Q+A WITH MARK HERNE – FPCAs

In this interview, Mark Herne explains the term “Flight Plan Consistent Assets” and how they can help pension schemes along their path to full funding. Mark is a managing director of investment consulting at Redington.

Flight Plan Consistent Assets (FPCAs) – how do you define them and what are the key characteristics?

I have never been a fan of the term FPCAs, it just happens to be a useful catch all expression for us. A “flight plan” goes in hand with the theory of a “glide path” or “journey plan” of some description. In a nutshell, they are those assets that do a couple of things.

Firstly, they display characteristics which are generally quite similar to parts of the typical pension scheme’s annuity-type liability. They don’t need to display all financial characteristics – interest rates and inflation sensitivity – and longevity, although indeed there are some “FPCAs” that do display some quite nice longevity attributes.

Secondly, not only do they have a high correlation to typical long-term liabilities of the type you would see in an annuity book or a pension scheme, they also exhibit an interesting return profile which is best characterised as a component of credit risk and illiquidity risk. Together this means you can generate returns from these assets that you would expect to be broadly consistent with the minimum required return that are needed within your flight plan. Hence, “Flight Plan Consistent Assets.”

So they have the 2-pronged benefit of providing enhanced yield for relatively limited risk, given that long-term liabilities themselves are relatively illiquid, and relatively remote credit risk. The reason credit risk is remote is due either to security available, or because of the fact they are fundamentally sound and structurally robust, and in many instances, if not all, they are also secured. So that all comes nicely together.

So what are typical examples of FPCAs?

They could be multiple things. I think the moniker lends itself to many asset classes. The ones we typically tend to associate with FPCAs have not just long-term duration but, in particular, long-term credit duration. Sometimes, although not necessarily the case, they will exhibit explicit inflation in various manifestations by which I mean RPI, potentially also CPI. Interestingly, assets with a property type bent may also have a manifestation of LPI, in particular a 0% floor. A lot of property type assets have what is known as an “upwards-only review pattern” with respect to the coupons or the cashflows which come of them. Often the property market doesn’t actually price that the way the financial markets would price that floor.

Would you say the assets are generally less correlated to the market environment and financial risks?

That’s an interesting one, let’s just take a step back. Classic examples of FPCAs will include ground rents, social housing (debt in particular), infrastructure debt, long-term secured leases on commercial property, long-term commercial mortgages and so on. What you raise is an interesting point in so far as how these assets are of value or should be looked at. I think that’s a whole separate argument and there’ll be lots of debates around that.

It would be fair to say that, for example the property market will not necessarily take the same view of how an asset might be valued on a “financial markets” , or risk factor basis. The question then comes down to if one buys these assets how do you capture the correlation to your liabilities if they are priced, for example, all off a conventional property metric? In other words, if the price of the asset is not sensitive to movements in underlying interest rates, movement in the gilt curve for example, or indeed inflation or credit spreads, how can you effectively take all of the benefits that they purport to offer to a pension scheme or annuity fund?

I think there are a number of schools of thought on that and I don’t think anybody is necessarily right or wrong. Just because conventional practice exists does not mean it is necessarily right.

Are these assets usually debt or equity related, listed or unlisted?

They can be either debt or equity, unlisted typically. It really somewhat depends on where the relative value is and what is available at any given time. While these assets do exist, they’re not usually in great supply. There is a need to be opportunistic.

Many schemes will try to place these assets under a traditional Growth or Matching portfolio, where do FPCAs typically fit in against those?

The whole Growth v Matching thing is convenient for purposes purely of labelling but, at the same time, it’s not particularly helpful because probably the best way to look at a pension scheme is in terms of risk factors with respect to both assets and liabilities. The point here is that with FPCAs, given their illiquid nature, you are earning an almost equity risk type premium. It would not be unreasonable to expect a Gilts+3% return in the current market, again depending on which asset one goes with. Your returns may be less, they may be more.

