DB plan assets in alternatives growing slower

Illiquid real asset investment strategies, energy and distressed debt had the most growth among the non-hedge fund alternative investment strategies, in the year ended Sept. 30, according to the findings of Pensions & Investments' top 200 retirement plan survey.

However, fewer alternative investment asset classes showed double-digit growth than the year-earlier survey. Unlisted assets in the real asset category were high fliers this year. Energy continued its rapid growth rate, up 59% to $11.9 billion after rising 67% in the survey for the year ended Sept. 30, 2012. Real estate equity was up 10.5%, to $259.9 billion, echoing its year-earlier growth rate; and infrastructure increased 6% to $8.5 billion, slowing from the year-earlier 25% hike.

Listed real asset investments did not fare as well, taking investors on a roller-coaster ride. Assets invested in real estate investment trusts dropped 8% to $20.6 billion and commodities were down 6% to $23.2 billion. In the survey for the year ended Sept. 30, 2012, REITs had gained 30% and commodities, 20%. Investors were diversifying out of asset classes with equity exposure, which includes REITs. What's more, investors that had piled into commodities for safety, left the asset class as the dollar began to recover in 2013, consultants say.

“Commodities don't do well when the dollar is going up because a lot of commodities are dollar-based,” said Tim Ng, managing director of New York-based consulting firm Clearbrook Global Advisors LLC.

Also, investors invested in commodities like gold as a “safe haven” and a surrogate for the U.S. dollar, Mr. Ng said. Investors moved out of gold when the dollar strengthened.

Another growth investment was distressed debt, which was up 37% to $25.4 billion. (Distressed debt was a new category in the survey for the year ended Sept. 30, 2012.) “Distressed debt investing is a direct reaction to the prospects of Fed tapering,” said David Fann, president and CEO of private equity consulting firm TorreyCove Capital Partners LLC, San Diego.

Returns tell part of the story in many of the asset classes. In real estate equity, however, it is the whole tale. For the 12 months ended Sept. 30, the NCREIF Property index was up 11%, the same percentage increase as the prior 12-month period.

REIT returns slowed during the period. The FTSE NAREIT All REITs index was 5.14% and the FTSE NAREIT All Equity REITs index was 6.23%.

“It was quite a year: equity REITs gained 18.51% from the end of September 2012 through April 2013, outpacing the broad stock market again,” said Brad Case, senior vice president, research and industry information for the Washington-based National Association of Real Estate Investment Trusts, in an e-mailed response to questions. “Beginning in late May, however, equity REITs went down sharply and had lost 1.34% through August before regaining 3.43% during September.”

The drop in investment by the largest U.S. defined benefit funds over the 12-month period is most likely due to their liquidation of REIT holdings, he said.

Last year, investors were less worried about inflation protection, said Mark Ruloff, director of asset allocation in the Arlington, Va., office of Towers Watson & Co. At the same time, investors were diversifying out of asset classes with equity exposure such as private equity, venture capital and REITs.

Most investors have “way too much equity exposure,” Mr. Ruloff said.

“REITs are still an equity exposure and investors are diversifying into other areas,” agreed TorreyCove's Mr. Fann. “If you're in REITs, you are probably better off in real estate.”

Still, real estate equity's growth has been “slow and steady,” said Jeffrey Havsy, Chicago-based director of research at the National Council of Real Estate Investment Fiduciaries.

The California Public Employees' Retirement System, Sacramento, retained its top spot of defined benefit plans reporting real estate equity. Its assets rose 16% to $25.9 billion. The West Sacramento-based California State Teachers' Retirement System was in second place for yet another year, with its assets rising 1.6% to $22.2 billion.

Much of the increase in CalSTRS' real estate portfolio was due to valuations, said Ricardo Duran, spokesman for the fund. Also, the pension fund's real estate investment managers sold more properties than they acquired, he said.

During the survey period, pension fund investors in real estate started putting assets into higher yielding properties, said Timothy Kessler, principal and managing director at Chicago-based real estate consulting firm FPL Associates LP. Also, investors became more willing to invest outside the U.S. for the first time since the financial crisis. P&I's data bolster that view: Real estate equity assets invested outside the U.S. by DB plans in the top 200 increased 9%, to $28 billion, during the survey period.

Private equity investments of defined benefit plans within the P&I universe remained flat or dropped. Private equity assets of CalPERS were down 3% to $31.3 billion from $32.3 billion. But CalPERS still had the largest private equity portfolio reported in the survey, followed by CalSTRS with $21.8 billion, down less than 1% for the survey period.

“Many large pensions have "maxed out' on their private equity exposure,” said Mr. Fann. “Private equity is suffering the problems of a mature asset class. Most large pension funds ... are concentrating capital with their best performers. They are not adding managers, in some cases, they are aggressively cutting.”

For example, the $282.7 billion California Public Employees' Retirement System, Sacramento, plans to trim the number of private equity managers to less than a third of the 389 managers now participating in the $42 billion program.

Commodities were popular when investors thought the markets would potentially crash. In 2013, investors were more confident about the markets and “reducing commodities is part of that play,” Mr. Ruloff said.

Topping P&I's list of the investors with the most assets in commodities once again was CalPERS, with $3.54 billion in commodities. While that figure is a slight increase from the year-earlier $3.45 billion, many of the other defined benefit plans on this year's list are showing reductions. For example, the Pennsylvania Public School Employees' Retirement System, Harrisburg, dropped to third from second, reporting a decline of nearly 19% to $1.899 billion. And the New Jersey Division of Investment, Trenton, while assuming the No. 2 spot, also is reporting a drop, of 8% to $1.9 billion.

One of the biggest winners among the alternative investment asset classes was energy. Some investors are moving into illiquid energy investments because they are worried about the long-term use of natural resources, Towers Watson's Mr. Ruloff said.

What's more, the investment opportunity is tied to the vast reserves of domestic natural gas, horizontal drilling and hydraulic fracturing, said Mr. Fann. “We believe the capital requirements (for those industries) will exceed $100 billion per year for the next many years,” Mr. Fann said. ”What's interesting is almost all of the large private equity platforms have hired energy teams, and in many cases, are raising energy specific funds.”

Many investors also are gaining energy exposure through their private equity funds. Kohlberg Kravis Roberts & Co., Blackstone Group and Apollo Global Management LLC are all investing in the sector through generalist funds.

In May, Apollo rocked the sector, leading a $7.15 billion leveraged buyout of North American oil and gas producer EP Energy from El Paso Corp. The investment group included energy-focused private equity firm Riverstone Holdings LLC as well as three limited partner co-investors. Apollo's funds invested $1 billion, the co-investors invested a total of $800 million, and the other partners invested the remainder of the $3.3 billion in equity needed for the deal.

Topping the list of defined benefit plans reporting energy investments was the Pennsylvania school employees' fund. Its portfolio skyrocketed 109% to $1.5 billion in the year ended Sept. 30. In March, the pension fund added a percentage point to its now 3% master limited partnership allocation.

The Minnesota State Board of Investment, St. Paul, which had led the ranking a year earlier, is now in the second slot, with its energy assets growing 13% to $1.13 billion. In 2012, the pension fund added a separate allocation to master limited partnerships.

New to P&I's energy list is fifth ranked Ohio Police and Fire Pension Fund, Columbus, with $697 million in energy assets. In December 2012, Ohio Police & Fire Pension Fund added a 5% allocation to master limited partnerships.