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Findings of Project POOL

Joint Working Group of Local Authorities January 2016

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Contents Page 1 Introduction 3 2 Participants in Joint Working Group 4 3 Executive Summary 5 4 Pooling Options 9 5 Structuring the pools – legal and implementation issues 22 6 Estimated Cost Savings 32 7 ESG & Responsible Investment 38 8 Workstream Chapters 40 8.1 Passive Equity 41 8.2 Active Equity 50 8.3 Fixed Income 59 8.4 Property 64 8.5 Infrastructure 85 8.6 Private Equity & Other Alternatives 105 8.7 Internal Management 118 8.8 Flexibility Around Pools 136 8.9 Regional/Multi-Asset Pools 148 9 Appendices – External Reports 153 9.1 Legal structures – Eversheds Report 154 9.2 Technical issues of establishing a pooled fund - Northern Trust Report 162

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1 Introduction

In the Summer Budget Government asked LGPS funds to put forward proposals to pool investments to reduce costs significantly while maintaining overall performance. In November 2015, the government confirmed the criteria it will apply in the assessment of those pooling proposals: scale, savings, governance and access to infrastructure.

The purpose of this report is to provide government with a joined up response from local authorities who run LGPS funds, setting out proposals which are sufficiently ambitious and will achieve government objectives in a way that also meets the needs of those who administer and manage the LGPS on behalf of the 4.6 million scheme members. The government has required that the assets should be formed into up to six pools with a minimum size of £25bn.

This report has been prepared by local authority officers from participating funds who have collaborated under the banner of Project POOL, supported by Hymans Robertson. Project POOL set out with three goals;

1. to produce an evidence based and objective analysis of pooling options

2. to enable LGPS stakeholders to gather round one or a small number of options which satisfy the Government’s criteria

3. to form a basis of discussion between the LGPS and Government on the best way forward

We are pleased to say that there is broad consensus on the conclusions drawn from our work and the proposals we set out in this report amongst the diverse group of funds who have committed time and effort to collaborate on this project.

Contributors to the report are set out in Section 2. As well as the 24 funds who participated fully as co-authors of the report, another 10-15 funds have given generously of their time and experience on work-streams that have worked intensively to provide the analysis that informed the report.

We are also grateful to others who have supported the work including the fund management community. Eversheds and Northern Trust have provided invaluable assistance on the complex issues of establishing pooling vehicles.

We are grateful for all of this help but above all thanks are due to the LGPS officers who have worked on the various chapters of this Full Report and the Summary Report.

While POOL has had significant support from Hymans Robertson, the local authority participants own the report and its conclusions. The project team, guided by a Steering Group consisting of some of the most experienced practitioners in the LGPS, has reached agreement on the recommendations set out in this report and we are happy to speak with one voice.

We believe that the work we have done together has already informed the discussions now taking place between funds as they work to form pools. It is our hope that it will be useful to all local authorities and elected members involved in the LGPS, and to government, in the period between now and the deadlines for pooling proposals in July 2016, and in the implementation phase that will follow.

On behalf of the local authority officers in the Project POOL Joint Working Group

January 2016

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2 Participants in Joint Working Group

 Bedfordshire

 Cheshire

 Dorset

 East Sussex

 Environment Agency

 Essex

 Gloucestershire

 Greater Manchester

 Hampshire

 Leicestershire

 LGSS

 Lincolnshire

 London Borough of Hackney

 Merseyside

 Norfolk

 Oxfordshire

 Shropshire

 South Yorkshire

 Staffordshire

 Suffolk

 Tyne & Wear

 West Midlands

 West Sussex  West Yorkshire

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3 Executive Summary

Executive summary and key findings

 Background: Currently the Local Government Pension Scheme (“the LGPS”) in England and Wales is organised as 89 funds. Most of the assets of the 89 funds are managed by “external” managers in the city but, in some funds, local authority staff manage some of the investments “in-house”. Some investments, mainly equities, are managed “passively” (tracking stock-market indices); others are “actively” managed aiming to beat index returns.

 Why pool? There is evidence that LGPS funds have procured external investment manager services at competitive fee levels. One way of achieving even greater economies and other benefits of scale, including the potential for performance improvement via a “governance dividend”, is to combine assets from more than one fund to form bigger investment pools. Government has asked LGPS funds to put forward proposals to pool investments. Assets of the 89 LGPS funds have to be placed in up to six pools, each with a minimum size of £25bn.

 Purpose of report: This report, written by local authorities who run LGPS funds, sets out proposals that will achieve the over-arching aim of costs savings and other scale benefits and meet criteria and parameters specified by government in relation to scale, cost savings, governance and access to infrastructure. The report considers options for pooling and the most effective way for those pools to access commonly used asset classes.  Recommended approach to pooling: The objectives are best met by establishing pools which allow for investment into a range of assets (Multi-asset pools (“MAPs”)) formed by regional and/or like-minded groups of funds. For most assets currently held, namely actively-managed listed equities and bonds, these pools will be of sufficient size to deliver the majority of scale benefits (including cost savings and employing enough managers for diversification but few enough to avoid index returns) while still being of a size that individual funds can participate meaningfully in the pool’s governance. Strong governance within the pool should help maintain a focus on the long term and reduce manager turnover.  How the MAPs will work: Individual funds will remain responsible for their own liabilities, for administration of pensions for their members, for setting their employer contribution rates, for their own investment strategy and for asset allocation decisions including use of active or passive investment. Pool responsibilities will include running the legal structure(s) needed, making available asset classes needed by the participating funds, accessing those assets efficiently, monitoring investment costs and performance and making manager hire and fire decisions. Some decisions could be made by the pool or by individual funds; the pool governance committee will agree some of these details. Some pools will use only external managers and others will use a mixture of external and in-house management. Some pools may also have specialist resources in areas like private equities and direct property investment. The asset types available in each pool may differ.  LGPS wide investment vehicles available to all pools (“MAPs Plus”): For a number of asset types, greater benefits may be available by LGPS-wide collaboration. For example, an infrastructure investment platform or a national procurement framework of passive investment managers could be set up alongside the MAPs and be accessible to all of them.

 Likeminded principles: It will be important for funds to agree the principles by which their pool will be run. These may include the pool’s approach to governance (e.g. one fund one vote, what decisions will be made locally initially and in the long term); attitudes on use of active, passive, external and in-house management; and what the pool will and won’t do in the short and long term. In the very short term there needs to be agreement on equitable ways to share the costs of establishing the pool and the cost of transition of assets from the participating funds to the pool.  Access to infrastructure: The infrastructure assets that historically have been most attractive to pension funds like the LGPS are established projects delivering steady income streams that rise with price inflation (since pension payments from the fund increase with inflation). There has also been some demand for some higher risk-return assets, but allocations will likely be lower. Improved access and lower cost is most likely to be achieved through a national platform accessible to all of the Multi-asset Pools (MAPs).

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It would have the ability to invest directly in funds and in direct investments and would offer 2-3 types of infrastructure investment (e.g. high, medium and low risk) to meet return expectations of the MAPs, which will in turn represent the collective requirements of the 89 allocating funds, some of which already have successful investment programmes in place. A significant amount of further work is required to determine how the national platform should be established and how it builds on or runs alongside any existing or pooled arrangements. Government can assist the investment in infrastructure by ensuring that there is a pipeline of projects that are suitable for investment by the LGPS.

 “In-house” management: Rather than creating a single pool for all “in-house” managed assets, the preferred approach is that a number of MAPs will use both external and “in-house” management. This gives more choice and greater potential to extend use of “in-house” management in future. On day one, funds participating in the pool with “in-house” management must have local choice as to whether or not they use the “in-house” manager but in future (once consistent comparative information is available) pools will decide on the extent to which “in house” and external management are used.

 Cost savings: Based on current asset allocations and market values, and allowing for future asset growth in the range 3 to 5% per year, the estimated eventual savings in year 10 values could grow to be in the range £190 to 300m per year.  The range of potential outcomes is wide. In the first five years, the majority of savings come from fee savings on actively managed listed equities; between five and ten years, changes to how unlisted investments are accessed will have an increasing impact.  Actual cost savings could be greater due to competition when pools appoint external managers driving fees down, additional savings on less visible layers of fees on alternative assets and greater use of “in-house” management.  Over the very long term, the costs of transition and establishing and running the pools will be more than recouped by savings and other benefits. However, in the short term the costs of implementing change and transitioning assets are likely to exceed the savings. There will be significant differences between pools in the savings achieved depending on where they start from (asset allocation, prevailing fees, current approach to accessing different types of assets). There will be winners and losers. For example, Funds which currently use a significant element of in- house management are likely to suffer higher costs.  The eventual cost savings are significant and should be pursued, but this should not be done in a way that puts investment performance at risk. A successful outcome is one which achieves cost savings and potential for enhanced performance through the pool governance arrangements; aggregate outperformance by active equity managers of only 0.25% would add more than £150m of value annually in addition to the fee savings above..  Structures: Approaches to pool structure that should be investigated further include: (1) FCA authorised pooling vehicle(s) combined with a joint governance committee: o There are a number of pooling vehicles recognised under current legislation, including the Financial Services and Markets Act (FSMA). Such vehicles include, for example, the ACS and exempt unauthorised unit trusts. Through these vehicles there is collective ownership of assets. o These pooling vehicles could be accompanied by some form of “joint governance committee” for the pool which could be formed of elected members from each of the funds participating in the pool. That “joint committee” for the pool cannot control the Operator (an FCA regulated business) but may exert a certain amount of influence and express views on the type of funds that the pooling vehicle would need to offer in order to allow the participating funds to implement their investment strategies and which managers the participating funds want to see appointed to manage the assets; the committee would expect the Operator to take those views into account. o The Authorised Contractual Scheme (“ACS”) in co-ownership form is the favoured structure for some asset types because of its tax transparency (reclaims are made at investor level rather than pool level) and the fact that it is possible to establish a range of sub-funds within a single ACS. o Pools may choose to rent or build their own FCA regulated Operator depending on their objectives.

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o However, the ACS does not have the flexibility required to accommodate the full range of asset types that LGPS funds currently invest in, including in particular, illiquid assets like private equity and infrastructure. It is likely that each LGPS MAP would need more than one pooling vehicle to accommodate its full range of assets, increasing the costs of running a MAP. A single Operator could however operate all of these structures in a single pool. Government assistance in making it possible to house assets in one pooling vehicle would be helpful. o Another issue is life policies which are commonly used for passive equity investment. These cannot be held in a pool structure and may instead need to be held outside the pool by the beneficial owners (individual funds), potentially accessed via a National Framework for procurement. (2) “Joint Committee” alone without a pooling vehicle: o Under this approach, the pool will have a joint governance committee of elected members from each of the funds participating in the pool (as above). Without a pooling vehicle, individual funds in the pool would remain owners of assets but all funds could have identical legal contracts with managers selected by pool’s joint committee. o Matters to be followed up in the next stage include, for example, demonstrating how a Joint Committee can be equivalent to a pooling vehicle in terms of governance and permanency of commitment and how to mitigate the risk that this arrangement is (1) deemed to be a collective investment scheme under the legal meaning set out in Section 235 in FSMA 2000 and becoming a collective investment scheme, or (2) the governance arrangement becomes involved in providing investment management or investment advisory services, in each case in contravention of FSMA. o The attractions in this approach are that it could achieve the same or similar outcomes in terms of fee savings and governance benefits but would avoid the complexity and significant higher costs involved in establishing and running a regulated pooling vehicle (potentially several million pounds a year for each pool).  Further work is needed to investigate fully the various potential approaches to pool structure, including consideration of legal aspects. Different pools might use different vehicles and structures; the optimal mix for each pool will depend on the circumstances of each including the asset types they will hold and how the assets are to be managed (e.g. directly using in-house resource or using external managers).  Flexibility to invest outside pools: Government has already acknowledged that existing directly held property investments can remain outside of pools. There are other investment types where a case can be made for keeping investments outside pools, at least until such times as the pools are better equipped to manage them. These include local investments, investments not available in pools needed for the purpose of employer specific strategies (e.g. buy-ins) and various risk management assets (including currency and interest rate hedges). If and when these assets and risk management instruments are managed within pools, in many cases ear-marking to particular funds will be necessary.

 ESG and Responsible Investment (RI) considerations: Government’s published criteria and guidance for pooling direct the opportunities for new investment pools to further improve the approach to Responsible Investment (RI) and Environmental, Social and Governance (ESG) in the LGPS. This report contains recommendations on the measures pools should take to achieve this (including a proposal that pools should develop a compliance statement to the UK Stewardship Code).  Implementation of change: Delivering these changes is an enormous undertaking. The effort, costs and risks involved should not be under-estimated, particularly in the context of continuing budgetary pressures and severe internal resource constraints within local authorities. The transition costs will be significant and risks involved in a transition of assets on the scale required are high - nothing on this scale has ever been done before. Government could assist by considering ways of mitigating transition costs.  Collaboration between pools in implementation phase: Better outcomes will be achieved by collaboration across pools. A joined up approach will result in synergies and minimise transition costs.

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 Next steps: Discussions between funds to create MAPs along the lines set out in this report are already in progress. Those discussions are informed by the work of Project POOL between September and December 2015. There is additional analysis in the detailed work of the Project work-streams that will also be helpful as these plans are taken forward. It is our hope that this report will be useful to all local authorities and elected members involved in the LGPS and to government, in the period between now and the deadlines for pooling proposals in July 2016, and in the implementation phase that will follow.

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4 Pooling Options Key definitions

National Framework A National Framework is an effective procurement vehicle designed to optimise the buying power of the LGPS for a given product or service. It is commonly used for various goods and services across the public sector. It creates pricing tension through a two stage process, the initial framework let that will include qualifying ceiling prices and the subsequent mini completion or call-off by individual users or user groups when providers consider pricing against the ceiling to win actual contracts for work.

MAP Multi-asset Pool: An asset pool comprised of the assets of a number of defined participating LGPS funds. A specific example would be a regional and/or like-minded grouping of funds. The pool invests in multiple asset classes.

MAP Plus Multi-asset Pools plus platforms hosting certain types of asset where LGPS-wide collaboration can deliver greater benefits e.g. a national platform enabling easier access to infrastructure investment.

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Pooling Options

Summary  A range of pooling models has been assessed. Multi-asset pools (“MAPs”) formed by regional and/or like-minded groups of funds can largely meet both the Government criteria and the needs of funds but may not be the best solution for all asset classes.

 For the bulk of currently held assets, namely actively-managed listed equities and bonds, these pools will be of sufficient size to deliver the majority of scale benefits while still being of a size that they can satisfy the requirement for meaningful involvement by individual funds in the pool’s governance arrangements.

 For a number of asset types, greater benefits may be available by LGPS-wide collaboration. For example, a national platform for infrastructure (below) or a national procurement of passive investment managers could be established alongside the MAPS, accessible to all of them. We refer to this pooling model as “MAP Plus”.

 Likeminded principles for any pool may include approach to governance (e.g. one fund one vote, what decisions will be made locally initially and in the long term); attitudes on use of active, passive, external and in-house management; and what the pool will and won’t do in the short and long term. In the very short term there needs to be agreement on the most equitable way to handle the establishment costs and transition of assets.

 Each multi-asset pool will offer a range of asset classes (decided by the pool governance committee) to meet the needs of all of the participating funds. There may be differences in the asset choices available in different pools according to the needs of its participants.

 Scale: It should be possible for individual funds to form up to six groups of funds in MAPs with size of at least £25bn. Any assets hosted on a national platform would remain the assets of the MAPs so that the total fund sizes of the six MAPs are not eroded. The scale of the individual pools will permit more effective diversification of manager risk; in other words there can be enough managers included to achieve diversification whilst avoiding having so many that the index (passive) return is achieved in return for paying active fees.

 Savings: Based on current asset allocations and market values and allowing for asset growth of 3-5% per annum estimated eventual savings could amount to circa £190-300m per annum after 10 years. Over the very long term, the costs of transition and establishing and running the pools will be more than recouped by savings and other benefits. However, it is important to appreciate that savings will take time to emerge and in the short term the costs of implementing change and transitioning assets are likely to exceed the savings. Funds which currently use a significant element of internal management are likely to suffer higher costs at least initially.

 Governance: Each pool must have a robust structure with effective decision-making and accountability; a formal structure, including for example the establishment of an Authorised Contractual Scheme (FCA authorised) with an Operator, could be put in place. Each individual fund in the MAP could have representation on the governance board of the pool. This should ensure meaningful engagement and pool accountability to individual funds in the pool. Making manager hire and fire decisions the responsibility of suitably experienced people at pool level will help to put the emphasis on a long term approach, reducing manager turnover that can be damaging to performance, thereby adding value over and above the cost savings.

 Access to infrastructure: Most likely via the MAPs working together to create a national platform accessible to all (built on or running alongside existing arrangements). It should be designed to give access to the types of investment that meet the needs of LGPS funds with a lower cost of investment compared to the existing arrangements for investing in infrastructure. Government can assist the investment in infrastructure by ensuring that there is a pipeline of projects that are suitable for investment by the LGPS

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 Two models for accommodating “in-house” management were considered: (1) a single large “in-house” managed pool (more than £30bn) or (2) a number of multi-asset pools with choice of external and “in-house” management. The latter approach is preferred by the working group since it introduces more choice for pools and greater potential to extend use of “in-house” management in future.

 This view is conditional upon: (a) on day one funds participating in the pool with “in-house” management will have local choice as to whether or not they use an “in-house” manager; and (b) pools in due course (once consistent information is available from both in-house and external managers is available) making the decision on which assets classes and the extent to which “in house” management is used.