The point is you are getting what is typically seen to be Growth type premiums. Yet, on the other hand, the characteristics in terms of the fundamental cashflows which come off these assets, which are very bond like, exhibit a sensitivity to the market and therefore a sensitivity to the liabilities. So they’re a bit of a hybrid really.

Essentially you have a Return asset with a Matching style risk characteristic?

Exactly. Consider, for example, Aviva Investors REaLM suite of these types of assets where REaLM stands for “Return Enhancing And Liability Matching”. There are other funds, too, of course offered by different managers who increasingly recognise the value in this space.

When talking about these assets to potential investors, what sorts of questions do they typically ask?

They are not new by any stretch of the imagination; it’s just that historically they have been principally funded by banks on a short-term basis. As a result of changing regulations, in particular from Basle II to Basle III, the capital considerations that a bank needs to put against these long-term assets makes it uneconomic for them to fund in the way they historically have been. We hope that funding void will be filled by the likes of pension schemes and annuity funds, and the wider “shadow banking community”. Increasingly we are seeing that sort of activity.

So the questions that typically tend to get asked ask are along the lines of “Why haven’t we seen these assets before?” “Where’s the free lunch?” There is no free lunch, you just have to accept that you cannot readily liquidate these assets and THAT’S why you get the return. To the extent that you can liquidate, then guess what, you don’t get the illiquidity premium and as a consequence you’re not going to get the returns that you need.

Beyond that it comes down to technicalities like “How do you value them?” and “How do I access them?” A lot of people are interested in the idea but, at the same time, are mindful of the fact it often takes quite a long time to acquire the assets.

Another is “How to implement?” although increasingly there is evidence of a number of asset managers now running funds that offer these kinds of underlying assets. For example, M&G have a number of different products – secured property income fund, social housing debt fund, hopefully in short order a ground rent fund, and others such as a commercial mortgage proposition which they are potentially looking to partner with selective larger pension scheme investors. Equally we talked about the Aviva Investors REALM suite so increasingly they are being made available in an “investor-friendly” way.

If you look at countries like Canada and Australia, their pension funds have been investing in infrastructure for a number of years. How do you think UK understanding compares against them given that they are also competing to get hold of the same assets?

Inevitably there is a first mover advantage although we shouldn’t get necessarily drawn into a conversation just about infrastructure because, unfortunately in this country, that has been somewhat misunderstood, in so far as the majority of investments that have been made in a fund-type format are really nothing more than leveraged private equity that is based on an underlying infrastructure project. It’s almost like a preference share.

Yes, it may be be fair to say that one COULD get the attributes one is looking for from such funds but it is not necessarily explicit in the way that we would want them to be, or that you might see from an FPCA. In the infrastructure space more generally, the evidence suggests the relative value would seem to be migrating more towards debt, in terms of risk-adjusted returns, and away from equity.

You were mentioning the change in regulations that are forcing pension schemes to shift toward safer assets. With the illiquid nature of FPCAs, how should trustees deal with that? Do they need to keep a certain percentage within the most liquid assets but then also try to generate extra returns from this illiquid nature?

The majority of FPCAs generate cash on cash which is helpful in terms of cashflow management, making sure that, among other things, members’ benefits are paid. That’s the first thing. The second, but equally important, is that they need to move in-line with the liabilities and be valued accordingly (for example, using market-consistent parameters within a DCF model).
 

In terms of liquidity, the point is that one has to look from an overall holistic perspective so it would be quite reasonable to have liquid assets sat alongside illiquid assets, in the way one has “risky” or “growth” assets sat alongside “matching” assets.
 
Liquidity needs to be very well understood, in particular with respect to collateral management if the scheme has derivative positions. It’s not a simple question to answer but the over-riding factor is that as part of a scheme’s good governance it needs to ensure that, howsoever it is invested, it maintains the requisite level, and a very prudent level at that, of liquidity in order to meet day-to-day demands as need be, and also to withstand in some instances a severe crisis – the so-called tail-end events.
 
[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]