Monday 21 May
9:00 – 11:30 am
The Codrington Room, Corinthia Hotel London
Whitehall Place, London SW1A 2BD
United Kingdom 

 

Over the next several years, it is estimated that European banks need to dispose of approximately €2.5 trillion of non-core assets. The €800 billion “firewall” against sovereign debt default in Europe and long-term refinancing operations (LTRO) have eased liquidity stress among the region’s banks, but has not dealt with their solvency issues.

Like US banks, European lenders bought plenty of lower quality, higher yielding debt between 2003 and 2008 to support leveraged buy-outs, real estate deals and structured financial products. They are now under significant pressure to sell these, and other, assets as a result of upcoming Basel III regulation, the need to reduce reliance on wholesale funding and requirements from the EU and local governments. For the first time, Europe is experiencing a distressed debt cycle of vast proportions.

This presents a compelling opportunity for investors. However some widely believed myths are preventing private capital from investing in European corporate distressed debt.

Banks are unwilling to sell assets at distressed prices due to weak balance sheets

The truth is that a number of European banks are selling distressed assets, but this is not necessarily visible because divestitures are generally less public for a number of reasons. The roundtable will discuss the reality behind this myth, what skills and experience are required to access these sales processes and the size of the actionable distressed debt opportunity.

European insolvency laws make it next to impossible to achieve debt-for-equity swaps

European insolvency laws are varied and complex. Knowledgeable investors carefully select the jurisdictions they work in and know what can and cannot be achieved. The roundtable will compare and contrast legislation in different countries to highlight the most attractive areas and how laws in more difficult countries are evolving.

Unions, laws and culture prevent effective operational restructurings of European companies

Restructurings in Europe are fundamentally different than in the US. European labour laws, unions and culture are important and powerful considerations. We will discuss how it is possible to work constructively with local officials and unions to develop realistic plans which can ensure a company’s long-term viability and maximize employees’ welfare over time while agreeing to appropriate short-term sacrifices.

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Water and how a company manages its exposure to this increasingly scarce resource is a key focus for Norway’s sovereign wealth fund in assessing the environmental and social performance of the more than 8000 companies in its portfolio.

Anne Kvam, the head of Norges Bank Investment Management’s (NBIM) corporate governance team, says the sheer size and scale of understanding the plethora of environmental, social and corporate governance (ESG) risks in its investments demands a focus on a selection of companies and a few key risks. Norges Bank is Norway’s central bank and NBIM manages the Norwegian Government Pension Fund Global on behalf of the ministry of finance.

“If we are to work actively on all 8000 holdings on all environmental, social and corporate governance topics, this would, of course, be impossible,” Kvam says.

“This is why the executive board decided we will have six focus areas and three of those are tied into environmental and social areas, and they are children’s rights, water and climate change. This doesn’t mean that we don’t see that there are many other risks out there that we hope and expect companies to manage.”

NBIM, the asset management arm of Norway’s central bank, is responsible for managing the investments of the $576-billion sovereign wealth fund.

Kvam explains that its investment staff can access an easy-to-handle, one-page report on a company that includes a scorecard of its performance across these three key areas.

The report draws on internally generated information and external research that the asset manager purchases.

Data on these three focus areas is gathered on more than 2000 companies. Broader ESG reporting for the fund covers 4000 companies, representing 80 per cent of the fund’s holdings.

 

Distilling best practice

NBIM has had water as one of these key focus areas since 2009. This includes issuing guidelines for companies it invests in on how they should report and manage water risk.

Under these guidelines, companies are expected to have a water-management strategy that evaluates the extent of water use in the production process and, more broadly, in a company’s supply chain.

Companies are also required to report on how its water use affects surrounding communities and how water risk management is built into corporate-governance processes.

NBIM reports that it is invested in several sectors with high water consumption. It has determined seven sectors particularly exposed to water-related risk: agriculture, food, manufacturing and power, mining, pharmaceuticals, pulp and paper, and water supply.

The fund has identified 1100 companies where water is an important input and output factor and these companies have a combined market value of $46.1 billion.