Warnings/notes  The costs and resource required to deliver this change programme should not be under-estimated, particularly in the context of continuing budgetary pressures and severe internal resource constraints within local authorities.

 In the implementation phase, better outcomes will be achieved with collaboration across pools. Efforts to ensure a joined up approach to find synergies and minimise transition costs should be encouraged through implementation but also during the preparation of pool business plans for submission in July.

 Collaboration should ideally extend to the commissioning of legal, tax and structural advice.

 The risks of a transition of assets on the scale required should not be underestimated as nothing of this magnitude has never been done previously. Outstanding project management and the use of the most skilled and experienced transition managers will be critical to managing these risks, but there will inevitably be a significant cost to a transition of this size.

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Introduction The purpose of this chapter is to:

1 Set out the long list of high level pooling options considered

2 Rule some out and assess others in greater depth

3 Propose a short-list of options likely to meet government criteria for pooling, show how each compares against those criteria and set out other pros and cons of each

This chapter draws from the work-stream analysis on the optimal approach to accessing various asset types, including internally managed assets. The diagram below is an illustration of investment pooling.

What is investment pooling?

Pool A Pool C Pool B

County County LB LB LB County County County LB LB LB County County County LB LB LB County CountyMetrop County LB LB LB County County LB LB LB County olitan

Each LGPS fund remains separate. Retain responsibility for asset allocation decisions, local liabilities, contribution setting, administration

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Long list of high level pooling options Potential high level pooling options include:

Pooling option Comments 1 Multi-asset Pools (MAPs)  Default position for government.  Up to six regional or “like-minded” pools  Benchmark against which other options should be  Multi-asset compared.  Formed by groups of funds linked by  Included in short-list for further analysis. geographical proximity or like-minded principles or a combination of the two 2 All internally managed  A long term aspiration for some LGPS administering  Up to six mutual companies authorities  Multi-asset  Not considered to be a realistic option on day one –  No external management too big a step and insufficient existing resource within local authorities.  Not considered further in this report. 3 Single asset type pools (SAPs)  Potential diseconomies of scale for actively managed listed equities.  Up to six pools  Potential lack of scale for cost savings for some asset  Based on asset type e.g. listed equities, classes, e.g. diversified growth funds bonds, property, infrastructure, other  Given that London MAP likely to feature in  Individual funds pick assets from asset pools government’s preferred solution, not a realistic and have no need to form alliances with option so not considered further in this report other funds 4 Multi-asset Pools “Plus” (MAP Plus)  Starting point is regional and/or like-minded groups of funds but could (in addition) also set up  Up to six regional and/or like-minded pools investment platforms for some asset types that may  Multi-asset work better nationally e.g. a national infrastructure  Formed by groups of funds linked by platform, a passive procurement available to all pools geography or like-minded principles or a nationally? combination of the two  Included in short-list for further analysis  Supplemented by a small number (potentially only one) of national platforms accessible for all of the pools to invest in 5 Liability pools  Group by employer type? Not possible to identify suitable number of pools of circa £30bn size (for  Pools based on liabilities with similar example, academies pool would be too small since characteristics e.g. by employer group such have no past service liabilities) as academies  Group by active / deferred / pensioners? Active liabilities pool cashflow positive and pensioner pool cashflow negative – lose benefits of netting off cashflows when in same pool?  Not considered further in this report. 6 Mixed economy  A mixture of MAPs and other approaches (single asset type pools and procurement)  A mixture of multi-asset and other  Included on short-list for further analysis. approaches (single asset pools and procurement).

Accordingly, the shortlist of options for further analysis is, 1) MAPs, 2) MAP Plus – i.e. MAP plus national asset vehicles and 3) Mixed economy. We consider each of these options in more depth below.

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MAPs - Regional and/or like-minded Multi-asset Pools Multi-asset Pools (MAPs)

Pool B Pool A Pool C Pool D

Pool E Pool F

Regional or “like-minded” groupings of Funds. Multi-asset pools. Up to 6 pools. Minimum £25bn.

Description  Each pool is a multi-asset pool, i.e. it invests in a number of different asset classes

 Each LGPS fund decides on day one which MAP it is in (or government could specify)

 Funds cannot change the pool they are in (except perhaps in an initial “transfer window”1) to avoid the risk that some could become sub-scale

 Pool governance arrangements will have representation from all participating funds (a requirement in guidance)

 The extent of the responsibilities of the pool governance committee will depend on whether a FCA authorised Operator is established to run the investment vehicles that house the assets; some of the current groupings of funds are exploring a joint committee structure which might exist without such an operator.

 With a joint committee structure (without an FCA authorised pooling vehicle and Operator) the pool governance committee will make decisions, whereas where an FCA authorised Operator has been appointed the committee will make recommendations to, but the final decision rests with, the Operator. The areas that will be subject to these decision processes include;

- what asset classes the pool will and will not offer to meet the needs of its participants (different regional and/or like-minded groups of funds may offer different asset types – for example a pool may decide whether to offer DGF / target return funds, hedge funds and which types of fixed interest fund it will offer)

- how the pool accesses each asset class (e.g. combinations of external, internal management, national procurement, etc.)

- how many mandates there will be for each asset type and what type (e.g. growth or value styles for equities, overseas or UK)

- all manager hire and fire decisions (with the expectation that the pool governance committee will take advice from specialist internal staff of the MAP and/or from independent investment advisers)

- number and type of resource required at pool level – budget agreed with participating funds

1 See chapter on Regional Pools

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- agreeing which decisions are made at pool level and which at individual fund level (at a minimum, high level asset allocation decisions to suit the liabilities and risk attitude of the individual fund)

- agreeing the principles on which the transitions to the pool will take place, for example, policy as to whether participants share transition costs or not

- approving the implementation plan for the transition

 Individual funds participating in the pool remain responsible for asset allocation decisions within the options available in the pool. Note that it is likely that over time funds will require the introduction of new investment options (there are numerous examples of this in the past, e.g. hedge funds, private equity) and there will need to be some flexibility to permit this

 Questions to consider include:

- what structure or legal entity is required?

- does one structure or legal entity work for all assets? (in particular for both liquid and illiquid assets)

- do MAPs produce maximum savings or would some asset types be accessed more cost effectively at national level?

- is there an optimum size in terms of access, flexibility and potential savings?

- which decisions are made at pool level and which are local? (examples include UK / overseas / non-UK region specific equity, active / passive, growth / value style)

- one fund, one vote even if funds differ significantly in size?

- does the pool buy risk management assets (buy-ins, LDI instruments, currency hedges, etc) at request of and on behalf of individual funds in response to specific requests or are they bought directly by funds that need them and outside of the pools? (in the long term, there may be an expectation that the pool will provide shared resources to procure risk management assets on behalf of an individual fund to meet its specific requirements and then ear-mark those assets to the fund that needs them)

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MAP Plus model Description As per regional and/or like-minded MAP except we believe that it may be appropriate to establish a means by which some asset types can be accessed collectively at a wider or national level to achieve scale benefits. These might include:

1. A small number of pools for access to infrastructure investment (potentially a national platform built from or running alongside existing arrangements)

2. A national framework or similar option for access to passive investment (TBC)

3. A national framework or similar option for access to Fixed income (or some elements of fixed income)

These additional national solutions can be considered as mechanisms for regional and/or like-minded pools to access these asset classes more easily and more cost effectively. Any assets invested by the MAPs in other vehicles would still count as assets of the MAP. These investment platforms used by more than one MAP to access assets should not count as one of the six pools.

This option may resolve one of the potential legal barriers in that assets within an ACS must meet certain liquidity requirements; an alternative vehicle for illiquid assets like infrastructure could alleviate these issues. This is a point that may need further legal clarification.

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Mixed economy Pooling based on a mixture of MAPs and other pools. The non-MAPs would be primarily asset based pools. Individual funds would choose the building blocks from pools to execute their strategy. The diagram below illustrates the concept.

Mixed approach:

National London CIV: Active National: National: Procurement Managers Bonds Infrastructure CIV Passive

Fund A: Fund B: Fund C: London No in-house In-house Borough management

Individual funds choose building blocks to execute their strategy

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Comparison of pooling models MAP MAP Plus Single Asset Pools Mixed

Description Up to six pool multi-asset Same plus some asset Pools for specific asset Some regional and/or pools formed from vehicles or procurement types. No need for any like-minded pools and groupings of regional for things that work regional and/or like- some single asset pools and/or likeminded funds better nationally minded fund groupings Scale Can meet government Can meet government Some pools would be too Possible requirements. requirements. Important small (e.g. diversified to recognise that the growth funds). For other assets in the additional asset types, national investment vehicles are pools could be too big still counted as assets of (e.g. listed active the multi-asset pools equities)

Savings High Higher Similar to MAP Plus Similar to MAP Plus Governance Good Similar to MAP Mixed Individual funds can be Individual funds will feel Individual funds will feel more involved and more distant from the more distant from participate in the selection governance of national governance. Cannot have of experienced officers to asset vehicles and will 89 Local Authorities on the executive team to have less opportunity to governance committee of manage the pool. participate in the a national pool From government’s point of selection of the executive view, professional resource for the pool in pools can help with risk From government’s point management, improve of view same benefit as decision making and reduce MAPs from professional the detrimental impact of resource. excessive manager change. Access to Better than current – more Better than pure regional Similar to MAP Plus Similar to MAP Plus infrastructure co-investment and pooling and/or like-minded MAP should be possible but six model for infrastructure MAPs may be too many and some other assets pools to maximise savings Other Simple. Alignment to Need to establish one or Who will set up and run Complicated? considerations government policy more additional vehicles asset vehicles? National generally. Geographic for the six multi-asset pots too big for some approach will be improved pools (e.g. to access asset classes so limitation by like-minded overlay infrastructure). to six pools may mean not a feasible solution Conclusion Good fit to criteria but not Best fit for criteria. Potentially greater Too complicated? Best best outcome for all asset Greater potential cost savings, but harder to link and worst of other classes savings? local and pool governance models?

Conclusion The MAP Plus model could generate better outcomes than any of the other options. Savings are potentially greater for MAP Plus and it is easier to link pool governance to individual local funds for reasons of involvement and accountability than would be possible with asset pools or a “mixed” model.

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Options for “in-house” management In-house management is defined as management by teams of investment professionals currently employed by a small number of individual LGPS funds. Two options were considered. One option is to bring all of the internally managed funds together in a single pool and combine their resources to manage their combined funds. The other is to embed an in-house managed fund or funds into a number of regional (or multi-asset) pools. The table below describes the two options and identifies the pros and cons of each.

One “in-house” managed pool More than one MAP with “in-house” capability Description  All in-house managed assets in one pool – size  Funds with “in-house” capability join their regional £30bn+ and/or like-minded MAP  Set up a new vehicle or investment company to  On day 1, funds currently without in-house may not house want to use in-house management. These funds  Staff in existing funds potentially transfer to should be allowed to choose to use “in-house” new entity management or not (an implementation decision rather than manager selection)  In future (e.g. 5 years), the pool rather than individual fund decides whether and to what extent to use in- house team  Government expects existing in-house management staff to transfer to the pool Pros  Low cost pool  Scope to manage more of the pool’s assets in-house  Pool resources across existing in-house teams in future to reduce costs further leading to better-resourced team?  Could enable greater leverage and cost savings across  Extend asset types covered? Further savings? the LGPS Cons  No diversification by manager or internal  Some funds (whether currently users of in-house or competition external managers) will be unhappy to have choice

 Harder to sack manager if underperform removed – although they should be involved in the  Challenges of attracting and retaining staff for decision via participation in pool governance alternative asset classes given constraints on  If underperform, pool may opt to use external remuneration and office location managers and shut down in-house management  Less scope to grow in-house management leading to the early termination of internal option unless sell services to other pools  Some MAPs will have little or no in-house capability  Funds which currently have internal (although they could develop it over time). This could management for part of their assets could end limit the growth of in-house management. up with investments in two pools (the second hosting their externally managed assets) Other  Less need to meet same due diligence standard  Need to meet same due diligence standard as as external managers initially at least although external managers comments this may change over time due to scrutiny and  In competition with other fund managers FCA authorisation  In future (if FCA authorised), potential to sell services  In future (if FCA authorised), potential to sell to other MAPs. services to other MAPs?  It is acknowledged that not all MAPS will necessarily  Where a fund currently has in-house and have internal management at outset or in the future. external managers, would their externally managed assets go to another pool? Conclusion  Could work but greater advantages in the  On balance, this approach is preferred by the working alternative model where MAPs contain an “in- group since it introduces more choice for pools and house” capability the possibility of extending use and savings in the long term. This view is conditional upon funds participating in the pool having choice as to whether or not they use “in-house” manager on day 1 (accepting this will become a pool decision in the longer term). Notes: 1. There may be greater challenges for funds without in-house capability to remove FoF fees on alternatives. 2. Individual LGPS funds will still need “client side” staff. Some additional considerations informing the comparison of “in-house” options and the conclusions are set out below.

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Pools containing “in-house” management

Our understanding of government expectations of in house management within a pool • Existing in-house management resources transfer to the pool and initially are only used by the former employer(s) of that team(s) • In due course, the Pool decides whether and to what extent to use in-house management on a value for money case • Must meet same standards of due diligence as an external manager appointment (costs, verifiable performance record, skill/experience of resources) • Has a part to play in pooling arrangements for main-stream and alternative asset classes • Reduces cost.

Questions to consider • Could an in-house management function (either a 100% in-house managed pool or an in-house function in a MAP) sell services to other pools or more widely? What conditions would need to be satisfied to allow this? • How does a pool deal with underperformance by the internal manager? • If embed in-house teams in one or more MAPs, there is the potential to increase cost savings if use of in-house expands. • However, most participants in pools will not wish to use in-house team (at least on day 1) and will not want to be in a pool where the pool forces an allocation to in-house. The funds who use in-house and who provide the in- house resource to the pool will not want to be forced to have an allocation to external, particularly as this is likely to carry a substantially higher cost and there is clear evidence that manager change measurably damages performance. • What are the consequences if more than one internally managed fund is in the same pool?

Some potential solutions? • Some MAPs could be formed with in-house management capability, other pools will have none • For a MAP with in-house management, on day one individual funds could be permitted and choose to use the in- house manager or not. • In future (say 5 years), the pool will decide whether and to what extent in-house management is used and individual funds have no say. Pool could decide to expand, reduce or stop use of in-house management as it would with any external manager. So if an individual fund wants (say) UK equity, the pool decides which managers (external and in-house) and the allocation to each. • This plan to transition governance decisions to pool would need to be explicitly set out in the proposed governance arrangements for the pool including planned review points (ie explain in proposals for pool governance submitted in July)

Conclusion Embedding in-house management in one or more MAPs is the preferred approach because it gives the best potential for in house management to be equitably measured against external management, ensuring that pools have the best chance of making an evidence-based decision in the future about retaining and potentially increasing their use of internal management to deliver greater cost savings.

This is conditional upon allowing flexibility to the Pools to opt to allow individual funds within MAPs to decide whether to use in-house management on day one but with the intention that this decision would be one for the pool to make after an agreed timescale which could differ between pools.

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Summary In the view of the working group, the short-list of pooling models that best meets government criteria for pooling are:

1. Six regional or “like-minded” multi-asset Pools (MAPs)

2. MAP Plus – i.e. six MAPS plus a small number of national asset vehicles

3. Mixed economy

In the table below we summarise how these measure up against government criteria for pooling.

Criteria Regional and/or MAP Plus model Mixed economy like-mindedMAPs Scale

Cost savings National collaboration delivers greater benefits for some asset classes Governance Funds grouped in MAPs Funds grouped in MAPs Individual funds more have direct involvement have direct involvement distant from in pool governance in pool governance governance of national asset pools Ease of access to Access to infrastructure infrastructure too fragmented in six MAPs and some may not have suitable in-house resource Conclusions Best combination for scale benefits and involvement in pool governance

Embedding in-house management in one or more MAPs is the preferred approach because it gives the best potential for in house management to be equitably measured against external management, ensuring that pools have the best chance of making an evidence-based decision in the future about retaining and potentially increasing their use of internal management to deliver greater cost savings.

This is conditional upon allowing flexibility to allow individual funds within Multi-asset Pools to decide whether to use in- house management on day 1 but with the intention that this decision would be one for the pool to make after an agreed timescale which could differ between pools.

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5 Structuring the pools – legal and implementation issues

Scope The purpose of this section is to provide an overview of the formal legal structures that could be adopted for the purpose of the pooling and collective ownership of assets.

Regardless of the nature of any pooled vehicles used, it is generally envisaged that a MAP or SAP, whatever its formal structure, will have a Governance Committee (“the GC”) constituted with a representative, most likely an Elected Member, from each of the funds forming the pool. There is no requirement for the members of the Committee to have any specific qualifications if they are not doing anything that requires them to be FCA authorised.

We also note that certain joint venture structures and/or arrangements (suitably conceived, resourced and, where appropriate, with regulatory permissions) could be deployed either in place of or in conjunction with the more formal structures considered here. The use of these less formal collaborative structures is briefly addressed at the end of this paper for completeness.

In this chapter we assess the suitability for LGPS pooling of structures and vehicles that achieve pooling as recognised under current legislation, including Financial Services and Markets Act (FSMA). Some pools are investigating an alternative approach - a “joint committee” (“JC”) without any pooling vehicle. This might achieve government objectives by combining governance and oversight but will not create a single pool of assets (i.e. each LGPS fund would continue to own their individual assets). It may be possible to do this more cost effectively, although it may need to demonstrate the same governance benefits as creating a single pool of assets with the strength of governance that is attached to FCA regulated and supervised entities. LGPS funds would exercise their decision making and build a governance framework via the joint committee). This sort of approach will require further investigation including consideration of legal aspects.

