocated in 1996, bringing it to around $230 million.
AEW was terminated in June because of personnel turnover and lack of interest in the securitization, said Mr. Picket. AEW officials said at the time that the firm is committed to the mortgage business via a REIT; that its performance exceeded the Salomon Broad index by 250 basis points; and that its mortgages are of good quality and are suitable for securitization at a future date. The system then put out an RFI for candidates for a new commercial mortgage manager. It has whittled down the list to six candidates: Capri Capital LP, Chicago; CB Richard Ellis Investors, Los Angeles; Heitman Capital Management, Chicago; Legg Mason, Philadelphia; Lend Lease, Atlanta; and Conning.
Mr. Picket said the next step will be to score and evaluate the RFIs and determine whether to recommend to the board at its Sept. 29 meeting that RFPs be issued to some or all of the candidates or whether to turn the entire account over to Conning. An assignment could be for as much as $150 million.
Commercial mortgage-backed securities are riskier than Fannie Mae-type loans, which guarantee principle and interest payments, Mr. Blaschka said. Because the commercial mortgage-backed securities don't offer such guarantees, few pension funds invest in them.
"They have equity attributes and a low correlation with fixed income. But if you use modern portfolio theory, adding real estate to the mix provides diversity and reduces the overall risk in the portfolio," he said.
Other pension funds that have used commercial lending programs are the New York State Common Retirement Fund, Albany, and the New York State Teachers' Retirement System, Albany. They are appropriate for certain clients, according to Mr. Blaschka, but pension funds that want to run them should be certain they have a fixed-income manager who understands the real estate risk or a real estate manager who is willing to expand his portfolio to include debt, advised Mr. Blaschka.
For San Francisco, it was an attractive alternative to the fixed-income program. "The spreads are still good, and there is less of a risk than there is with junk bonds," said Mr. Blaschka.
"We expect our return to be north of 10%" said Mr. Picket. But the actual returns will depend on how the proceeds from the securitization are reinvested. For now, they are invested in 10-year Treasury notes.
The $100 million in loans were securitized as part of a $225 million deal packaged by Conning. One hundred million dollars came from San Francisco; another pool of $100 million in private loans came from Conning. The remaining $25 million came from AEW.
"We sold our top-rated mortgage loans -- the triple and double A rated loans -- and retained the nonrated and below-investment-grade piece," said Mr. Picket.
As a complement to the program, the system also started a below-investment-grade loan strategy, a separate program giving $50 million apiece to Fidelity Investments and Land Lease to manage.
"It started in December and we expect that to return over 10%," said Mr. Picket. He plans to recommend a higher allocation.
The key to doing these kinds of investments is hiring highly specialized managers who understand the underlying loans, he emphasized. "Our managers have been able to pluck out gems. That's how we have been able to add value."