Kvam says that NBIM has narrowed its analysis of water risk at the companies it invests in to 447 companies selected from these high-risk industries.

These companies represent the largest holdings for the fund across these chosen sectors.

It reports annually on these companies in its Sector Compliance Report, which aims to encourage better reporting practices across industries, as well as identify top performing companies for disclosure and management of water risk.

The report notes that: “despite a notable increase, companies’ reporting on relevant metrics that track their exposure to water-related risks and the performance of their water management systems was still too low.”

The forestry and paper sector had the highest level of disclosure whereas companies in the mining and industrial sector had the lowest.

“We are dependent on companies disclosing good relevant information so we can make good investment decisions and good calls,” Kvam says.

Nestlé, Anglo American, Anheuser-Busch InBev and Danone were among 14 companies with the highest marks for reporting on water-related risks in 2011.

GlaxoSmithKline, Kellogg, Kirin Holdings, Merck & Co, Molson Coors Brewing, PepsiCo, Pfizer, PG&E, SABMiller and Sanofi were also top performers.

Of the 447 companies assessed in this area, 32 per cent scored zero.

“It is common to name the worst performers as a kind of naming-and-shaming part of ESG, but we are trying the other route by naming what we think are the best performers and who are the best at disclosure,” she says.

The global scarcity of water continues to make headlines, but a water-themed investment approach is only just starting to make waves with large institutional investors.

Estimates of the assets in equity funds in this niche corner of the investment world vary from about $3 billion to $6 billion in funds under management – a veritable drop in the ocean in terms of the asset management world. However, proponents of a water-investment strategy are seeing a surge in interest from large institutional investors.

Mechanical and biomedical engineer Bill Brennan is also a portfolio manager at Summit Global Management, the oldest and biggest water-focused investor in the United States.

Summit’s founder John Dickerson has been investing in the water sector for 40 years and launched a hedge fund more than 12 years ago.

The hedge fund tracks an investable universe of 405 companies involved in what it describes as “hydro commerce”.

Industry estimates put the total global investable opportunity set, across all asset classes, as somewhere between $360 billion and $700 billion.

Companies Summit invests in typically have a 30-per-cent or greater direct exposure to water and ideally generate more than half of their revenues from the water industry, according to Brennan.

He says that some long-term focused investors who previously classed water investments as part of their natural resources, commodities or infrastructure asset classes are now beginning to think of it as a discrete asset class.

“This industry has gone from being a sideline to becoming a recognisable, investable theme and really a line item with the consultants,” Brennan says.

“Before you could chuck it in resources, natural resources, commodities and for some reason it wasn’t a perfect fit. Now people are taking a look at single-line item water investing as part of the overall asset allocation.”

Brennan notes that Summit’s team is made up of water-industry veterans, not just financial analysts, because understanding the interconnectedness of the industry, as well as its unique risks, is vital to investment success.

“It is one of those things where people looked to see how the water-investing industry would evolve and they needed time to better understand the underlying nuances. It is not just financial analysis that you need, it is a grasp of the engineering, the political and regulatory landscapes.”

Summit has around $425 million in assets under management, split evenly between its water-focused equities and a water-rights fund invested in the US and Australia.

 

How the water funds flow

Typically, corporate pension-fund investors have been those already in the water industry, says Brennan, but this is expanding with sovereign wealth funds in particular, showing growing interest in water.

Recent headline-grabbing forays into water investing by sovereign wealth funds include the Chinese Investment Corporation snapping up more than 8.68 per cent of British water utility Thames Water, the utility that supplies water to households in London and the Thames Valley, an area of 5000 square miles. This follows a 9.9-per-cent stake bought by the Abu Dhabi Investment Authority in December.

Norges Bank Investment Management, the asset manager for Norway’s sovereign wealth fund, also invests heavily in water as part of its 21.1-billion-Kroner ($3.65 billion) environmental-investments program.

Three of its 10 environmental-investment mandates cover water, mainly focusing on companies that develop technology and infrastructure for its treatment and distribution, often in emerging markets.