However care must be taken to ensure that neither the GC nor any joint venture or committee structure gets caught by the provisions of the Financial Services and Markets Act 2000 by, for example, carrying on regulated activities. One risk is that a structure that operates in a similar way to a regulated vehicle is deemed to be an unauthorised pooling vehicle with potential legal and taxation consequences.

Structures considered We set out some of the key characteristics of the various structures considered, together with brief comment on their suitability in Appendix 1 to this section. Ideally, the same structure would be used to accommodate the full range of LGPS assets, as it is otherwise likely that the costs of establishment and running of the pooled vehicles will increase. However, as noted below and in the following section, it is possible that the most appropriate arrangements will result in each LGPS pool using more than one investment vehicle or structure.

The Authorised Contractual Scheme (“ACS”) in co-ownership form is the favoured structure, primarily because of its favourable tax characteristics. However, it may not be the most appropriate for investment in illiquid assets or the most cost effective for passive investment in liquid assets. The relevant issues are considered in the next section.

In order to provide maximum investment flexibility, the ACS could be structured as a Qualified Investor Scheme (“QIS”).

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The functions that will have to be performed include

 appointment of service providers

- Fund Administrator

- Depositary

- Global Custodian

- Lawyers

- Tax consultants

- Auditors

 FCA regulated operator

- Manager ``selection and on-going monitoring

- Compliance with the FCA rules

- Monitoring of outsource providers including the Fund Administrator

- Reporting to the investors

- Regular Board meetings

- Interface with the FCA

Appendix 2 sets out a diagram of the structure required and the responsibilities of the various parties.

Issues requiring clarification Use of life policies Many LGPS funds currently invest via life policies and this is most common for their passive equity investments which can be a significant proportion of their total assets. Life policies do not fit well in a pool structure. Pooling vehicles cannot hold life policies – instead the entity with the insurable risk (the individual fund) must be the beneficiary of the contract. The risk lies with the LGPS fund, not the (newly created) pool.

Even if it were possible to put life policies within an investment fund structure, it would potentially involve additional costs as there would be the cost of the life policy itself and the cost of investing through the investment fund and so it is unlikely that this would be an attractive route. Transferring existing passive investments out of life policies and into pooling vehicles would potentially incur transition costs (e.g. stamp duty on UK equities) and also result in higher costs on an on- going basis due to a reduction in the efficiencies gained from ‘crossing transactions’ under those existing life policies.

If there is a cost (or other) benefit to accessing passive investment through a life policy then this investment could in theory sit by the side of investment fund structures but the uncertainty as to where the life policy could or should sit must be addressed. One approach might be to allow passive investments in life policy wrappers to remain with individual funds, outside of pools. Recent procurement exercises have shown that product providers are willing to give individual funds significant fee savings under a joint procurement.

Suitability of vehicles for investment in illiquid assets (e.g. private equity and infrastructure) As mentioned above there is concern that the current structures that are commonly used by the LGPS for investments in private equity and infrastructure are closed-ended and therefore offer very limited liquidity. As the ACS requires a degree of liquidity to be available, analysis will be required to determine whether the ACS (the favoured vehicle for other asset types) would be suitable.

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The table in Appendix 1 sets out a range of investment fund structures, some of which can be established in both open- and closed-ended form and so could be used for illiquid assets. The Exempt Unauthorised Unit Trust could be an option for these asset types.

It would be helpful if a means could be found to accommodate illiquid assets under the same fund structure as liquid assets as otherwise it is likely that the costs of establishment and running of the pooled vehicles will increase.

Implementation We use an ACS as an example, although similar arrangements would be required for the other structures considered. An ACS must appoint an FCA-authorised Operator who is responsible for the operation of the scheme. The Operator is also responsible for decisions about the investment of participants’ funds under the contractual arrangements. The Operator of an ACS would also be able to act as the Operator of other collective vehicles, e.g. an Exempt Unauthorised Unit Trust, where an ACS was not able to accommodate the full range of LGPS assets.

An ACS must also appoint an FCA-authorised depositary, responsible for safeguarding scheme assets, and other service providers required under the rules.

Appendix 2 to this section sets out a diagram of the typical structure required and the responsibilities of the various parties.

It is important to distinguish between the Operator and the ACS itself as one of the first decisions that a group of authorities will have to make is whether to set up its own Operator (the “build” option, which the London CIV has chosen) or use an Operator already established by an external party (e.g. Capita, Thesis, host Capital, Fund Partners the “rent” option). A question for each of the potential providers will be the scale they can support.

It is not intended to recommend either building or renting here, although some of the issues relevant to the decision are touched on further in the rest of this section.

Timescales It is estimated that it will take between four and ten months to set up an ACS, including the design stage.(Other structures would require a similar length of time.) The FCA has announced its intention to turn around a QIS ACS application in one month although the statutory authorisation period is six months for a non-UCITS ACS.

However, an ACS cannot be approved until the Operator has been set up and approved. The timescale for this process is six to twelve months. Under the build option, some parts of the ACS set-up can be run concurrently with the Operator set-up. However, there will come a point when the Operator needs to be established to progress the ACS approval. We would therefore estimate the combined set-up time to be 6-18 months. Within this timeframe the service providers to the ACS and the Operator e.g. the depositary and Fund Administrator would also have to be appointed.

Under the rent option, the Operator will already be approved and so the timescale is determined solely by the set-up of the ACS.

In terms of timescale, the rent option is more advantageous.

Governance and risk The Operator is responsible for all strategic and operational decisions relating to the ACS and, consequently, bears all the risks (financial, compliance, operational, etc.) that arise.

Under the build option, the relevant authorities would be the shareholders of the Operator and exposed to the various risks that the Operator runs. The GC, as representative of the Operator’s shareholders, would expect to have a significant influence on the composition of the Operator’s Board and, indirectly, have some influence over management decisions.

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Under the rent option, the risks are borne by the shareholders of the third-party Operator and management control exercised by its Board. (It is possible to envisage a situation in which a third-party provider sets up an Operator for the specific purpose of running an ACS for LGPS schemes, in which case the GC might expect to nominate some members of the Board. However, this might offset some of the advantages of the rent option in respect of set-up time.) The GC could exercise influence through selecting an Investment Committee for the ACS. In practice, it would be extremely unusual for the Investment Committee’s recommendations not to be accepted. If the GC is dissatisfied with the Operator’s management of the ACS, then the investors in the ACS (not the GC itself) have a couple of options (neither of which would be straightforward or cost-free):

 withdraw their invested funds; or

 appoint a new Operator by convening a meeting and passing a resolution to require the depositary to remove the Operator.

The GC and the relevant authorities will have greater control over the strategy of the ACS under the build option. Rent options have the advantage of transferring risk to a third-party Operator.

Costs Scale of resource required As an example, we understand that the London CIV is setting up with an initial team of 5 full time investment professionals. Given that the CIV has established only a small number of sub-funds so far, we would view this as a minimum guideline for an Operator established by any of the pools formed by groups of LGPS funds.

Establishment We understand that the costs to date for the establishment of the London CIV have been of the order of £2.5m. We do not know how this amount is split between the costs of setting up the Operator and the costs of setting up an ACS. However, we estimate that the costs of setting up an ACS on its own would be under £0.5m.

We think that £2m is the minimum that should be budgeted to set up an Operator. These costs would not be incurred under the rent option, although there would still be significant spend in selecting and appointing a rented operator and the additional annual fees of the rented Operator. ACS set-up costs would be incurred under either option.

In terms of establishment costs, the rent option is more advantageous, albeit with ongoing fees to the rented Operator.

Running As a guide, a fund structure hosting £25bn of assets for 15 investor funds across 20 sub-funds could suffer annual costs of 0.03% (£7.5m). These costs vary according to number of factors, including

1 the size and number of the sub-funds in the ACS

2 the frequency of investor dealing and valuation points

These would not all represent additional costs to LGPS funds. The running costs include custody fees, which are already being paid under current arrangements (at an estimated 0.01% p.a.) and various fund administration costs that are currently being paid in respect of any investment in pooled funds.

We would expect that pooling will deliver some economies of scale in respect of these costs. It may also be possible for funds to retain a larger proportion of the income generated from stock lending than they do under current arrangements.

Based on current information we would expect running costs to be similar for both build and rent options.

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Internal management Investment management of an ACS cannot, strictly speaking, be internal, as local authorities are no longer the direct owners of the assets being managed.

Under both build and rent options, existing internal management resource could act as investment advisor or investment manager to the Operator in respect of relevant sub-funds of the ACS. The structuring of such a resource is considered briefly in the next section. Providing investment management and/or investment advisory services to the Operator would likely be a regulated activity under FSMA which would require FCA authorisation.

Under the build option, existing internal management resource could be transferred to the Operator and provide investment management services directly. For this reason, the build option might be a more attractive solution for authorities with current in-house management resource.

Less formal pooling and collaborative joint ventures Some pools are investigating an alternative approach using a “joint committee” without any pooling vehicle. by combining governance and oversight but will not create a single pool of assets. This means that each LGPS fund would continue to own their individual assets, but would agree to invest into the same investment mandates with the same managers in the proportions relevant to their individual investment strategies. It may be possible to do this more cost effectively, although it may need to demonstrate the same governance benefits as creating a single pool of assets with the strength of governance that is attached to FCA regulated and supervised entities. LGPS funds would exercise their decision making and build a governance framework via the joint committee). Further investigation, including the legal aspects is required.

There are other examples of joint venture structures that could have applications for LGPS pools. For example, LGPS funds are able to establish a joint venture limited company (or other vehicle) with a view to pooling internal investment teams and leveraging from these teams to provide support for other LGPS funds that do not have an internally managed function. Such vehicles may be used to provide investment advisory and/or management services amongst LGPS funds in a more flexible and less formal manner and also potentially act as manager/operator of any collective investment vehicle in a manner that could potentially reduce external costs (subject to obtaining the suitable FCA permissions). Such vehicles might also provide the flexibility to allow LGPS funds to apply different forms of collaboration to the relevant asset class (e.g. formal pooling for equities, less formal collaboration for alternatives and other less liquid assets etc.) where a single formal pooling approach might not be appropriate or cost effective.

It is important to recognise the establishment and operation of “joint committees” and other joint venture structures of this nature in this section, but a detailed consideration of the resourcing, regulatory, tax and other considerations is not considered here and would require to be analysed on a case by case basis and in the context of the relevant collaborating parties/initiative. Several LGPS funds already operate such structures and so are able to provide further insight into this model and how it could be further adapted in support of the more formal pooling options considered within this section.

One of the risks that would need to be considered in further detail is the risk that the joint committee might inadvertently create a pool or provide investment or investment advice. Those activities would require FCA authorisation.

Conclusions

The purpose of this chapter was to assess the suitability for LGPS pooling of structures and vehicles that achieve pooling as recognised under current legislation, including FSMA. These pooling vehicles could be accompanied by some form of “joint governance committee” for the pool which could be formed of elected members from each of the funds participating in the pool. That “joint committee” for the pool cannot control the Operator (an FCA regulated business) but may exert a level of influence and express views on the type of funds that the pooling vehicle would need to offer in order to allow the participating funds to implement their investment strategies and which managers the participating funds want to see appointed to manage the assets.

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Some pools are also likely to consider an approach using a “joint committee” alone, without a pooling vehicle. This alternative approach would be attractive if it could be set up in a way that achieves similar outcomes in terms of pool governance (in line with the requirement set out in government’s guidance on pooling criteria) but with lower cost and effort. However, funds considering this approach will need to consider carefully the potential risks as well as the cost savings. Using a joint committee alone (without combining it with another solution) will not create a single pool of assets under FSMA, but will combine governance and oversight.

Before pools reach any firm conclusions on which of the approaches above will work, clarification and further consideration of the legal aspects will be required. Some of the questions that will need to be answered before any final decision is reached are set out in the summary table below which also sets out some of the features of each approach as currently understood.

Joint governance committee in Joint committee alone combination with pooling vehicles

What is it? A joint governance committee for the pool A joint committee (as recognised by 1972 Local plus pooling vehicles recognised under Government Act) but without a formal legal current legislation structure or pooling vehicle for the purpose of holding the assets

Common ownership of Yes (within the pooling vehicle) No – individual funds remain owners of assets assets by the pool? but all funds could have identical legal contracts and terms of business with manager selected.

Joint committee Yes – technically the Operator of the Yes – some operational group (could be influence on decisions vehicles decides but in practice would be delegation to officers) acting on behalf of the on asset managers expected to take account of wishes of participating funds to implement and monitor etc? investors the appointments will also be required

FCA authorisation and Authorisation - Yes – Operator and vehicle Care will be required to ensure that (1) a pool capital requirements which meets the definition of a collective Capital – Yes for Operator. Capital is a investment scheme (Section 235 Financial reserve stipulated by FCA – modest cost of Services and Markets Act 2000) is not holding capital inadvertently created, and (2) that the governance arrangement does not manage or advise on investments, as in each case FCA authorisation would then be required

Value for money: set Higher establishment costs (est £3-4m for Significantly lower establishment costs up and running costs one vehicle; less for any additional vehicles since they can use the same Operator) Lower running costs

Higher running costs (est 3bps per annum including custody, depositary / investor registration and operator – equivalent to £7.5m a year for a £25bn pool, compared to 2 bps or £5m as typical costs now).

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Joint governance committee in Joint committee alone combination with pooling vehicles

Manager fee savings? Yes – pool is one client Expected – manager likely to be prepared to treat funds in the grouping of funds as one client if uniform reporting etc is accepted but will need separate accounting, custody and reporting for each

Works for in-house Can do – ‘in-house’ team likely to be FCA authorisation required for in-house management required to be FCA authorised management team in order to serve all of the funds in the pool?

Tax Choice of tax transparent vehicles Each LGPS would continue to invest its own assets, so the their current position would continue to apply,

Care required to ensure that a collective investment scheme has not been inadvertently created as tax treatment applied will be that applicable to that vehicle and may be disadvantageous.

Questions and issues It may not be possible/efficient to house all How to demonstrate that a JC can be to be addressed assets in preferred vehicle (ACS) due to the equivalent to a pooling vehicle in terms of liquidity requirements which do not work governance and permanency of commitment. for some illiquid asset classes (e.g. PE and infrastructure). If the arrangement is deemed to be a collective investment scheme and/or the governance Government assistance in making it possible arrangement advises on or manages to house assets in one pooling vehicle investments then there is a risk that FCA would be helpful. regulation should have been sought (see above) and failure to do so is an offence. This test is a continuing one which can be failed in the future if some action is taken that results in a breach.

Any structure for pooling has to reconcile, potentially conflicting forces (transparency, legal, regulatory, cost and control). Some of these issues involve complicated legal and regulatory questions on which professional advice will be required. Resolving these is critical to a successful outcome and is something on which collaboration (not least to save fees) is recommended. No structure can score highly on every point. Different pools may use different vehicles and structures; the optimal mix for each pool will depend on the construction and circumstances of each.

Whatever structure is determined for each pool that structure cannot guarantee success. There will be many issues to be resolved at outset and ongoing. It is this project’s view that pools comprising like-minded authorities who are willing to collaborate is as, if not more, important than structures.

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Appendix 1 – Investment Fund Structures Vehicle Income tax Capital gains FCA FCA authorisation FCA depositary VAT position Umbrella transparency exempt authorised structure operator possible required?

ACS – co-ownership Yes Yes Yes Required Required FM fees exempt Yes form Potential to mitigate on The same principles depositary fees would apply to an ALP (authorised limited partnership) but this has not been considered in detail as it is not possible to set one up as an umbrella fund with a number of different sub-funds

Both structures must be open-ended

Exempt Unauthorised No Yes Yes Not required Required No exemption under current UK Yes Unit Trust law

This structure can be formed as an open- or closed-ended fund

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Vehicle Income tax Capital gains FCA FCA authorisation FCA depositary VAT position Umbrella transparency exempt authorised structure operator possible required?

Limited partnership Yes generally, As for income Yes Not required Required No exemption but some No but opaque in tax mitigation possible These can be formed certain transparency as either open- or overseas closed-ended funds jurisdictions

Pension fund pooling Yes Yes Yes Comment: - introduced 1996 but has not been popular and now superseded by ACS. No longer vehicle used by anyone as a third party investment vehicle

Common Investment Participants must be corporates in the same group. Would require Government to create an exemption for LGPS funds to use for pooling. You impose VAT Fund on investment management fees. Risk of insolvency due to cross liabilities. Not understood as a structure in many countries and so such funds are not always treated as tax transparent.

Master Trust LGPS would need Secretary of State permission to establish a new trust-based pension fund.

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Appendix 2 – Key parties (Source – Northern Trust)

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6 Estimated Cost Savings

SUMMARY

 Allowing for investment growth of between 3 and 5% a year for 10 years the estimated savings in year 10 values could be in the range £190-300m per year.

 We have assumed no change in current asset allocations including infrastructure and the proportion of assets managed in-house.

 Cost savings can come from a number of sources;

 Reduced manager fees due to larger mandate sizes and commercial pressures

 Changing the means of access to an asset class, e.g. moving from active management to passive management or removing layers of fees that are common in some alternative asset classes

 By moving more assets away from external managers to a dedicated LGPS investment management resource (“in-house management”).

 There is potential for actual savings from each of these sources to be higher than current estimates.

 Savings will take time to emerge and will be offset by the costs of implementation including the expenses involved in setting up the pooling vehicles and the costs of transitioning assets into the pools. In the short term there is a real risk that costs will exceed savings.

Cost savings should not be pursued in a way that puts investment performance at risk. A successful outcome is one which achieves cost savings and potential for enhanced performance through the pool governance arrangements.

