October 21, 2016
Interviewed by: Matt Malone
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Why Your DC Plan Should Include PE & Real Estate

The nature of defined contribution pension plans is complementary to private equity real estate. The hard part is convincing plan sponsors that diversifying their portfolio to include private equity will benefit them in the long run.

The nature of defined contribution pension plans is complementary to private equity real estate. The hard part is convincing plan sponsors that diversifying their portfolio to include private equity will benefit them in the long run.

Why Your DC Plan Should Include PE Real Estate
With Robert Collins of Partners Group and John Payne of Heitman

Matt Malone, Privcap: Hi, I’m Matt Malone from Privcap. I’m very happy to be joined today by Robert Collins of Partners Group and John Payne of the Defined Contribution Real Estate Council and Heitman. Welcome, gentlemen.

Robert Collins, Partners Group: Thank you.

John Payne, Heitman LLC, DCIIA: Thank you. Great to be here.

Malone: Today, we’re going to talk about defined contribution plans in the context of alternatives. What’s a pitch to a DC plan sponsor in terms of the desirability of alternatives and the benefits of having access to those investments in a DC plan?

Payne: First of all, the pitch starts with real estate as the third-largest asset class. It’s a proven investment class that has been long utilized by defined benefit plans, sovereign funds, in leading investors globally, but it’s really non-existent in the DC world. Real estate really presents fiduciaries with an opportunity to pursue improved outcomes through the benefits that private real estate brings to the table, namely extended diversification, stability of income yield and the potential for inflation protection.

Malone: What about DC plans makes them particularly well-suited for alternatives allocation?

Collins: I think private equity fits extremely well with defined contribution plans. If you think about the long-term nature of a retirement program for any employee, it’s congruent with a longer-term equity allocation. And many of the people we’re speaking with actually view private equity as just another type of equity. Not necessarily an alternative, but an essential part of their investment program.

I think the challenge has been how do you bring those benefits to the defined contribution market, which has been really built around a system that requires certain characteristics that you haven’t found in traditional private equity markets? For example, daily net asset value or daily liquidity.

Malone: Let’s talk a bit about those issues, about liquidity valuations. How are some of those challenges being addressed right now?

Payne: The DC industry really grew up with the mutual-fund vehicle, so embedded in the DC system is the notion that participants need to have daily valuations and daily liquidity. For an asset class like private equity or private real estate, at least at this point in time, our industries have to bend to the current realities of the DC marketplace.

In the private real estate space, that’s been solved by a series of products that have come to market, offering allocations to private real estate, typically combined with a liquidity buffer comprised of real estate securities. Those allocations tend to be 85 percent/15 percent or 75/25 and it’s that liquidity buffer that really offers the normal day-to-day operations to occur within the context of a DC plan.

Malone: I think we’d agree that private equity might be a little farther behind in terms of addressing the DC plans with “problems,” but for a private equity fund to be able to have that sort of liquidity, how far along are we? What are some of the solutions being looked after?

Collins: There is an enormous amount of collaboration going on—not only within private real estate but in private equity—to develop some industry standards and approaches to addressing some of these challenges within the DC environment.

When it comes to liquidity, not only is the private equity market taking a similar approach in terms of having a bit of a hybrid model—a core portfolio of private equity investments with some listed or liquid securities—but within that core private equity portfolio, many members of the Privcap audience would recognize that there can be a significant amount of liquidity. There is a significant amount of liquidity within private equity portfolios, if they are constructed in a certain way.

For example, if you have a mature portfolio that consists not only of partnership, commitments or investments, but also direct investments, equity and debt—if you’re able to utilize different segments of the market such as the secondary market, where you can buy existing portfolios of assets, you can take a different approach to duration or liquidity than if you were just solely investing through fund commitments or primaries.

Malone: The whole benefit of having a long-term asset class is that it’s patient capital that can improve operations, improve an asset and generate above-market returns. What, to that point, of this balance of providing liquidity and its impact on returns?

Payne: One thing we’re seeing in our conversations with some of the industry’s most sophisticated plan sponsors (particularly large, mega-sized DC plans that have custom target-date funds, for example, where they’re beginning to extend diversification with the use of alternatives) is that they’re becoming more and more comfortable managing liquidity elsewhere in the portfolio. If you take a look at the early versions of the private real estate solutions that came into the DC market five or 10 years ago, they had high liquidity buffers, typically 25% or 35%. We’ve seen that come down dramatically over the last couple of years.

Collins: You also have a number of sponsors that are developing white-label solutions and we would see a private equity solution being incorporated within those formats. The same, I believe, [is true] for private real estate, and not as a single line item that an employee would be investing in and managing himself or herself. That’s an important aspect of how these investments are being implemented.

Payne: We talked about the notion of DC capital or DC assets as patient capital and we feel that DC assets represent perhaps the most patient pool of capital in our industry. Right now, that’s being driven to a large extent by a legacy of the Pension Protection Act of 2006, which validated multi-asset default funds. Those outcomes should lead ultimately to better income replacement for those retirees in retirement.

Malone: What about the issue of fees? Going into the investment performance side, obviously one of the general criticisms of alternatives is high fees. How would a DC plan sponsor who’s evaluating alternatives understand the fee structures in relation to the benefits of the alternative asset class?

Payne: I think there’s no question that optically there’s a perception that private equity or private real estate has high fees relative to the DC marketplace. There is a lot of fee pressure in the DC market. But the real focus, from a fiduciary perspective, needs to examine the value-add or the contribution of the asset class to diversifying the portfolio, reducing risk, offering downside protection and perhaps generating a stable income return, with the opportunity for capital appreciation.

In the context of portfolio construction, that needs to be gauged against the incremental cost increase. You’re going to drag that average cost up per participant account up a few basis points, but you may very well outstrip that year over year in terms of volatility reduction, return potential and basically risk-adjusted return improvement.

Collins: When we speak with sponsors, we see them taking very much a barbell-type approach. They’ve been able to experience significant fee savings for their public equity portfolio; we see those portfolios being implemented more and more in a passive manner. And what they’re able to do is to take some of those savings and apply that to the other parts of the portfolio, where active management actually makes a difference. Private markets, especially, cannot be replicated. It’s the ultimate activist or active investing. That’s how we see sponsors approaching it.

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