Water also forms part of Norges’ overall investment strategy and is recognised as one of its six key risks.

For water investors, the crisis in Europe has resulted in a short-term hit to portfolios but may result in long-term opportunities.

Water stocks were hit hard as the Euro crisis caused markets to tumble in late 2011. However, investors are seeing the potential for attractive opportunities as countries running austere budgets look to privatise their water utilities in the coming years.

In Europe one of the longest water-focused managers is Kleinwort Benson Investors (KBI) whose 11-year-old Water Strategy equity fund has attracted more than $600 million in assets under management.

Matt Sheldon, portfolio manager for KBI environmental strategies sees investors using the fund in a number of ways to compliment other exposures in their portfolio.

“There is no obvious bucket, there is no global asset allocation that has a slice called water,” Sheldon says. “So, it fits into a lot of different places like global equities. Think about it as mid-cap, core, global equities with an emerging-market component to that. But it also fits anywhere from infrastructure to alternatives to inflation protected to sustainability. These are the other niche slices that our clients are slotting it into.”

The fund holds 45 stocks, with a 13-per-cent direct exposure to emerging-market companies. However, when developed-market companies that generate a large proportion of their revenue from emerging markets are included into the picture, the exposure of the fund to emerging markets rises to about 30 per cent, according to Sheldon.

KBI invests solely in water equities and has other funds focused on agribusiness and renewable energies. Sheldon says that investors also look to its water fund as a potential sustainability diversifier, as it has a low correlation to its renewable energy fund.

Benson and Sheldon point to the capacity of their funds to beat the broader market over the long-term. KBI Water Strategy has beaten its benchmark MSCI World Total Return Index by an average of 4 per cent since inception. Over three and five-year periods, it has returned 22.92 per cent and 1.39 per cent, respectively, compared to its benchmark return of 20.78 per cent and -0.14 per cent over the same time periods.

Summit did not directly provide performance figures, but marketing material shows that it has achieved an average compound annual return of 9.5 per cent since inception, compared to the S&P 500 TR at 2.3 per cent and the Russell 2000 TR at 6.4 per cent.

 

Overflow

Sheldon and Brennan acknowledge that water stocks are not immune to market downturns.

Water-industry research firm Global Water Intelligence notes that its 2011 year-end figures for its global water index showed a 5-per-cent fall in the value of water stocks.

There is a silver lining in the storm clouds of market uncertainty for Brennan and Sheldon.

Long-term valuations are attractive for water stocks, pointing to underlying fundamentals – the growing need to replace ageing infrastructure, increased water needs from industry and the push for water security by India and China – as potential drivers for growth.

“The cycle has turned from the 2008 financial-crisis weakness. We’re just to the right of the trough, but we are still years away from the peak,” Sheldon says.

Summit’s analysis shows that water-utility and industrial-stock multiples are respectively trading about 17 per cent and 18 per cent below their seven-year averages.

KBI’s own analysis points to similar attractive valuations.

“Current valuations of the fund are the cheapest – on an absolute and relative basis – since inception and certainly over the last five years. The fund is about 13.5 times our next 12-month earnings and 12 times calendar year 2013,” Sheldon says.

Usually KBI splits its fund’s exposure evenly between water infrastructure, technology and utility companies but recently has tilted the portfolio to a bigger play at infrastructure companies.

This reflects a bullish outlook for infrastructure spending, with Global Water Intelligence’s research showing that capital expenditure on water infrastructure is expected to grow to $131 billion in 2016, up from $90 billion in 2010.

For KBI it also indicates a growing confidence in what Sheldon describes as infrastructure companies focused on supplying late-cycle water-infrastructure products and services for particularly large projects.

This might involve, for example, water-pump manufacturers supplying a refinery or a water-treatment company providing specialty skills and equipment to a new power plant.

“The visibility of these kinds of projects is very good, as they are multi-billion-dollar projects that have been in planning and, from inception to completion, could take five to 10 years or even longer,” Sheldon says.