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Establishing a base line Data provided by LGPS funds (current costs) To provide supporting analysis to Project POOL Hymans Robertson issued a questionnaire to all 89 English and Welsh funds within the LGPS. The questionnaire asked each fund to provide details of their current investment arrangements focussing on the breakdown by asset class and mandate, and the fee arrangements and management costs related to these investments. The questionnaire was designed such that funds could provide information in varying levels of detail to allow for sensitivities around disclosure of the information, given the commercial sensitivity around fee arrangements.

The timescales for the completion of the JWG’s report to government required the data to be submitted and analysed within a relatively short time period. There was limited opportunity to be able to query and “clean” the data responses. Where data was incomplete Hymans Robertson LLP have made assumptions or interpretations as required, and in other instances performed calculations on data provided. We believe any assumptions, interpretations or calculations made are appropriate given the intended use of the data.

We receive a good response from the LGPS funds as follows:

 Complete responses on 2015 data from 43 funds;

 These responses provided us a coverage of £141.8bn of assets;

 One additional response was received from a Scottish fund which was not included in the main data analysis.

Data provided by Fund Managers (potential future savings) To enable further analysis (e.g. commonality of mandates and existence of sliding fee scales which could result in fee savings on larger mandates) Hymans Robertson LLP issued a questionnaire to the 40 largest external investment managers who hold LGPS assets. The managers cover a wide range of both traditional and alternative asset classes. The questionnaire asked each manager to provide details of their LGPS assets under management as at 31 March 2015, focussing on the breakdown by asset class and mandate, and the fee arrangements and management costs related to these investments.

The data provided by the investment managers is highly commercially sensitive and Hymans Robertson LLP has agreed not to disclose details of any individual manager’s data to clients, the participants in Project POOL or any other third parties.

The data provided by the investment managers was largely fit for the intended purpose, although in some cases Hymans Robertson LLP has made assumptions or interpretations as required, and in other instances performed calculations on data provided. We believe any assumptions, interpretations or calculations made are appropriate and fit for purpose given the intended use of the paper.

We received a good response from the investment managers as follows:

 Completed responses from 35 of the 40 investment managers;

 These responses provided us with a coverage in excess of £150bn of assets;

 However, incomplete responses mean that the total assets considered in our analysis covered some £127bn in total;

 The responses received covered a broad range of traditional and alternative asset classes as well as a broad range of pooled and segregated mandates.

We believe that the sample data collected is broadly representative of the total externally managed LGPS assets.

A key objective of this analysis was to understand how fee levels might reduce with a greater aggregation of LGPS mandates. Given the meaningful commercial sensitivities around this question, this was one area where the responses received were incomplete. However we have been provided with sufficient information to make a conservative estimate of the fee savings that might be available for significantly increased mandate sizes for the main liquid asset classes.

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It is our expectation that commercial pressures applied at appointment to the new pools will lead to further fee reductions being achievable. However there will be some tension on mandate types where there are capacity constraints.

Current costs identified Each workstream chapter summarises the fees currently being paid, where possible differentiating between the costs incurred by internal management and by external management. Where other sources have been available they have been used to confirm or modify the raw data from the survey. The table below sets out a high level summary of the data received from funds, pro-rated to reflect the full assets of the LGPS in England and Wales. The £763m total is reasonably consistent with the c£750m identified in the report to DCLG in December 2013 base on analysis carried out by CEM Benchmarking Ltd.

Asset Class Current costs (£m)

Equities (actively managed) 288

Equities (passively managed) 27

Fixed Income 86

Property 121

Private equity 113

Infrastructure 30

Multi-asset fund (inc DGFs) 38

Hedge funds 36

Other (inc cash) 24

Total 763

Total costs of running LGPS assets are likely to be higher since we expect that the estimates above do not include data that is difficult to quantify including, for example, some performance fees and other less visible layers of fees in Fund of Funds arrangements.

Projecting into the future Sources of cost savings Cost savings can come from a number of sources;

1. Reduced manager fees due to larger mandate sizes (many managers offer a sliding fee scale which means that lower fees are charged on funds added at the margin)

2. Reduced manager fees due to commercial pressure – we anticipate that a number of managers will be very keen to retain and grow their LGPS business

3. Changing the means of access to an asset class, e.g. moving from active management to passive management or removing layers of fees that are common in some alternative asset classes

4. By moving more assets away from external managers to a dedicated LGPS investment management resource (“in- house management”).

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For the liquid asset classes (quoted equities and bonds) the analysis is based on the estimates of external manager fee reductions expected for larger mandate sizes. No allowance for moving more of these assets passive (which would mean sacrificing the potential for manager outperformance) or to in-house management though the latter is an option that pools might consider in the future.

For illiquid asset classes there is a focus on removing or reducing some of the layers of fees.

Estimated cost savings The table below summarises the potential sources of cost savings and the estimated annual amount of savings all based on asset values today. We have pro-rated the assets in the fund survey to reflect the total assets of the LGPS. Internally managed assets have been excluded as it is unlikely that further reductions could be achieved.

Asset class Sources of future savings Annual savings (£m) (based on current asset values) Year 1 Year 5 Year 10 Active listed equities  Reduced manager fees (5-10bps) 0 £32-64 £32-64 (externally managed) Passive listed equities  Reduced manager fees (c4bps) est £5 £10-12 £10-12

Bonds – active and  Reduced manager fees 0 £5-10 £5 - 10 passive (external mgd) Property  Remove multi-managers (FoF) 0 £15 £37  Migration from indirect to direct  Pooling direct mandates  Total = c28bps Infrastructure  Remove FoF fees 0 £5 £13.5  Move directly invested in-house  Total = c75bps Private Equity  Remove FoF fees 0 est £10 £35  Move directly invested in-house  Fee reductions ext managed Other alternatives: Multi-  MAF: fee reduction 5-10bps £2-5 £7-11 asset Funds (MAFs) &  Hedge Fund: reduce base fees on FoF (MAF (MAF and Diversified Growth Funds using external advisor only – hedge) (DGFs), Hedge, Debt  Others: No material saving assumed run-off Strategies, hedge) Commodities Total £5 £79-121 c£140-183

It is difficult to forecast long term cost savings with certainty and the range of potential outcomes is wide. The estimates given here should be treated with caution.

In the first five years, the majority of savings come from fee savings on quoted actively managed listed equities; between five and ten years, changes to the unlisted investments are accessed and will have an increasing impact.

By year 10 we estimate that potential savings could be running at circa £140-185m per year based on asset values today and current asset allocations. Allowing for investment growth of between 3 and 5% a year for 10 years the estimated savings in year 10 values could be in the range £190-300m per year.

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Actual savings could be higher than current estimates since:

a) manager fee reductions in competitive tenders could be greater than currently estimated;

b) we do not have sufficient data to estimate the potential savings on some of the less visible layers of fees on alternatives (including performance fees); and

c) extended use of “in-house” management in future would result in greater savings.

A change in investment strategy to increase the allocation to infrastructure will however most likely lead to higher total costs despite the lower cost per £1 of investment as the increase in exposure would be expected to be funded from equities which carry much lower investment fees. In setting out their expected cost and savings profiles in submissions to government, pools should quantify any increase in costs expected as a result of any intention to increase allocation to infrastructure investment and government should recognise this effect in measuring future costs and savings.

There will be significant differences between pools in the savings achieved depending on where they start from (asset allocation, prevailing fees, current approach to accessing different types of assets, etc),

Offsets to savings The costs of implementing change (establishing new structures and transitioning assets) will exceed savings in the short- term.

Until transition costs are estimated more accurately, it is difficult to estimate how many years it will take to break even. Transition costs across the LGPS will depend on the fund structures that each individual pool decides to put in place, the extent of manager and mandate change that is required to bring all funds into alignment in each pool and the timing of the required changes (to the extent that the pools work together to try to reduce to market impact of the changes in structure).

For some asset types (including private equity, hedge funds and infrastructure), it will be necessary to let existing investments run to their natural termination date to avoid the costs of early termination. This means that the potential annual savings from pooling and new investment platforms will not be fully achieved until year 10 or later.

Assumptions made We have assumed current asset allocations (including infrastructure) are unchanged and remain the same for the next 10 years and no change in the proportion of assets managed in-house.

In estimating asset values in 10 years we have assumed no net new money (contributions in and pension payments out net off – in fact there is likely to be some new money) except for investment return..

Assumptions of savings for each asset class are set out below.

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Asset Class Assumptions made Sources of saving Active listed equities  Assets of c£60bn today  Manager fees reduce by 5- 10bps due to mandate scale Passive listed equities  Assets of c£35bn today  Manager fees reduce by c4bps due to mandate scale Bonds – active and passive  Assets of c£31bn today  Manager fee reduce by c5bps due to mandate scale  Pooling direct mandates – fees Property  Assets of £13-14bn  54% UK direct reduce by 5bps  13% UK indirect (internal)  Move from indirect to direct –  27% indirect (external fees reduce by 50bps multi-manager)  Removal of multi-managers –  6% overseas fees reduce by 20bps  Assets £2bn today Infrastructure  Remove fund of fund layer –  £0.4bn fund of funds fees reduce by c94bps  £1.6bn direct  Move direct in-house – fee reduce by 55bps Private Equity  Assets £6.2bn  Remove fund of fund layer –  £2bn fund of funds fees reduce by 80bps on  £0.8bn direct with external committed capital advisor  Move direct in-house – fees  Undrawn commitments reduce by 50bps 65%  Negotiate fee reductions on underlying investments – fees on total commitments reduce by 15bps  Reductions offset by in-house costs in-house costs

Other alternatives, including  Multi-asset funds - £5bn  Multi-asset fees reduce by 5- 10bps due to scale of mandate multi-asset and hedge funds  Hedge funds – £2bn  Base fee 80bps on both  Hedge funds base fee to segregated and fund of external manager reduced to funds 30bps (no change in cost assumed for internally managed hedge funds)

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7 ESG & Responsible Investment

Background

Potential to improve the efficiency and effectiveness of stewardship  The Local Government Pension Scheme: Investment Reform Criteria and Guidance, clearly directs the opportunities, created through investment pooling, to improve the efficiency and effectiveness of robust stewardship and consideration of environmental, social and governance value drivers.

 More LGPS funds now have a greater opportunity to be among the leaders in the UK asset owner community in developing Responsible Investment.

 Responsible Investment begins and ends with asset owners, rooted as it is in meeting long term investment horizons and the varied fiduciary obligations these imply.

 It addresses the ecology of the investment world by seeking to improve outcomes (such as financial stability under- pinning long-term returns) and the processes by which these may be attained (e.g. improved corporate governance standards in UK companies). For the LGPS, pooling presents an opportunity to better pursue these outcomes. The benefits of working collaboratively across pools include cost and time efficiencies to consider ESG/RI issues at scale, development of a more united, powerful voice and collective action that will enhance the reputation of the LGPS with stakeholders and benefit companies, fund managers and policy makers.

 The collective enhanced outcomes will assist in delivering strong, stable, long term shareholder returns and contribute to financial stability for the UK economy; but also have the potential to enable the LGPS to become a stronger force in supporting the Government’s objectives in delivering the recommendations of Kay Review, assist in the rebuilding of societal trust in the Finance sector and enhance the global reputation of the UK businesses and markets. Proposal

Preferred options

• Each pool (MAP or SAP) should 1. Nominate a named lead to co-ordinate the implementation of the consideration of ESG/RI issues, risks and communications for the pool and support underlying funds in implementation. For example, ensure investment policies are consistent with guidance produced, relating to specific government policy areas, as outlined in the Local Government Pension Scheme: Investment Reform Criteria and Guidance. 2. Identify ESG risks and opportunities, as part of the wider risk framework, to communicate to underlying funds to assist in strategic asset allocation. Each pool should seek to identify ESG risks and opportunities to assist underlying funds developing policies, processes, in particular Investment Principles behind their Investment Strategy Statements 3. Share best practice across LGPS and in the wider UK pension fund industry. We anticipate considerable time and cost savings as well as enhanced reputational benefits of a co-ordinated approach to engagement with stakeholders and non-governmental organisations. The pool will be able to look for opportunities to consider collective action including but not limited to engagement and voting. 4. Use National frameworks and other collaborative initiatives (for example LAPFF) to access services to support cost effective stewardship and consideration ESG/ RI issues. The use of collaborative initiatives enables more effective collective action.

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5. Develop a compliance statement to the UK Stewardship Code (or other global codes as appropriate or may supersede) for the pool. Underlying funds should more effectively use the code(s) to clearly articulate their policies and approach to beneficiaries and other stakeholders. Delivery of consideration of ESG should also to be consistent with the guidance produced by DWP2 and TPR. 6. Seek, over time, to apply international best practice, consistent with the application of fiduciary duty as set by the Law Commission. A practical step would be for each pool to become a signatory to the United Nations Principles of Responsible Investment by 2020.

Implementation guidelines • Each pool will need to ensure ESG risk consideration is explicit and fully embedded in the wider pool and governance and risk framework. The following are practical ways to demonstrate this: • In setting up each investment option, sufficient flexibility should be included to enable funds to select thematic, tilted or screen funds3 as conducive to the investment strategy and asset allocation of the underlying funds. • In selecting fund managers (internal or external) for the sub-funds, the pools should be clear how the pool has considered and weighted RI issues within the selection process. We recommend that the levels are risk based and commensurate with international best practice4. For example it would be expected that asset classes with inherently more ESG risk e.g. emerging market equities would have a higher weighing than other asset classes. • ESG considerations should be explicitly referenced within fund manager due diligence, appointment and monitoring and reporting practice. To assist we identify sources of best practice guidance that should be used by pools, but recognise that these will be updated over time. • ESG considerations factored into manager selection, appointment and monitoring including ESG expectations in requests for proposals, questionnaires, monitoring and discussions with managers – see Aligning Expectations: Guidance for Asset Owners on incorporating. • ESG considerations factored into manager appointment - International Corporate Governance Network - https://www.icgn.org/, with reference to the IGCN model mandate for IMA design • Reporting should be enhanced both for funds and also for beneficiaries. The guidance developed by asset owners (including 4 LGPS funds) is applicable to other asset classes. http://www.plsa.co.uk/PolicyandResearch/DocumentLibrary/0424_guide_to_responsible_investment_ reporting_in_public_equity_published.aspx • Pools should consider not limiting future opportunities through prescription and enable potential development for consistent policy approaches, whilst allowing flexibility for underlying funds to express different views where this is appropriate to their investment principles.

2 https://www.gov.uk/government/consultations/occupational-pensions-reducing-regulatory-burdens-and-minor-regulation-changes 3 This could include funds or indices where the stock selection has rules or guidelines (positive or negative) that are designed to either seek to exploit an opportunity e.g. sustainable equity funds, clean technology or water funds or minimise a certain area of risk e.g. carbon-tilted indices, exclusions for landmines. 4 Aligning Expectations: Guidance for Asset Owners on incorporating. And emerging best practice shared through media and events such as https://www.responsible-investor.com

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8 Workstream Chapters

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8.1 Passive Equity Background Asset Class  Passive equity management provides equity market returns by investing in funds tracking a range of market and non-market capitalisation weighted indices;

 ‘Smart beta’ allocations have been included where the weighting of the tracked indices’ are determined by a measure(s) other than market value. To qualify as passive, smart beta indices must be transparent and available via more than one implementer; funds tracking indices proprietary to one manager, including ‘enhanced indexation’ are excluded. Scale, variability, management and access  Equities account for c.£115bn of LGPS assets of which c.£35bn is passively managed and of this c.£29bn is managed externally.

 The investment in passive equities represents 18% of total assets.

 Passive equity mandates differ widely in scale; mandates range in size from £2m to £2.5bn.

 There are well over 100 individual passive equity mandates but only five external managers are used and of those one manager accounts for some 40% of passive equity mandates by value

 The vast majority of LGPS passive assets are invested through externally managed, life wrapped pooled funds. Internal and a small number of external funds are managed on a segregated basis. Current costs  The annual management charge for externally managed passive equity pooled funds is 8bps (arithmetic average) or 6.4bps (weighted average). Proposal

Preferred options  A National Framework open to all LGPS funds should be established. This would include a ‘ceiling pricing’ to ensure meaningful average fee savings are achieved. The Framework would be limited to two or three managers, which will be sufficient to maintain pricing tension. This would provide a ‘quick win’ for LGPS in terms of demonstrable fee savings.

 The National Framework would be accessed by the MAPs. Each of the six MAPs would have average passive equity assets of c.£5bn and retendering mandates on this scale should capture almost all the saving available for a SAP while retaining greater accountability.

 The overlay of a National Framework would allow passive providers to look at LGPS in aggregate although it would potentially be implemented by MAPs. Expected savings  The MAP / National Framework structure could achieve savings of savings of c.4bps p.a. (£10m - £12m) compared to the current average fee for externally managed passive equity assets.

 The low passive fees will further inform the debate over net value added vs active management.

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Governance assessment  MAPs provide the platform for a good balance between scale fee saving and improved governance while maintaining local accountability.

 Providers should be reviewed regularly but not excessively. Notes/Warning  Currently the majority of LGPS passive assets are invested through externally managed, life wrapped pooled funds. This poses an issue for all forms of pooling (where pooling implies owning a number of shares in a pot of assets where each share is identical) because the beneficiary of each policy must also be the owner of the policy. It is not clear that ownership can easily be shared across the Administering Authorities that invest in a pooled investment vehicle (an ACS or any other scheme).

 In the short term there are likely in to be costs of transition through moving from life policies to another structure and in the long term costs could be higher due to a reduction in the scale of crossing opportunities (crossing is where inflows and outflows are matched off, reducing the need for more costly market transactions).