“By the time our companies are beneficiaries, there have already been a number of others – from engineering and design companies through to construction companies.”

 

Pipes, pumps and water rights

The infrastructure component of the portfolio was the best performing component of the fund last year. It makes up 41.9 per cent of the portfolio.

Brennan also sees opportunities for infrastructure, not only in the need to replace ageing hardware, but also more broadly as urbanisation trends across the globe continue to gain momentum.

In the US alone, the American Society of Civil Engineers says that that in 2010 alone there was a $54-billion gap in the funding required to maintain and meet the country’s water needs. It predicts this gap will grow to $80 billion in 2020.

In emerging markets, India and China have comprehensive five-year plans around improving water security. In China this would amount to more than $128 billion in new spending.

Brennan says that concerns around corporate governance standards have stopped it investing in Chinese companies. But it accesses China’s growth opportunities through Japanese companies with a China focus and Hong Kong-listed companies that must meet higher reporting and governance standards.

New industries are also seen as potential drivers of growth.

The shale gas industry in the US is notoriously water hungry, and Brennan says this provides opportunities both for water companies that service these new projects and the holders of vital water rights in shale gas reserves.

Brennan says that the Summit fund focuses its water-rights business in American states where there is an established water-rights trading regime, in some cases going back more than 150 years.

These include Colorado, New Mexico and California.

It is also undertaking a long-term strategy of owning water rights in close proximity to large shale gas deposits in the Rocky Mountains around West Texas, New Mexico and Colorado.

 

Supposedly long-term investors typically have the patience to wait about three years to see if an investment strategy will pay-off with managers needing to manage to their own and their client’s career risk tolerance, investment icon and Grantham, Mayo and van Otterloo (GMO) founder Jeremy Grantham says.

In his quarterly letter to investors, Grantham says GMO believes that what it calls “standard client patience time” is three years in normal market conditions.

“With good luck on starting time, good personal relationships and decent relative performance, a client’s patience can be a year longer than three years, or even two years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience,” he says.

“The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.”

In his letter Grantham notes that the central truth of investing is that investment behaviour is driven by career risk.

According to Grantham, career risk results in herd mentality and market momentum that creates market volatility and, ironically, the opportunities for investors like GMO to beat the market by betting against irrational bull markets.

He believes that career risk explains the wild movement of stock markets relative to the fundamentals underpinning those markets.

Grantham’s reputation as an investor was built around picking these so-called moments of market irrationality, in particular the 2001 dot-com bust and the global financial crisis in late 2008.

He notes that clients show “little mercy” to managers who underperform as boom markets peak and points to GMO losing 40 per cent of its clients for running a relatively underperforming defensive strategy in the lead-up to the tech bubble bursting.

According to Grantham, GMO were two to three years too early in picking the price bubbles in the 1989 Japanese stock market and the subsequent tech bubble 11 years later.

“Picking cash or “conservatism” against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise,” he says.

“It simply cannot take the risk of being seen to be wrong about the big picture for two or years years, along with the associated loss of business. Remember, expensive markets can continue on to become obscenely expensive two or three years later, as Japan and the tech bubble proved. Thus, because asset-class selection packs a more deadly punch in the career- and business-risk game, the great investment opportunities are much more likely to be at the asset-class level than at the stock or industry level.”

 

Do not underperform in bear markets

Grantham advises that investors can survive betting against bull market irrationality if they meet three conditions:

  1. Allow a generous margin of safety and wait for a real outlier before making a big bet
  2. Try to stay reasonably diversified
  3. Never use leverage.

He explains that GMO has to manage to career risk, leaving clients’ pain “just tolerable” and typically tries to leave the portfolio looking “faintly normal” when positioning investments for the end of the an irrational bull-market run.

“Too big a safety margin and we are leaving too much money on the table. We are probably protecting our jobs rather than attempting to maximise our clients’ return,” he says.

“Too narrow a safety margin and clients may fire us, as some have done in the past.”