 It would be helpful if government could provide some clarification on this point.

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Introduction In simple terms, managing passively means matching (or tracking) the performance of a benchmark for example, the UK stock market, using a market index provided by an index provider, for example FTSE or MSCI. The primary indices currently in use by LGPS funds are constructed on a weighted market capitalisation basis, but may also be constructed on a non- market capitalization basis. In particular “smart beta”5 indices are gaining particular traction as an alternative to active management. There is a degree of variability in pricing between indices not least due to the licensing costs payable to certain “smart beta” providers.

Managing passively is challenging because the index performance, which is published by the respective index providers does not take account of transaction costs or tax. The constituent parts of an index change weights as market prices change, dividends require reinvestment and index constituents change due to corporate action or a material change in value. When index trackers have to buy or sell shares to match movements in the index they incur transaction costs (bid/offer spreads and tax) and they may be subject to market movements when other market participants are aware the index providers need to rebalance. Hence there is a potential headwind to make up in matching an index but it is the ability of the best providers to manage this process that gives them a quality advantage in implementation. The value of this ability (evidence suggests it is a repeatable systemic advantage) is potentially material compared to the level of fees charged.

Index trackers can add value in the way they operate. They can for example:

 trade efficiently,

 take small views on the timing of some changes to the index,

 take advantage of dividends offered in the form of shares and

 add value in stock lending (but there needs to be a rigorous assessment of collateral and a clear understanding of the accrual of benefit between the provider and the institution whose capital is being lent out).

 vote and engage with company management on environmental, governance and social (‘ESG’) issues

The first four provide the manager with opportunities to add value which means they can often beat the headwind they face in transaction costs and go on to provide a small level of outperformance. This can typically be in high single digit or low double digits in terms of basis points performance enhancement. It is important that implementation quality and total expenses are carefully considered in selecting a passive implementer as these may be more material to the final outcome than the absolute level of invoiced fees, particularly at the fee levels currently being discussed.

ESG Considerations All large passive managers currently working with the LGPS ‘vote’ their shareholdings and engage with the investee companies. This is important as part of the concept of universal ownership. Given the scale of the large passive providers they can exert significant pressure on companies on corporate governance and engagement matters. Entirely appropriately managers concentrate on matters that deliver long term shareholder value. Managers will generally aggregate their shareholdings in voting and in doing so become some of the largest individual shareholders in a company. This gives them significant leverage in engaging with companies. Some managers have the flexibility to allow individual funds to ‘vote’ their own shares either directly or by an overlay provider, but that is not always the case and some fund managers have previously added costs regarding this as a customization feature. There will be an opportunity for the LGPS as a whole to discuss how to use its voting and engagement on its passive funds to achieve positive outcomes for the members of the scheme overall and contribute to achieving long term financial stability. Managers will engage with interest groups such as LAPFF but retain the right to make their own decisions on how to vote.

5 Constituents of ‘smart beta’ indices are weighted by factors other than market capitalisation (e.g. fundamental accounting measures, low volatility etc.).

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Exclusions of particular companies or sectors are difficult to manage practically and cost effectively through a pooled solution, unless selecting an index for which this is already integrated e.g. FTSE for Good. LGPS funds that have exclusions have traditionally used a segregated approach for these mandates. Current scale and market structure All LGPS funds have exposure to either internal or externally managed passive equities. The current structure of LGPS passive equity exposure is set out in the following tables:

LGPS £’bn %

Total assets 190 n/a

Total equities 115 60

Total passive equities 35 30

Of which external 29 83

And in-house 6 17

Source – (extrapolation of) Project POOL LGPS Fund Data survey.

Unlike active equity there are a few managers who by their scale dominate the passive equity market. LGPS has well over 100 individual passive equity mandates but only five external managers are used and of those one manager accounts for some 40% of passive equity mandates by value.

The vast majority of LGPS passive assets are invested through externally managed, life wrapped pooled funds. The largest passive managers in the UK, LGIM and BlackRock, manage UK equity funds in the £25bn - £35bn range and global equity funds in the £5bn - £10bn range or higher in some cases. As a result the participants have very large pools of funds from which to achieve economies of scale. Internal passive equity and a small number of external funds are managed on a segregated basis.

Applied Example: The ‘Seven Shires’ project (Cheshire, Leicestershire, Nottinghamshire, Shropshire, Staffordshire, Warwickshire and Worcestershire) This group of seven Midlands authorities carried out a collaborative procurement exercise for their passive management in anticipation of the Government consultation. In doing so, they informally agreed to ‘pool’ their decision making into appointing one manager. That meant that the market looked at their assets in aggregate even though the funds were not technically in a pooled investment vehicle. The total assets exceeded £20bn of which over £6bn were invested in passive mandates. Between the seven funds there were four different managers and they were invested in funds tracking some 20 different benchmark indices. One of the search criteria was to maintain the existing asset allocation, so managers were required to provide a full suite of funds. That did mean that some managers who were unable to comply with this requirement were eliminated from the final selection.

The passive managers clearly approached this exercise not only from the point of view of the Seven Shires tender itself but also being mindful of the wider context of the LGPS pooling consultation. The result was a fee saving of the order of 50% and therefore in line with our projected fee saving for both the SAP and MAP options. This ‘real world’ example is of particular relevance and importance to the pooling debate, illustrating what can be achieved by pooling resources even without the cost and complexity of a formal CIV structure.

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Current fees The tables below show average fees for the main passive pooled equity mandates.

Pooled Average fee (bps) Weighted Average fee Number of funds (bps) Passive Equity 7.9 6.4 88

UK 3.5 3.1 21

Global 7.8 7.5 20

Emerging Markets 15.8 14.1 6

RAFI Global 12.6 12.5 6

The tables below show average fees for the main passive segregated equity mandates.

Segregated Average fee (bps) Weighted Average fee Number of funds (bps)

Passive Equity segregated 3.6 2.0 10 UK 2.6 2.6 4 Global 9.0 8.3 2 Emerging Markets n/a n/a n/a

The average size across mandate types was £205m for pooled mandates and £790m for segregated mandates. Options analysis A broad range of options were considered initially before narrowing these to the SAP and MAPs and National Framework.

 SAP

 MAPs

 Informal MAPs (similarities to London CIV model)

 National Framework

 LGPS share class

 Internal management

Options discarded at an early stage Informal MAPs Essentially this has the same benefits as the MAP option but with this approach groups of authorities would combine to exercise enhanced buying power through joint procurement and/or combine more formally with the aim of rationalising the number of manager relationships. In each case the local authorities would retain control of the decision over mandate parameters and the choice of manager.

This approach would potentially achieve meaningful cost savings, retain local accountability and would be less costly / complex than a formal MAP structure (assuming a ‘virtual MAP’ i.e. less formal than London CIV).

However, it was clear that this solution did not meet the government criteria to remove the individual manager decision from the diverse range of local authority decision making committees and thus it was discarded at an early stage.

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LGPS share class If all participating managers were to create an exclusive LGPS share class it would potentially allow the smaller local authority funds to gain the same benefits of scale accruing to larger funds. This approach would yield savings without incurring the potential costs of transferring assets between managers or into a MAP/SAP.

However, the initiative would be with the managers and it was felt fee savings would not be maximised.

There is also uncertainty about whether this meets the Government’s criteria - a LGPS share class would only address fees, there is no governance improvement and no mechanism to improve performance.

For these reasons the LGPS share class option was discarded at an early stage.

Internal management A little under 20% of LGPS passive equity assets are managed internally. In some cases authorities will use a mixture of internal management and external funds where the former does not have sufficient breadth of coverage.

Internal management is covered separately within this report and therefore has not been considered in detail within this chapter. However the following points are considered important:

 Passive funds should exhibit a narrow tracking range around the benchmark index (e.g. +/- 0.25% for a UK equity fund and +/-0.5% for a global equity fund).

 Taking the Seven Shires project (see comment below) as a guide, the differential between external and internal manager fees is likely to shrink markedly when the pooling initiatives have run their course.

 Externally managed funds can often generate positive tracking error within these parameters due to judicious management of corporate actions (including index changes), scrip dividends, stock lending etc. If sufficiently persistent, take this added value into account alongside fees.

 External managers benefit from economies of scale in custody costs and in transaction costs. For the latter, the scale of existing index-tracking funds and/or access to wider trade flows within a passive organisation can provide crossing opportunities which significantly reduce transaction costs especially where regular rebalancing is required. This is a further factor to consider.

 Stock lending is a feature of internal / external passive equity management. Consideration should be given both to the robustness of risk controls around stock lending and to ensure that full net of costs benefits accrue to the funds.

 The breadth of index-tracking capability needs to be weighed up, especially with the growth of smart beta indices which generally incur higher turnover than their market capitalisation equivalents.

Options given further consideration National framework It is expected that the framework would target having 2 or 3 framework managers in order to create pricing tension.

More specifically:

 Scale – the National Framework would cover £29bn of passive equity assets (excluding internal management for the time being).

 Governance - there would be no change in governance so on its own a National Framework would appear to fall short of the government criteria in this regard unless there were a softening of view by government regarding the use of virtual pools in respect of passive assets.

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 Fee Saving – a single manager framework should maximise fee savings initially but would compromise ongoing commercial tension and would imply a higher cost of change for LGPS as a whole. A framework of two or three managers would be preferred.

 SRI / ESG – voting arrangements and environmental / social policy would remain largely delegated to the managers as they are currently.

 Speed of Implementation and Simplicity – setting up a National Framework should be very straightforward. A National Framework would be a ‘quick win’ in terms of the broader LGPS pooling initiative (completed within six to nine months) so also scores strongly on this point;

 Practicalities of Delivery – again a strong point as it is likely that a majority of local authority / manager relationships would remain intact.

While simplicity and speed are strong factors in favour of a National Framework, on its own it does not meet the government’s governance criteria and fee saving may not be completely maximised. However, there may be a role for a National Framework as part of an optimal solution.

SAP A SAP would bring together all the LGPS passive equity assets under one governance structure, with the possible exclusion of internally managed assets (although it would seem odd to keep a small proportion of assets separate). It is likely that a SAP would maintain a limited number of sub-pools allowing authorities to choose whether to track, say, UK equities or global equities or a combination thereof etc.

More specifically:

 Scale – the SAP would cover £29bn of passive equity assets (excluding internal management for the time being). There should be no dis-benefits of scale in contrast to active equities.

 Governance - governance would move to the SAP in line with the government’s criteria. There is likely to be a meaningful deterioration in local accountability and possibly flexibility (e.g. how many smart beta indices would the SAP offer tracking funds for).

 Fee Saving – a SAP would be in a position to maximise fee savings even if more than one manager was appointed to maintain commercial tension (but see comments on MAPs below)

 SRI / ESG – voting arrangements and environmental / social policy would remain largely delegated to the managers, as they are currently, but the SAP would be in an influential position to represent the collective local authority view (e.g. LAPPF);

 Speed of Implementation and Simplicity – setting up a SAP, gathering information and transitioning assets is likely to be a protracted and relatively expensive process. • Practicalities of Delivery – Without the existence of the life wrap, the actual transfer of assets to a SAP would be relatively straightforward given the commonality of passive equities mandates but not without cost (e.g. emerging market assets have to be sold and repurchased) and the SAP structure itself would have to be established. However, it is likely that any form of pooling vehicle will be unable to invest in life wrapped pooled funds (this would appear to be the experience of the London CIV and is reflected in the chapter on structures). The London CIV has set up tax transparent funds through which its passive assets will be managed. While this has some advantages in respect of withholding tax, it may be a sub-optimal solution for the broader LGPS as scale advantages of the existing life wrapped pooled funds would be lost. Overall a SAP would not offer a material fee saving over a MAP solution, would be less optimal in terms of accountability and would be at least as complex/costly to set up and administer especially if costs were not ‘shared’ with other asset classes.

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MAPs A MAP solution would be formed by up to six regional and/or like-minded groups of funds with average assets of around £30bn in each. Each MAP would have an average of £5bn invested in passive equities.

Internally managed assets would form part of at least some MAPs initially, though its continued use would thereafter be under the remit of the MAP to whom all governance matters would be transferred.

More specifically,

 Scale – on average each of the MAPs would have passive equity assets of just under £5bn or just under £6bn including internally managed assets. There should be no dis-benefits of scale in contrast to active equities;

 Governance - governance would move to the MAPs in line with the government’s criteria. Local accountability should be better retained than with a SAP solution due smaller groupings and greater cohesion; initially, internal and external management could be retained but ultimately, given the homogenous nature of the product, the MAP may wish to decide which is the optimum delivery model

 Fee Saving –a MAP solution could deliver to all intents and purposes the same level of savings as a SAP based on evidence from the ‘Seven Shires’ (a project to combine the passive assets of seven local authority funds with a single manager). They could also operate in conjunction with a pre-existing National Framework for passive equity. The potential savings have been estimated below:

Average fee 2015 Estimated future fee Estimated future fee (bps) saving (MAPs) saving (MAPs) (bps) (£’m)

Passive Equity (pooled) 8.0 4.0 10 - 12

Passive Equity (segregated) 3.6 0 n/a

 SRI / ESG – as with the SAP voting arrangements and environmental / social policy would remain largely delegated to the managers, as they are currently, but the MAPs would be in an influential position to represent the collective local authority view (e.g. LAPPF);

 Speed of Implementation and Simplicity – setting up MAPs and gathering / transitioning assets would take time and incur transition costs. However, set-up costs could be defrayed across multiple asset classes. - Practicalities of Delivery – Without the existence of the life wrap, the actual transfer of assets to a SAP would be relatively straightforward given the commonality of passive equities mandates but not without cost (e.g. emerging market assets have to be sold and repurchased) and the SAP structure itself would have to be established. However, it is likely that any form of pooling vehicle will be unable to invest in life wrapped pooled funds (this would appear to be the experience of the London CIV and is reflected in the chapter on structures). The London CIV has set up tax transparent funds through which its passive assets will be managed. While this has some advantages in respect of withholding tax, it may be a sub-optimal solution for the broader LGPS as scale advantages of the existing life wrapped pooled funds would be lost. - With one manager accounting for some c.40% of external passive equity assets (c.35% of total passive equity assets) transition costs will clearly be higher if another manager wins a mandate. Although there is significant scope for in specie transfers of holdings, this is not possible for emerging market shares and there will be smaller administrative costs incurred in the change of ownership in other domiciles. There is potential for a winning passive manager bearing some or all of the transition costs but while this is not ruled out, unsurprisingly the managers are unwilling to make such a commitment hypothetically.

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- UK share transfers involving change of ownership incur Stamp Duty Reserve Tax of 0.5% on transfer. LGPS has passive UK equity exposure of the order of £8bn; triggering a transfer of ownership on these assets would imply a tax bill of up to £40m, swamping the potential fee saving from the pooling arrangements. Whilst passive equity asset transfers between life fund vehicles may be exempt from UK stamp duty, the issue of an ACS structure not being able to invest in life funds assumes considerable financial significance. - Timeframes will depend entirely on the time needed to implement the MAP structures but initial savings could be available from establishing a National Framework on a in six to nine month view if all MAP groupings agreed to re-tender through the Framework. - Market impact is likely to be relatively muted for passive equities compared to, say, active equities. Each passive manager is capable of managing and accounting for the cost of its own transitions though there may be some scope for coordinating timing between individual MAPs. A MAP structure is considered to be the best model for managing passive equities as it appears to offer more or less the same fee savings as a SAP whilst maintaining local accountability and flexibility and meeting the government’s criteria in terms of governance.

Comparison against government criteria Pooling Option Scale Savings Governance Speed of Practicalities of delivery delivery

National Framework

SAP [1]

MAPs

[1] An amber rating for National CIV governance expresses our reservation on its local accountability

How will these passive equity options work with broader pooling solutions MAP MAP Plus Mixed economy National CIV

National Framework Yes Yes Yes No

SAP No Yes Yes Yes

MAPs Yes Yes Yes No

Preferred option A MAP structure is considered to be the best model for managing passive equities as it appears to offer more or less the same fee savings as a SAP whilst maintaining local accountability and flexibility and meeting the government’s criteria in terms of governance.

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8.2 Active Equity

Background

Asset Class  Active equity management aims to provide equity market returns plus a premium attributable to manager skill.

 Portfolios with high active share (genuinely different from the benchmark) generally comprise a much smaller number of stocks than the benchmark with implications for liquidity; it is widely accepted that there are dis- benefits of scale in active management but the point where these occur varies widely between strategies.

 There are also dis-benefits from combining too many managers with a common benchmark; individual portfolio positions can off-set each other leading to falling active share as more managers are added. We believe four to six managers in any one pool is optimal for diversification and maintaining active share.

Scale, variability, management and access  Equities account for c.£115bn of LGPS assets of which c.£80bn is actively managed and of this c.£64bn is managed externally.

 The investment in active equities represents 42% of total assets.

 Active equity mandates differ widely in scale; mandates range in size from £2m to £6bn.

 There are over 170 individual active equity mandates managed by around 40 different external investment managers.

 Some 20 of the external managers have only one LGPS mandate. These managers account for around 10% of actively managed equity assets.

 Of the c.£64bn externally managed active equities 85% - 90% are managed on a segregated basis with the balance invested in a range of pooled vehicles including UCITs funds, unit trusts, OEICs, SICAVs etc. Current costs  The annual management charge (‘AMC’) for externally managed segregated active equity is 44bps (arithmetic average) or 31bps (weighted average).

 The equivalent AMC for pooled funds is 58bps and 50bps respectively.

 On average these fees represent a 12% reduction compared with the average fees quoted in DCLG: LGPS Structure Analysis December 2013 (Hymans Robertson LLP). Proposal Preferred options  MAPs formed by regional and/or like-minded groups of funds provides the best compromise between meeting the government's criteria and maintaining local authority accountability and flexibility.

 A SAP would be less locally accountable and more likely to encounter dis-benefits of scale; we found no evidence that it would leverage greater fee savings than MAPs each with over £10bn in active equity. Expected savings  The MAPs structure could achieve savings of between 5bps - 10bps p.a. (£32m - £64m) compared to the current average fee for externally managed active equity assets.

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Governance assessment • MAPs provide the platform for a good balance between scale fee saving and improved governance while maintaining local accountability. Co-ordinated decision making by smaller, more focused decision making groups should reduce the frequency of manager change. Notes/Warning  Due to the large number of LGPS active equity mandates / participants and the complexity of setting up new decision making structures, we favour a phasing period where all mandates are drawn into the MAP and rationalisation completed over time and in conjunction with other MAPs to minimise costs.

 It is anticipated that some investment managers will decline to join a MAP thus requiring immediate action.

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Introduction

Active equity management aims to provide investors with equity market returns plus a premium attributable to manager skill. Active managers will focus their portfolios on stocks, sectors, regions or factors (e.g. higher yielding shares) that they anticipate will perform better than the market average over time and thus add value relative to the alternative of tracking a benchmark index. While some active managers run portfolios investing in specific sectors, the overwhelming majority are divided regionally (e.g. UK, Global, Emerging Markets etc).

The MSCI All Countries World Index comprises some 2,400 companies whereas active manager portfolios typically comprise anywhere between 25 stocks and several hundred with the majority around 50 – 100 stocks. Many, but by no means all, active equity strategies will have some bias towards smaller, less well researched and less mature businesses. As a result, while scaling up assets is clearly beneficial in passive equities, it is widely accepted that in active equities dis-benefits will accrue at some stage in the scaling process. The dis-benefits that will eventually adversely impact performance are mainly the restriction of the active manager’s opportunity set of possible investments, lack of flexibility to change the portfolio and potentially excessive demands to service an expanding client base. Unfortunately, although the best managers will monitor the liquidity of their portfolios, there is no generic yardstick by which to measure capacity across the vast range of active manager funds.

Active share is a measure of how different an active portfolio is from the benchmark index which it is aiming to outperform. It has attracted considerable interest after academic research linked higher active share to greater relative outperformance. The corollary has been a focus on ‘closet index’ funds which charge active management fees but deliver portfolios and performance which is very close to benchmark. Interestingly, combining active portfolios which aim to outperform a common benchmark can have an unintended ‘closet indexing’ effect as it is not uncommon for managers to take opposing positions which offset each other when aggregated. This is a major contributor to active management achieving only benchmark like returns from active management in aggregate. In fact, our analysis suggests that even careful combination of more than four to six portfolios begins to seriously undermine aggregate active share.

These twin issues of capacity and active share are important when assessing optimal pooling solutions. It is key to avoid mandates so large that investment flexibility and the ability to differentiate is lost but also to avoid aggregating so many active equity portfolios that benchmark like performance is almost inevitable. However material fee savings and mandate rationalisation can be achieved without falling into either of these traps. Current scale and market structure Almost all LGPS funds have exposure to either internally or externally managed active equities. The current structure of LGPS active equity exposure is set out in the following table:

Average mandate size Active equity Total assets (£’m) Mandates (£’m)

Global 27,900 75 370

UK 8,300 34 245

Emerging markets 2,700 22 125

Europe 1,900 9 210

Asia-Pac (ex-Japan) 900 7 130

North America 900 4 220

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Average mandate size Active equity Total assets (£’m) Mandates (£’m)

Japan 700 4 170

Undefined 3,000 5 615

Total 46,300 160 290

The table below extrapolates this information to the LGPS as a whole. LGPS £’bn %

Total assets 190 n/a

Total equities 115 60

Total active equities 80 70

of which external 64 80

of which in-house 16 20

The data indicates that the active equity assets are split across more than 175 mandates of which around 10% by number are internal. The range of mandate sizes is extreme, starting at £2m and going as high as £6bn though, as stated above, the average size is just under £300m.

The external mandates are managed by around 40 different investment managers although 20 of these managers have only one LGPS mandate and these mandates account for around 10% of actively managed equity assets. Clearly there is a significant ‘tail’ of managers with a single LGPS relationship and while this is an area ripe for rationalisation, it accounts for a relatively small proportion of active equity assets - so the impact on overall fee savings will be commensurately limited. Current fees The tables below show average fees for the main active equity mandates.

External / internal Average fee (bps) Weighted Average fee (bps) Number of funds

External 44 31 161 Internal 13 8 15

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The following two tables include both internal and external mandates

Pooled Average fee (bps) Weighted Average fee (bps) Number of funds

Active Equity 58 50 61

UK 79 67 -

Global 39 42 -

Emerging Markets 72 65 -

Segregated Average fee (bps) Weighted Average fee (bps) Number of funds

Active Equity 32 20 115 UK 27 15 - Global 34 23 - Emerging Markets 56 50 -

Average size across mandate types was £124m for pooled mandates and £458m for segregated mandates. Options analysis A broad range of options were considered initially before narrowing these to the SAP and MAPs and National Framework.

 SAP

 MAPs

 Informal MAPs (similarities to London CIV model)

 National Framework

 LGPS share class

 Internal management

Options discarded at an early stage Informal MAPs Essentially this has the same benefits as the MAP option but with this approach groups of authorities would combine to exercise enhanced buying power through joint procurement and/or combine more formally with the aim of rationalising the number of manager relationships. In each case the local authorities would retain control of the decision over mandate parameters and the choice of manager.

This approach would potentially achieve meaningful cost savings, retain local accountability and would be less costly / complex than a formal MAP structure (assuming a ‘virtual MAP’ i.e. less formal than London CIV).

However, it was clear that this solution did not meet the government criteria to remove the individual manager decision from the diverse range of local authority decision making committees and thus it was discarded at an early stage.

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National Framework A National Framework is most effective procuring goods and services where these are relatively homogeneous in nature allowing the procurement process to focus on price. For active equities there is a wide range of ‘products’ available and a price based comparison is unlikely to produce a sufficiently like-for-like comparison.

Moreover a National Framework(s) would have to appoint a wide range of managers in order to provide sufficient capacity for the LGPS and some of the more skilled managers, aware of capacity limitations, may decline to participate or offer attractive pricing due to the uncertainty of take up once appointed.

Finally a National Framework solution would not meet the government’s governance criteria in terms of moving direct manager selection away from diverse range of local authority decision making committees.

For these reasons the National Framework solution was also discarded at an early stage.

LGPS share class If all participating managers were to create an exclusive LGPS share class it would potentially allow the smaller local authority funds to gain the same benefits of scale accruing to larger funds This approach would yield savings without incurring the potential costs of transferring assets between managers or into a MAP/SAP.

However, fund managers operating at or near to capacity on active equity products would have little incentive to offer what is likely to be a reduced fee to public sector clients, especially where private sector clients could “take up any slack”.

There is also uncertainty about whether this meets the government’s criteria - a LGPS share class would only address fees, there is no governance improvement and no mechanism to improve performance.

For these reasons the LGPS share class option was discarded at an early stage.

Internal management Around 20% of LGPS active equity assets are managed internally; in some cases authorities will use a mixture of internal management and external funds where the former does not have sufficient breadth of coverage. Internal management is covered separately within this report and therefore has not been considered in detail within this chapter. However the following points are considered important:

 When a MAP is considering the merits of internal versus external management, each should be subject to the same rigorous scrutiny in terms of ability, resource and stability, track record, fees and other costs;

 With internal management, any evolution of product development and coverage will have to be borne by the MAP and its participants rather than shared with an external manager’s broader client base; a hybrid internal / external model would address this issue but costs of smaller external mandates would need to be monitored;

 External research may become an additional, albeit moderate, cost burden if forthcoming MIFID II rules enforce the separation of the cost of research from dealing commissions;

 Assuming additional resource is not required, internal management costs are generally not ad valorem i.e. not linked to growth in assets in the same way as with (most) externally managed assets;

 There will always be a slightly higher hurdle for an external manager to achieve a net of fees performance target, compared to an internal manager, because of the difference in fees. However the management approach cannot be determined solely on the absolute level of fees.

Options given further consideration SAP A SAP would bring together all the LGPS equity assets under a single governance structure,

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It is likely that a SAP would maintain a limited number of sub-pools allowing authorities to choose between, say, UK, global and / or emerging market equities etc.

Internally managed assets could be excluded, although it would seem odd to keep a small proportion of assets separate.

More specifically,

 Scale – the SAP would cover some £64bn of active equity assets (excluding internal management). Even if the SAP were to divide its active equity assets into UK, global etc sub-pools, in order to avoid diversifying away active share6 each mandate would have to be several billion pounds in size which could materially limit manager choice due to individual manager capacity constraints. Creating more sub-pools would alleviate this issue but is arguably an artificial and overly complex solution.

 Governance - governance would move to the SAP in line with the government’s criteria. Such a change could lead to a material deterioration in local accountability with governance too far removed from the local funds. An element of flexibility could also be lost.

 Fee Saving –theoretically a SAP would be in a strong position to maximise fee savings. However, if the scale of the SAP restricts the choice of available managers, this could reduce competition as a result. In addition. research indicates that fee reductions may plateau at mandate levels of c.£1bn. Therefore extra fee saving accruing to a SAP with larger scale mandates is far from certain and is, in any case, not identifiable in advance.

 SRI / ESG – ESG considerations for active equities are wider than stewardship (engagement and voting). The Law Commission has clearly stated that pension funds need to consider ESG risks where they are financially material to the long term sustainability of the companies invested in. This is clearly articulated in the pooling criteria. A pooling arrangement would enable the SAP to leverage existing expertise and knowledge and to share the costs of risk assessment as part of its fiduciary duty. The ESG risk assessment information could be used to influence investment decision making at the discretion of individual funds as well as funds being more able to retain a greater degree of influence on how their assets are voted etc. The later point may be harder to achieve with the SAP solution.

 Speed of Implementation and Simplicity – setting up a SAP, gathering information and transitioning assets is likely to be a protracted and relatively expensive process.

 Practicalities of Delivery – potentially consolidating assets on the scale of a SAP would be expensive and not without considerable risk.

The research undertaken did not identify any meaningful additional fee savings associated with the greater scale of a SAP relative to six MAPs. In fact, the scale of mandates may restrict choice / competition. In addition, the remoteness of a SAP and the potential lack of local accountability is considered to be a significant concern. Finally, a SAP would be complex and costly to set up especially if costs were not ‘shared’ with other asset classes. For these reasons a SAP solution was not preferred by the work-stream.

MAP A MAP solution would be formed by up to six regional and/or like-minded groups of funds with average assets of around £30bn in each. Each MAP would have an average of £10.5bn invested in externally managed active equities.

Internally managed assets would form part of at least some MAPs initially, though its continued use would thereafter be under the remit of the MAP to whom all governance matters would be transferred.

6 Active share is the proportion of the portfolio that does not overlap with the benchmark i.e. it is a measure of how different a portfolio is compared to its benchmark

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More specifically,

 Scale – on average each of the MAPs would have active externally managed equity assets of £10.5bn. If each MAP created sub-pools of, UK, global equities etc. and followed the model of no more than four to six managers with a common benchmark, then individual mandates could be structured to fall in the £800m - £1bn range. As under the SAP comment above, this should be of sufficient scale to capture all the fee savings from active equity managers that it has been possible to identify. Mandates on this scale may still preclude some smaller managers from tendering but this would be a less significant issue than in the case of the SAP model and would be considered on a MAP by MAP basis.

 Governance - governance would move to the MAPs in line with the government’s criteria. Local accountability should be better retained than with a SAP solution due smaller groupings and greater cohesion. Nonetheless, it is important to reflect that local accountability will inevitably be reduced.

 Fee Saving – for the reasons set out in the SAP discussion, MAPs, with potential mandate sizes of £800 - £1bn should be able to deliver a similar level of savings as a SAP. The potential savings have been estimated below: Average fee 2015 Estimated future fee Estimated future fee (bps) saving (MAPs) saving (MAPs) (bps) (£’m)

Active Equity (pooled) 58.0 5 - 10 4 - 8

Active Equity (segregated) 32.0 5 - 10 28 - 56

NB Based on £64bn external active equity mandates of which £8bn pooled and £56bn segregated

 SRI / ESG – the potential considerations for SRI / ESG issues are similar to those for a SAP. However local funds ESG views are likely to be more readily incorporated under a MAP structure with increased local accountability.

 Speed of Implementation and Simplicity – setting up MAPs and gathering / transitioning assets would take time and incur transition costs. However, set-up costs could be defrayed across the entire MAP assets rather than just active equities.

 Practicalities of Delivery - leaving aside the time and cost involved in setting up a MAP structure (dealt with elsewhere in this Report), the issue of implementation from an asset point of view is no less complex. With external active equity assets of £64bn covering over 175 mandates and 40 or so managers, the risk of attempting a one-off rationalisation and transition is significant. In order to effect a single transition: - the MAPs would need to be fully functioning, - all the MAP manager appointments would need to be agreed and in place, - the scale of all mandates would need to be settled and - stock ‘wish lists’ provided by each appointed manager. Rule of thumb estimates for transitions generally of 0.2% - 0.5% and assuming that roughly half of the assets would require to be transitioned would imply a transition cost range of £50m to £150m in this case. However the scale of this transition would be unprecedented making it challenging to come up with credible cost estimates. Typically transition manager fees are a small part of the overall ‘implementation shortfall’ used to calculate total transition costs. In the work-stream’s view, a focus on a large scale transition to bear down on transition manager fees would be misguided; by far the bigger factor would be trading costs and here there may well be dis-benefits of scale given the magnitude of trading activity required.

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It is therefore considered appropriate for:

- MAPs to organise their own transition activity - MAPs to collaborate where there are managers in common. - The London model, which allows funds to decide which assets to put into the MAP, to be adopted as a “stepping stone” between the current arrangements and a final pooling end state. This would provide a means of mitigating the forced cessation of successful mandates (which would raise questions over fiduciary responsibility) but must be managed by the MAP against a definitive timetable for rationalising the range of mandates. Where managers with existing LGPS mandates do not wish to become part of the broader MAP structure, this would have to be dealt with by individual MAPs and local authorities on a case by case basis. A MAP structure is considered to be the best model for managing active equities as it appears to offer more or less the same fee savings as a SAP whilst better maintaining local accountability and flexibility and meeting the government’s criteria in terms of governance.

Comparison against government criteria Pooling Option Scale Savings Governance Speed of Practicalities of delivery delivery

SAP [1] MAP [1] An amber rating for National CIV governance expresses our reservation on its local accountability

How will these active equity options work with broader pooling solutions? 5/6 MAPs MAP Plus Mixed economy National CIV SAP No Yes Yes Yes MAP Yes Yes Yes No

Preferred option It is clear that many s101 Committees will have reservations in relation to the migration of fund manager selection decisions away from local Funds and into larger Pools. This has a particular resonance for active equities.

Active equities are the cornerstone of the strategies LGPS Funds use to address deficits. To fully exploit the potential of this asset class, good governance is essential. The characteristics of good governance are demonstrated in a number of Funds. The pooling or collectivisation of investments, presents the opportunity to ensure good governance is not only seen as standard but is also universally applied.

There may be some dis-benefits of scale with a SAP and it would result in governance arrangements that were too remote from underlying Funds. As a consequence, MAPs were seen as offering a better link from local funds to the governance structure of the MAP. However significant concerns remain about how local funds, whilst responsible for asset allocation, can maintain accountability for investment performance and risk allocation, even in a MAP model.

On balance, the MAP model is favoured. This could reflect “like minded” Funds grouping together / thematic MAPs and should not be interpreted solely as regional / geographical MAPs with predetermined boundaries. It also fits with a MAP Plus model.

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8.3 Fixed Income

Background Asset class • Fixed income has traditionally played a stabilising role in LGPS portfolios, acting as a low-risk counterweight to equities and other return-seeking assets. • Investment has been predominantly in government bonds (mainly conventional and index-linked gilts) and sterling investment-grade credit. • In recent years, the low level of gilt yields has encouraged some investment in Absolute Return Bond (ARB) funds (which seek to provide a return in excess of cash). • The search for diversification from equities has encouraged some investment in higher-risk fixed income, such as emerging market debt and a wider range of credit markets. Scale, variability, management and access • Fixed income accounts for c.£31bn of LGPS assets of which c.£4bn is internally managed. • The Investment in fixed income represents just under 18% of total assets. • It seems likely that this allocation will increase over time, as LGPS schemes mature (making security of income a more important consideration) and repair deficits (giving them the option of reducing investment risk from current levels). • Nevertheless, fixed income is likely to be a relatively small (and relatively low-cost) part of LGPS portfolios for some time. We therefore believe that the costs of any solution specific to fixed income would be outweighed by the benefits of following the governance arrangements proposed for equities. Current costs • Costs vary widely by category of fixed income. Weighted average external management fees range from 0.03% p.a. for passively managed index-linked gilts to 0.69% p.a. for actively managed Emerging Market Debt. Proposal Preferred options • The pools set up for managing equities should offer passive and (demand permitting) active funds for each of gilts, index-linked gilts and investment-grade credit. • Other funds, for emerging market debt, broader credit markets et al., could be delivered by a national investment vehicle; alternatively, funds could be hosted by one or more MAP. This may prove more resilient to an increased exposure to these assets in the future. At current levels of investment, we do not think that pooling will deliver significant cost savings. Expected savings • Overall, it is estimated that the pooling proposed would deliver annual savings of between £5m and £10m, effective once the pools are set up and initial transition complete. Governance Assessment • MAPs provide the best platform for a good balance between scale fee saving and improved governance while maintaining local accountability • Providers should be reviewed regularly but not excessively

PROJECT POOL 060

Notes/Warning • The pooling proposed could involve a significant restructuring of assets. Transition costs for gilts should be relatively low compared to the scale of the assets involved, but costs for investment-grade credit could be substantial. Costs would also be high for other categories of fixed income but, given the relatively small scale of investment, the absolute levels would be modest relative to other transitions in fixed income and equities.