Grantham’s letter comes as GMO launches its Benchmark Free Allocation Fund on a stand-alone basis. The fund was previously part of GMO’s real return strategy and is an open-ended fund with an objective to provide a positive return regardless of market direction. Year to date, the fund is up 4.71 per cent, and over three and five-year periods, it is up 11.5 and 5.56 per cent, repsectively.

The benchmark-free strategy allows GMO to take bets when markets are overpriced without being constrained by a benchmark, which Grantham says entails its own risk of being swept up in major market downturns.

A conservative investor constrained by a benchmark can relatively outperform in a market downturn but still make a loss in absolute terms.

The benchmark-free strategy looks to protect capital during downturns and provide returns with lower volatility over the long term.

“The cardinal rule is to not underperform in bear markets,” Grantham says.

 

The angst in Europe has calmed down, relatively speaking, but according to Mercer, it will be a long haul, with deleveraging there and in the US taking many years. Investors need to act accordingly.

Part of the problem is that conventionally safe assets, such as US Treasuries, are expensive.

“That will take years to work through and investors need to work assets hard in different ways. For example bond investors need to look outside of the core to a broader range such as private markets, anything that produces an income,” Mercer’s global chief investment officer, Andrew Kirton, says. “This requires thinking more creatively to behave more dynamically.”

Kirton believes there is a role for specialist managers in unique asset classes such as high-yield bonds or private markets, and Mercer has invested in boosting its research coverage of alternatives.

A decade ago bond investing was relatively straightforward, Kirton says, now there is a new product or investment strategy every month.

“It’s a very exciting time. While it remains a challenging time, it is not without opportunity.”

Kirton is encouraging clients to think laterally, to get out of their comfort zone.

“I say to investors they need to be prepared to look at assets that are less familiar to them.”

The biggest mistake investors can make is to lose sight of their objectives, Kirton says.

“Keep a careful eye on the risks to not achieving your objectives in a world where there will be more shocks,” he says. “Look at risk-management issues and the journey you’re on.”

Global head of fixed income at Mercer, Paul Cavalier, says the safety of fixed income has been called into question.

This is especially so in credit markets but also sovereign debt, he says, adding while it is a mistake to call the asset class risk-free, it can still be branded least risk.

The three elements of fixed income

Mercer is advising that fixed-income portfolios need three elements, with the exposures to each varying according to each client’s individual needs.

  1. An absolute-return portfolio that looks at all types of fixed-income alpha.
  2. A core structure in the middle that includes government debt.
  3. Satellite investments, which include emerging-market debt, high-yield debt such as bank loans, and credit opportunities.

 

Beware the benchmark

One of the consequences of the upheaval is investors need to be more cognisant of the benchmark composition.

“Over the past few years benchmarks have come into question, first in credit then in sovereign. In credit, financials represent 40 per cent of the benchmark, which is a large percentage, but financial credit operates differently to industrials. Investors have to understand what they’re getting into.”

The result is that indices are being split, and customised portfolios, such as credit ex-financials, are being built. This happened in equities 20 years ago, he says.

The inherent volatility can be observed by looking at yield levels on indices, Cavalier says.

“In December 2006 the global aggregate index was yielding 4.25 per cent and the US Treasuries 5 per cent; in December 2011 the global aggregate index was yielding 2.25 per cent and the US Treasuries 1 per cent. Is that what people expected?” he says.

“Further, during that period the emerging-market sovereign-debt local-currency index has traded at between 6 and 8 per cent the entire time, so there is a bubble in the risk-free assets.”

Cavalier is a proponent of an emerging-market debt allocation and says there is better value in emerging-market debt than developed-market debt, pointing to better growth, better debt to GDP and ratings upgrades.

“In the developed world the downgrades are outpacing the upgrades, but last year in emerging markets there were 17 upgrades and only 3 downgrades. All indicators favour emerging markets,” he says.

It is Cavalier’s view that fixed-income exposures should not be organised by regional diversification, but different asset classes, with the liquidity premium more important than ever, especially in credit.