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Introduction Fixed income is traditionally considered a stabilising asset class for LGPS funds. Allocation to low risk assets such as government bonds (gilts, index-linked gilts and overseas bonds) and investment-grade (IG) credit are long-established. The total LGPS allocation to fixed income has been relatively steady at around 17%.7 of total assets; year-on-year fluctuations probably reflect changing prices rather than strategic shifts. Within this total, funds have in recent years diversified their fixed income investments more widely, with increasing allocations to categories such as:

• absolute return bond (ARB) funds, which seek to provide returns in excess of cash regardless of movements in longer- dated yields; • emerging market debt (EMD); and • a wider range of credit markets. In private sector schemes, fixed income often plays an important part in liability-driven investment (LDI). This is currently less important for LGPS schemes: their relative immaturity, the strength of the employer covenant, and a different regulatory framework are all relevant factors.8 This may change over time; some schemes are already considering LDI for small pockets of liabilities as they look to link investment strategies more closely to individual employer positions. However, the potential role of fixed income in liability-driven investment is not considered here.

Nevertheless, it seems likely that allocations to fixed income will increase over time, as LGPS schemes mature (making security of income a more important consideration) and repair deficits (giving them the option of reducing investment risk from current levels). In particular, allocations to non-traditional investments are expected to rise from current relatively modest levels. It is therefore important that any proposed pooling arrangement provides a solution that will be resilient to these developments and provide a solution that is cost-effective over the long term. Current scale and market structure All LGPS funds have exposure to fixed income. The current structure of LGPS fixed income exposure is set out in the following table:

TOTAL Gilts Index- Overseas IG Credit ARB EMD Wider Other linked credit AUM (£bn) 3.5 8.4 1.0 8.0 2.3 0.8 0.2 1.1 Number 29 35 7 55 17 9 5 7 Note: The figures reflect the notional splitting of composite mandates, e.g. those with the flexibility to invest in gilts, index- linked gilts and investment-grade credit, into their underlying components. The value of these composite mandates amounted to £6.3bn, but their heterogeneity means that they are not susceptible to pooling. Individual schemes would still have the option of approximating their current arrangements under any of the pooling arrangements proposed.

7 http://www.plsa.co.uk/PolicyandResearch/DocumentLibrary/~/media/Policy/Documents/0309_Local_Government_Pension_Sc heme_2013_-_Investing_in_a_changing_world_An_NAPF_report_DOCUMENT.ashx 8 As for 1.

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Current fees The tables below show average fees for the main fixed income mandate types.

INTERNAL Gilts Index- Overseas IG credit ARB EMD Wider Other linked credit AUM (£bn) 0.9 1.5 0.4 0.8 0.0 0.1 Number 4 4 2 5 1 1 AMC (% p.a.) 0.02 0.01 0.02 0.01 0.04 0.03

EXTERNAL Gilts Index- Overseas IG credit ARB EMD Wider Other ACTIVE linked credit AUM (£bn) 1.9 1.1 0.5 6.2 2.3 0.4 0.2 0.7 Number 19 9 3 42 18 7 4 4 AMC (% p.a.) 0.15 0.07 * 0.19 0.33 0.69 0.36 0.25

*Fee information is not available as all mandates are part of composites.

EXTERNAL Gilts Index- Overseas IG credit ARB EMD Wider Other PASSIVE linked credit AUM (£bn) 0.7 5.7 0.1 1.0 0.3 0.3 Number 6 22 2 8 2 2 AMC (% p.a.) 0.07 0.03 0.12 0.10 0.09 0.05

Options analysis A broad range of options were considered initially before narrowing these to:

• SAP • MAPs; and • Mixed Economy A National framework was discarded on the grounds that it is not able to guarantee the scale of pools required to deliver cost savings. The scale of overall investment suggests that fixed income should not dictate the details of the MAP solution. All of the pooling solutions considered will involve substantial operational and governance costs. It makes no sense to duplicate these – it will be more efficient for fixed income to follow the approach adopted for equities. This may also argue against a national solution if the relevant expertise and governance arrangements are not being set up for any other reason.

The remainder of this section concentrates on external active management.

- Internally managed assets would continue to be an option in any pooling arrangements,. - In respect of passive management, the scale of fixed income investment relative to equity investment suggests that the solution proposed for equities should be adopted for fixed income. Estimated savings would be small (around £2m p.a.) for both SAP and MAPs. Different categories of fixed income are considered in turn. For the purposes of illustration it has been assumed that there are six MAPs of approximately equal size.

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Gilts Even with a SAP, there would only be a small savings from pooling.

For MAPs, the average pool size could be under £100m if both all maturities and long-dated options were available.

It should be left to the discretion of individual pools which, if any, active gilt options should be made available.

Index-linked gilts As for gilts.

Investment-grade credit There are many potential variations in the detail of investment-grade credit portfolios (e.g. all maturities or long-dated; all non-gilts or corporate bonds only; all ratings or excluding BBB-rated issues). It is assumed that there will be some consolidation of approach under any pooling arrangements. As illustration:

• 12 funds (2 for each regional pool) averaging around £500m, each managed by one manager, would deliver total savings of the order of £3m p.a., assuming a reduction of 0.05% p.a. from the current weighted average management fee. • One fund per pool might double the saving estimated above. • Further consolidation within a SAP would not deliver significant additional savings because the pools would be unmanageable (or indistinguishable from a passive portfolio) unless they had multiple managers.

ARB funds Here, too, there is a wide variation in the detail of approach in current mandates and pooling would involve a degree of rationalisation.

A MAP could offer either one or two funds, and savings of £1m p.a. and £2m p.a. respectively could be delivered, reflecting reductions of 0.05% p.a. and 0.1% p.a. from current average fee levels.

Once again, consolidation within a SAP would not necessarily be matched by further rationalisation of managers and further savings would therefore be limited.

Others Current levels of investment in other fixed income categories do not really require one fund for each of six MAPs.

Aggregation into a SAP would be one option; alternatively, funds could be hosted by one or more MAPs.

The latter solution may prove more resilient to an increased exposure to these assets in the future.

At current levels of investment, pooling is unlikely to deliver significant cost savings.

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8.4 Property

Asset class  Property represents investment in land and buildings and has typically been used by LGPS funds as a diversifying asset. Property provides investors with a rental income stream (that in some instances can be directly linked to inflation) and the potential for capital growth. However, property is more expensive to transact and manage and is less liquid than other asset classes.

Scale of assets and means of access  Property currently represents about £13bn of LGPS assets, invested both in direct property assets or indirect pooled funds. The majority of investment is in UK property with around 5% of property assets allocated to overseas markets.

 Existing LGPS Funds with more than £200m in property generally invest in direct property whereas smaller allocations tend to be invested indirectly through pooled funds, typically overseen by a third party manager. Overseas investment is all indirect.

 A national pool is not large enough on its own to meet the Government’s target size. However, a pool of this size (£13bn) would place the LGPS property pool amongst the top ten of global property investors. If managed as a single portfolio, this would limit the choice of assets deemed suitable for the pool, introduce significant concentration risk (particularly in London) whilst reducing investment in other UK locations.

 A pool size of £1–3bn would be regarded as a large property portfolio, sufficient to invest directly in most property sectors and is considered to be of an appropriate size for a regional structure. However, certain market sectors will continue to be better accessed through specialist indirect vehicles.

 Data provided by IPD demonstrates that larger portfolios (>£2bn) have, over the longer term, demonstrated small levels of outperformance primarily due to their ability to invest in larger lot sizes. Data also suggests that direct portfolios have outperformed indirect portfolios over the longer term.

 Data also suggests that the greatest savings can be achieved by migrating assets from indirect to direct management. Small management cost savings can be achieved by increasing the overall scale of portfolios.

Current costs  Property investment management costs depend on the means by which the asset class is accessed. Indirect investment is generally more expensive than direct investment with the average annual costs of management (including property expenses) falling in the range of 1.3% to 1.7%. In contrast, the costs of direct management (on a broadly comparable basis) are estimated to be 0.5% to 0.7% lower.

Proposals and potential savings  There are two key barriers to change: (1) Property transactions incur significant costs. The round trip cost for sale/purchase typically falls in the range of 6-7% of which 4% is Stamp Duty Land Tax (SDLT). The waiver of SDLT on consolidation transactions would allow for a more efficient process of change; (2) Property markets are illiquid. Whilst the costs of dealing in indirect funds can be (partially) mitigated through secondary market transactions, there is insufficient volume to allow change to take place quickly.

 The report has considered three pooling approaches: a single national pool, a regionally constructed pool and a virtual (or collaborative pool) whereby assets are consolidated within a single investment manager, over a period of time. A single national pool is not recommended given the excessive scale of the portfolio that would result.

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 Whilst the creation of a small number of pools is preferred to a single pool and the idea of virtual pooling is deemed sensible as a short-term means of placing downward pressure on management fees, it is appropriate that the pooling approach ultimately adopted be sufficiently flexible to ensure that performance is not unnecessarily damaged.

 Acknowledging that Government has proposed that existing direct portfolios can sit outside pools, there may be opportunities to allow such portfolios to be consolidated within a virtual pool.

 The largest fee savings are expected to come from migration of indirect to direct assets. Based on the data available, it is estimated that annual management cost savings of around £36m could be achieved if all existing property assets were switched to direct management. However, these savings are only likely to emerge over the very long term (10+ years) due to the potential costs of change.

 Pools, whether constructed on a regional or virtual basis, need to introduce an appropriate governance mechanism with responsibility for both oversight and day-to-day operational matters. The separation of oversight and operational functions is likely to be appropriate although, in considering this further, pools should consider and be informed by the governance framework in place for other property vehicles.

Notes/warning The implementation of any pooling arrangement must take into account both the costs of change and the underlying illiquidity of the market. Consequently, change will take a number of years to fully implement. Government could potentially accelerate this process by facilitating the efficient movement of assets between structures without triggering SDLT.

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Introduction Property has long been the alternative to equity and bond investing for LGPS Funds, and most have an allocation to property. Currently, Funds have allocated about 7% of their investments to this asset class (£12.7bn as at 31 March 2014; source: Scheme Advisory Board report).

Property as an asset class provides an income stream (that can be linked to inflation) and capital growth opportunities, which have lower volatility than equities and historically over the long term have had higher returns than bonds over the long term. However, property is more expensive to transact and manage, is less liquid than other asset classes, and individual investments or buildings are heterogeneous in nature.

Why do LGPS funds invest in property? From the information received, the vast majority of current property exposures are mandated to deliver performance relative to a representative measure of the UK property market, usually an IPD benchmark. Whilst a small number of funds employ absolute return benchmarks, these are typically focused on either overseas or more value-driven property investments.

It is therefore reasonable to assume that the principal reason for investment is to provide diversification through broad exposure to the UK property market, where income is a key driver of return.

Approaches to investment Property can be accessed in one of two manners, either by directly holding the assets or by investing in a vehicle that directly invests in property. By considering how indirect exposure can be managed, there are several routes to market.

Direct investment This approach is normally reserved for very large investors given the need to be able to build a sufficiently diverse portfolio. Without being prescriptive, assets of at least £200m would be required to allow this to be achieved. Investors typically employ a specialist manager for the management of direct property portfolios.

Indirect investment (unlisted) This is achieved by investing in an unlisted vehicle which may have one of a number of different legal structures, for example, Property Authorised Investment Fund, Property Unit Trusts and Managed Property Funds. Indirect vehicles provide access to a broad range of opportunities although access to the most successful vehicles can be limited. This approach requires an extensive amount of time and resource to research the opportunities and undertake the necessary due diligence on prospective investments and managers.

Recognising the governance burden associated with the due diligence requirements, investors can also choose to employ a manager for the management of the portfolio, either through a fund-of-funds or a managed account.

Indirect investment may be in open-ended or closed-ended vehicles. Open ended vehicles have an indefinite lifetime with investors having the ability to invest/disinvest through the creation/redemption of units by the investment manager. Closed-ended vehicles have a finite lifetime with no such liquidity and investors expect to receive a return of capital as the vehicle matures.

Indirect investment (listed) Property investment can be accessed via publicly quoted closed-end vehicles, such as Real Estate Investment Trusts (REITs). This offers liquidity to investors as they can be bought and sold like other quoted assets. The majority of investors in REITs typically gain exposure by investing in a managed property equity portfolio. This can provide exposure to global real estate.

Characteristics of property Whilst the general characteristics of property investment are generally well understood, there are several general issues that need to be borne in mind, particularly in considering property with other asset classes, which have a bearing on how any pooling solution should be considered.

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Property is heterogeneous Whilst data suggests that the vast majority of LGPS property allocations are managed with reference to a UK benchmark, the manner in which these strategies are implemented by property investment managers will differ from portfolio to portfolio. Although no different to any other asset classes, the implications for the consolidation of two property portfolios is more significant given the underlying assets are not fungible.

For example, within an equity mandate, one share in BP is identical to every other share. If two portfolios, both holding BP shares are merged then the combined holding is simply increased. However, a £10m office in Manchester is not the same as a £10m office in Birmingham. If portfolios with these assets are merged, the resultant portfolio has two £10m offices, not one £20m office.

It is therefore the case that whilst the underlying holdings in any given property portfolio may make sense given the circumstances of that mandate, pooling may begin to invalidate the reasons for holding assets. For example, one manager may focus on managing smaller assets whereas another may focus only on managing larger assets. Consolidation would imply that the two portfolios fall under the control of a single manager which would result in change, and cost. This is explored further below.

Direct and indirect property are different As set out below, property allocations are currently managed both directly and indirectly. Again, whilst this is no different from other asset classes, this again poses a challenge for the consideration of pooling options.

For example, within an equity mandate, it is possible for an investor who is seeking to move holdings from a pooled vehicle to take an “in-specie” transfer of the underlying shares. However, this is less likely to be possible in the case of investments in pooled property funds – transferring individual assets out of a property portfolio does not preserve the shape of the portfolio for either transferring or remaining investors.

However, there still is a place for Indirect Property in direct portfolios as this can be used to obtain greater diversification into areas of the property market that would be difficult to get exposure to directly. This is explored later in this note.

Leverage may be an issue Many pooled property funds, particularly those which are focused on value-add/opportunistic strategies, make use of leverage. However, whilst leverage can boost returns, it also increases risk. This is particularly apparent during periods of market stress and falling rental income when liquidity may otherwise be compromised. In comparing performance and costs, it is therefore appropriate to ensure that the effects of leverage are recognised.

Current LGPS exposure Within the LGPS, we have identified three different approaches to the management of property exposure.

 Direct: Portfolios which are reported as being invested only directly in property or which supplement direct investment with investment in specialist pooled funds in order to gain exposure to niche sectors of the market.

 Indirect (in-house): Portfolios comprising one or more pooled fund investments and which are governed directly by the LGPS fund, i.e. there is no third party acting in a fiduciary capacity. These portfolios may comprise both open ended and closed ended vehicles.

 Indirect (external): Portfolios comprising one or more pooled fund investments where a third party has been appointed. These portfolios may comprise both open ended and closed ended vehicles.

We have not identified any clients with specific investment in listed property although we note that this will likely form part of many funds’ equity exposures.

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Fund analysis Based on our analysis of 41 LGPS funds covering c£140 billion of assets, all 41 funds responding had exposure to property. The table below sets out a breakdown of the different mandate types and the total exposure to each mandate type.

Indirect Indirect Direct Total (in-house) (external) Number of mandates within sample 17 56 29 102

Total (£m) 5,776.9 1,706.2 3,289.0 10,772.1 (Of which identified as non-UK) (Nil) (190.5) (415.7) (606.2)

Split 54% 16% 31% 100%

Source: Hymans Robertson Note: some Funds reported more than one mandate and hence the number of mandates is greater than the number of Funds in the sample.

In total, these funds account for £10.8 billion of property assets, equivalent to an allocation to property of 7% from the Funds sampled. It is also worth noting that, even for Funds where the majority of assets are managed internally, the management of direct property assets is outsourced. The implication is that property investment management is considered to be a specialist activity.

UK vs Overseas investment We note that indirect exposure includes both UK and overseas assets although direct exposure is focused wholly in the UK. Based on the information available, around 5% of total property assets is invested overseas although this varies significantly between individual LGPS funds. Many funds have no allocation to overseas property whereas several have made explicit allocations to overseas assets.

It is also noted that some Funds have permitted multi-managers the freedom to invest overseas although this is not clearly identifiable within the data and hence the current allocation may be higher than set out above.

Local investment A small number of funds have also introduced allocations to property which are focused on the local region. These allocations are typically directly invested given the specialist nature of the mandates although a simple legal structure, such as a Limited Partnership, may also be introduced to allow more effective collaboration between funds.

Costs of property investment management Fees for the management of a property portfolio, whether direct or indirect, can be split into a number of distinct areas depending on the nature of the services provided. The table below sets out each of these areas and the services that would typically be covered.