“Dynamic asset allocation needs to focus also on illiquid markets – private debt, for example – and giving up liquidity for long-term return. Banks are out, now institutional investors play a role as patient capital.”

Cavalier, who managed money for an asset management firm for 22 years, advises investors to consider specialist managers rather than generalists who can do everything.

Asset management is not a profession he envies in the current environment: “I’m glad I’m a consultant not an asset manager at the moment, I can take a step back.”

Jim Keohane’s first annual results as chief executive of HOOPP have been satisfying. The fund returned 12.19 per cent in 2011, a result well above its peers. It is 103-per-cent funded, and has reached assets of more than $40 billion for the first time. However, he says the unique investment approach and structure that has allowed the fund to reach these heights has been more than 10 years in the making.

The Healthcare of Ontario Pension Plan (HOOPP) has a large derivatives program, amounting to more than 1500 positions worth about $200 billion. The worth of its net assets available for benefits is $40.3 billion.

This unique approach to investing – using its balance sheet as an asset – has enabled the fund to remain fully funded throughout the global financial crisis, an enviable position among its peers.

Chief executive of the fund, Jim Keohane, who was chief investment officer for 10 years before taking up the top job, says HOOPP is clear about its investment strategy and its strategic advantage as a long-term investor.

“We don’t have any strategic advantage in security selection. Where we do have a strategic advantage is we are creditworthy, have a large balance sheet and low liquidity needs. We can find strategies that we can do that others can’t, and that is often non-traditional,” he says.

According to Keohane, the external environment is in the biggest state of flux since he’s been in the pension business.

“There has been high market volatility, low interest rates and changes in government policy. Pensions are on the front page and will be for some time to come.”

Keohane says the fund has been positioned fairly well in this environment, and some of the actions of the past few years to restructure the portfolio have meant it could take advantage of the opportunities as well.

“We have done a lot of long-term option writing. We saw an anomaly had been created, there had been a lot of annuity sold but they hadn’t hedged them. These options provided equity-like returns with nowhere near the risk.”

 

Clear objectives: split and divide

The HOOPP investment portfolio is divided into two: a liability-hedging portfolio and return-seeking portfolio.

Within the liability-hedging portfolio there is a large weighting to long-term bonds as well as real-return bonds and real estate. The investment strategy is to hedge the liabilities, but it also turned out to be a source of 2011 returns.

The fund entered the international real-estate market last year, closing its first deals in the UK and the Czech Republic.

In the return-seeking portfolio, managed by Jeff Wendling, the fund gains equity and credit exposures through derivatives.

The structure of HOOPP’s investment process is most akin to the Danish ATP, which also divides its portfolio into two separate portfolios.

The difference is that ATP uses derivatives for fixed-income exposures and cash for equities exposures, while HOOPP does the reverse.

“ATP does the reverse of us. They use interest-rate swaps to hedge the liabilities and use cash to fund the return-seeking portfolio. We do the reverse, use derivatives for equities exposure, because there is not a well-developed interest-rate swap market in Canada.”

The fund has a list of approved counter parties, which Keohane says can be up to 15 investment banks, and it has a team to manage the credit and collateral management very tightly around that. It has also been cutting-edge in setting up the systems to support that.

Over the past few years the previous chief executive, John Crocker, oversaw the spending of more than $100 million in technology.

The result is a sleek operating system for both investment and administration that will save costs in the long run.

“We spent the money to get daily price feeds on everything we trade, we mark to market daily,” Keohane.

He sees this technology and the particular in-house expertise necessary, as one of the barriers to other funds investing the same way.

“Developing some core in-house expertise is a barrier to others investing the way we do. For example, [with] cash management and collateral management and managing the balance sheet, we have a treasury function similar to a bank. The fund started using derivatives in 1999, it’s taken about 13 years to get where we are.”

Keohane says having very clear objectives of what it is trying to achieve is a key driver of the fund’s success.

HOOPP’s vision is that all healthcare workers enjoy a financially secure retirement. Its mission is to deliver on the pension promise, and it is driven by the values of professionalism, accountability, collaboration and trustworthiness.