Fee bracket Services covered Payable to 3rd party? Management Research and strategy development N fees Transactions N Portfolio accounting and record keeping N Reporting and client relations N Fund expenses Fund administration, legal and marketing fees. Y Audit, valuation, custody/trustee costs. Y Fund set up costs (if amortised) Y IPD reporting Y Property Property management including rent/service charge collection* ? expenses Service charge shortfalls Y Rent review/lease renewals Y

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Fee bracket Services covered Payable to 3rd party? Maintenance/repairs Y Property insurance Y Marketing of vacant property Y Project management ? Transaction Stamp duty Y costs Agency fees Y Legal, survey costs etc. Y *to the extent not recoverable from tenants

Management fees are payable to the investment manager whereas fund expenses, property expenses and transaction costs will typically (although not always) be payable to third parties.

Directly invested portfolios need not incur the fees and costs associated with the “fund wrapper” although certain costs such as valuations will still be incurred. Further, investment management fees will be lower as the manager is responsible for reporting to a single client rather than multiple clients. However, in other aspects, there is little if any difference in the fees and costs that will be incurred.

Pooled funds We have sourced fee information which has been calculated in a manner consistent with the guidelines set out by the Association of Real Estate Funds (AREF) from the largest 13 balanced fund managers which are collectively responsible for £4.2bn9 of LGPS property investment. We set out a summary of this information in the table below:

Minimum Maximum Average for universe Management fees 0.40% 1.00% 0.67% Fund expenses 0.00% 0.49% 0.06% Property expenses 0.22% 1.79% 0.57% Total cost 0.84% 2.83% 1.30% Source: Investment managers, expense ratios for periods ending between 31.12.2014 and 30.06.2015; averages are weighted by fund AUM

Whilst property expenses will vary from fund to fund, they are shown in the table above to provide some indication of the level of costs. Funds with more activity will incur more costs although such activity can typically be associated with some form of value preservation/enhancing activity.

A number of managers in the sample have sliding fee scales whereby larger allocations will result in a lower overall investment management fee. Several managers also have separately negotiated fee arrangements with a small number of LGPS funds. The calculations set out above assume the lowest tier of investment management fees will apply. Within this sample, several funds also levy performance fees which are not reflected in our calculations.

We note that a number of LGPS funds also have exposure to more specialist strategies which may incur higher fees than set out above.

Multi-manager mandates For a number of LGPS funds, UK property strategies are implemented by way of a multi-manager mandate. This introduces two further potential direct areas of cost as follows:

 Management fees. These fees are payable to the multi-manager for the provision of similar services to those payable to the underlying property manager.

9 Note that this includes all LGPS funds, not just funds in England and Wales

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 Broking commissions. Where multi-managers seek to reposition indirect portfolios, investments can be transacted through the secondary market. Whilst some fund managers will directly facilitate secondary market transactions, many are brokered by third parties incurring a commission which is typically set at 0.25% of the value of the trade.

Multi-manager mandates are invested in strategies beyond the core balanced fund universe. Many managers have sought to add exposure to specialist vehicles in order to access specific sectors or investment management talent.

Given there are relatively few multi-managers in the UK (and three which have significant market share), we have sourced information on fees in respect of representative mandates directly from these three managers. For this, we have distinguished between the fee payable to the multi-manager and the underlying fund costs, split in the same manner as above. This is set out in the table below.

Average (Multi manager) Average (pooled fund universe) Multi-manager fee 0.20% n/a Management fee 0.70% 0.67% Fund expenses 0.13% 0.06% Property expenses 0.65% 0.57% Total fees/costs 1.68% 1.30% Source: Investment managers

It can be observed that the underlying costs of a multi-manager portfolio compared to the average costs within the balanced fund universe are slightly higher. This is likely to be due, in part, to the use of more specialist strategies within multi-manager portfolios.

The principal difference between total costs, however, arises from the cost of the multi-manager. Whilst multi-manager fees for a standard mandate are likely to be similar (all respondents stated fees in the range of 20-25bps) all also indicated the willingness to enter into discussion on fee levels for scale.

8.4.1 Direct property mandates Fees for the management of direct property mandates are generally low. Whilst we have sought to understand the fees that are payable in respect of the investment of direct mandates, in many cases these will be dependent on the investment objective, the length of the contract and the underlying portfolio to be managed.

Contract length is important as it may influence the use of transaction fees. For example, some managers may impose management fees on the sale and purchase of assets whereas others may seek to accommodate these within a standard investment management fee.

For this reason, managers have been reluctant to quote even indicative fee scales for the management of an unknown portfolio. To overcome this, we have provided information on the average investment management fee that was quoted by managers who were invited to tender for two separate direct property mandates. In each case, the proposed fee bases have been applied to portfolios of different sizes in order to determine whether there is any discount for scale. In addition to illustrating the average quoted fee, we note that fees will be subject to competitive negotiation and hence have also shown the average of the lowest three fee quotations received. For the avoidance of doubt, where appropriate, these figures make allowance for any transaction fees that would be imposed by managers although we note that such fees were proposed in one instance only.

It should be noted that this approach will not be precise as fees for each exercise were based on the specific requirements of the mandate. However, this approach provides sufficient information to allow a sensible comparison to be made between direct and indirect property management.

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Average proposed investment management fee (p.a.) assuming portfolio of £250m £500m £1,000m £2,000m All observations 0.28% 0.27% 0.24% 0.23% Lowest three observations 0.18% 0.18% 0.16% 0.14% Source: Hymans Robertson.

The costs of day-to-day property management, assumed to be 0.05% p.a. have been excluded from the figures set out above. These costs may be partially (or wholly) recovered from tenants. Other costs will be incurred in the management of assets, either in respect of property expenses or transaction costs levied by third parties. These are excluded from the comparison as costs are expected to be incurred, regardless of the means of access.

Evidence suggests that managers are prepared to offer lower fees for larger mandates although the ability to offer fee discounts as a consequence of scale is limited due to the physical nature of the underlying assets. In contrast to equity and bond investment, a larger portfolio implies either more assets or bigger assets (or both). This implies that an investment manager will require more resource in order to effectively manage the portfolio. In effect, there is likely to be a limit beyond which fees are unlikely to fall.

In any event, the benefits of seeking the lowest possible fee for the provision of services in respect of physical assets where quality is a factor should also be considered. A willingness to pay (slightly) higher fees may give access to more experienced people and could represent the difference between an asset being let and an asset remaining vacant.

Transaction costs We have not included transaction costs in the analysis above as these will vary over time depending on the underlying portfolio activity. Within both direct portfolios and indirect funds, the round-trip transaction costs associated with the sale of an asset and subsequent reinvestment are typically around 6%. Assuming portfolio turnover of, say 10% per annum, this would give rise to further costs of 0.6% p.a. However, these costs are relevant in considering transition.

Non-UK investment Given the relatively small scale of investment in non-UK mandates, we have not explored the potential costs incurred in detail. For mandates which are implemented on a multi-manager basis, fees are higher than for UK only multi-manager mandates. We have not taken further account of this difference in our analysis.

Pooling considerations The main benefit of larger portfolios is diversification. Whilst analysis has shown that effective diversification of risk can be achieved within property portfolios with just ten to fifteen assets and hence does not require significant scale, a larger portfolio would ensure that diversification is maximised and that assets could be spread across a range of sectors, lot sizes, styles and locations. Direct investment in a diversified global portfolio could also be considered.

Portfolio size Whilst one consideration may be to pool the entirety of LGPS property assets into a single portfolio, the potential ramifications of this should be explored. At £13 billion, such a portfolio would be among the ten largest portfolios globally and by far the largest in the UK. This is illustrated in the chart below which considers the distribution of the 150 largest global real estate investors with the combined LGPS allocation also shown.

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Source: IPE

In order to gain efficiencies of management, such a portfolio would need to target larger assets which would ultimately result in a concentration of investment in London and a small number of other regional locations.

In contrast, if the entirety of LGPS assets were split into (say) six pools, a UK real estate portfolio of £2-3 billion would still be of a significant size relative to other global real estate investors and would be among the largest in the UK. Such portfolios would also compare with the largest UK pooled funds. Given this, we do not believe that the consolidation of assets into a single national pool would confer any advantages.

Performance: Large vs Small portfolios In order to consider the potential benefits of larger versus smaller portfolios, we commissioned analysis from IPD, the largest UK provider of property benchmarking services and now part of MSCI.

IPD has drawn returns for portfolios which are constituents of the Annual Index. This series offers 30 years of data with the number of portfolios in the sample starting at 188 in 1985 and ending at 286 in 2014. It should be noted that the portfolios considered include both balanced and specialist portfolios, for example, sector specific portfolios, but the returns represent a property return only, i.e. the impact of any financial engineering, cash holdings, leverage etc. has been removed.

Given the increase in values over time, the analysis has split the universe into percentile bands as opposed to the use of a fixed nominal amount which would otherwise have distorted the distribution of portfolios within the sample. As at 31 December 2014, the top 5% of portfolios in this sample had assets in excess of £2bn. This is equivalent to the size of the resultant portfolios that would arise in the event that the LGPS property allocation was split into six equal pools.

Using this data, we have calculated both the average annual performance and the volatility of annual performance for each group. This is set out in the table below.

Portfolio size range Direct portfolios (as at 31.12.14) Average Return (p.a.) Volatility of Return (p.a.) Small (Bottom 20%) < £120m 9.2% 9.5% Medium (20%-80%) £120-£1,020m 9.2% 9.7% Large (80%-95%) £1,020-£2,070m 9.1% 10.3% Very Large (Top 5%) >£2,070m 9.5% 10.9% Average n/a 9.2% 10.2%

Source: IPD

It should be noted that the IPD universe does not include portfolios equivalent in size to a single national pool. What is noticeable from the results is that there is a (small) performance premium in respect of very large portfolios relative to portfolios of other sizes but also that as portfolio size increases, so does the volatility of return.

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We conclude that whilst there is merit in considering the pooling of property assets, there is no evidence (from a performance perspective) that would support a single pool over multiple regional pools.

Performance: Direct vs. indirect portfolios Over the period from 31 December 2000 to 30 September 2015, the total return (7.8% p.a.) on the IPD Quarterly Index (reflecting direct property investment) has been 1.5% per annum higher that the return (6.3% p.a.) on the AREF/IPD All Balanced Funds Index (reflecting indirect balanced property investment).

Whilst management costs for direct property need to be taken into account to make the comparison valid, this still gives rise to excess performance from direct portfolios of perhaps 1.2% per annum.

As set out above, the management costs and fund expenses associated with indirect investment are greater than the costs of managing direct portfolios which explains an element of the difference in performance. The balance can however be attributed to differences in the performance of underlying portfolios, noting that this may, in part, be explained by cash balances and the use of leverage.

Pooling options In considering potential pooling options, it is appropriate to consider how a portfolio could be structured over the long- term. This is illustrated below alongside an example of the portfolio that could be inherited although this depends on the property holdings that are to be combined.

Inherited portfolio Target portfolio

Taking account of the comments set out above, within the target portfolio, the following is assumed:

 Direct investment will generally be preferred to balanced indirect investment for core property exposure;

 Indirect vehicles can provide exposure to large lot sizes, niche sectors and specialist management;

 Overseas property exposure may be increased.

Given the heterogeneity of property, both in terms of the underlying assets within directly managed portfolios and the different approaches to the management of allocations, there are no simple ways of approaching pooling. In order to achieve scale, the pooling options that we believe could be considered are described below. For the purposes of this commentary, we have assumed that direct portfolios are also included within pooling considerations. We do however note that there are particular issues associated with this and that Government has proposed that existing direct portfolios can be retained outside of any pooling solution.

Single national pool Grouping assets into a single national pool under the control of a single managing entity would create a portfolio which is considered to be too large for a UK investor.

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However, creating a single national pool with mandates of an appropriate size awarded to multiple managers could achieve the desired objective although this would essentially replicate the structure that could be achieved under multiple pools, as discussed below.

In respect of indirect investments, a single national pool would consolidate holdings into one portfolio which would represent a significant proportion of the current pooled fund universe. If the intention is to achieve the long-term migration of assets from indirect to direct portfolios, this option could be explored further as a transition mechanism for unwinding indirect holdings.

Satisfaction of suitability criteria Criteria Comment

As a single entity, a single portfolio would be too large although certain elements of Scale ? a single pool could be beneficial for transition purposes. Savings  Will allow savings in migration from indirect to direct Would require significant, dedicated internal resource and co-ordination of Governance ? requirements across 89 investors likely to be challenging Practicality ? Overall size likely to be cumbersome Savings will emerge as a consequence of the migration from indirect to direct Speed of X investment although, to avoid excessive transaction costs, this will take time to delivery/savings achieve.

In summary, we do not consider a single national pool to be worthy of further consideration; the compromises necessary to implement an underlying management structure can be replicated under other approaches.

Multiple (regional) pools Grouping property allocations into six portfolios on (say) a regional basis could deliver mandates at a scale of £2-3bn. This is consistent with the size of other large global real estate investors. However, at the point of consolidation, each portfolio would comprise a mix of both direct and indirect holdings drawn from a range of different investment managers as illustrated by the inherited portfolio above.

It is envisaged under this approach that the existing direct mandates would not be merged as this would give rise to costs. Individual funds would retain ownership of legacy direct portfolios which would be would down over time, with proceeds being reinvested into a single ongoing portfolio. However, cost savings could be achieved through the appointment of a single manager for the respective portfolios in the pool, thereby achieving, from outset, a form of virtual pooling.

It is further envisaged that indirect assets would be expected to be wound down over time through various means:

 Close-ended vehicles will be allowed to run-off and income/capital cash can be reinvested on receipt;

 Income received from open-ended vehicles can be reinvested on receipt with opportunities for other exit routes such as unit sales and in-specie transfer being explored.

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Satisfaction of suitability criteria Criteria Comment

Pools can be arranged such that the resultant allocation to property falls within a Scale  range of £2-3bn. Savings  Will allow savings in migration from indirect to direct Internal resource for the oversight of indirect portfolios may already exist and can Governance ? be drawn on in the first instance although it is likely that this will need to be increased. Pools will align with the grouping of funds although this may result in multiple legacy direct portfolios for which some future alignment could be considered. Practicality ? Approach will allow the creation of local investment pools with a clear alignment of interests, Savings will emerge as a consequence of the migration from indirect to direct Speed of investment although, to avoid excessive transaction costs, this will take time to ? delivery/savings achieve. Certain functions may be able to be taken on by internal resource more quickly.

In summary, we consider multiple regional pools to be worthy of further consideration

Multiple (virtual) pools An alternative approach is to consolidate multiple existing mandates under the control of each property investment manager within a single mandate. The considerations here are different depending on how portfolios are currently managed

 For direct/hybrid portfolios, this would have the advantage of creating larger portfolios within a relatively small number of managers, thereby allowing some economies of scale. This would also allow funds to retain the management style that they have selected and ensure that the underlying portfolio assets are retained under the management of the investment house responsible for their acquisition. However, there will be differences in the size of portfolios from manager to manager.

 For indirect, externally managed portfolios, mandates within a single manager will typically have a large degree of commonality and hence require little adjustment. With larger portfolios, there is the potential to gain economies of scale in the cost of third party management and through direct negotiation on fees with the underlying investment managers. However, greater cost savings are likely to arise from the migration of assets from indirect to direct management and the long-term goal should be to mandate the managing body to migrate assets towards direct management.

 Indirect, internally managed portfolios, these currently lie under the direct control of each LGPS fund and could be amalgamated with one of the above options to ensure their inclusion in the process of consolidation.

Some investment managers, for example CBRE and Aviva, manage both direct and multi-manager portfolios and would be well placed to oversee the migration to a virtual pool. Others, particularly those only managing indirect portfolios, would need to either work alongside or cede control to a separately appointed direct manager for the purposes of managing the migration with the process by which indirect holdings are wound down similar to that set out above.

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Satisfaction of suitability criteria Criteria Comment

Pools will be of varying size depending on the total assets currently managed by Scale  each property investment manager, but are likely to fall within a range of £500m to £3000m. Will allow savings in both the migration from indirect to direct and on the Savings  consolidation of directly managed mandates. Internal resource for the oversight of indirect portfolios may already exist and can Governance ? be drawn on in the first instance although it is likely that this will need to be increased. Pools may not align with the groupings of Funds. However, funds will initially retain Practicality ? management style that is presently implemented allowing continuity. Speed of Certain aspects could be implemented relatively quickly as no change in initial ? delivery/savings investment manager is necessary

Under this approach, individual funds would initially retain relationships with existing managers and the challenge will lie in introducing a governing entity that will oversee the longer term consolidation of assets into larger asset pools.

Approach for non-UK property assets The scale of overseas property assets within the LGPS means that direct investment overseas is unlikely in the near term and any pooling solution will make use of indirect vehicles. Whilst an appropriate starting position may be through the use of fund-of-funds or pan-regional vehicles, over time, the pools could develop the ability to build internal expertise to allow investment in more specialist pooled vehicles and to make co-investments, depending on the overall scale of assets.

Conclusion on pooling mechanism The current arrangements through which property investments are held means that, whilst a long-term structure can be identified, no single approach lends itself directly to the immediate pooling of assets. Whilst the creation of a small number of pools is preferred to a single pool and the idea of virtual pooling is deemed sensible as a short-term means of placing downward pressure on management fees, it is appropriate that the pooling approach ultimately adopted be sufficiently flexible to ensure that performance is not unnecessarily damaged

Potential savings from pooling of UK exposures As noted above, there are significant costs associated with the management of property portfolios. For the purposes of our analysis, we have focused primarily on investment management costs and the savings that could be achieved.

Investment management savings We have undertaken some analysis to estimate the potential savings that could arise on the pooling of property investments and note that savings could arise in three areas as set out below:

 Removal of multi-managers. Whilst a number of funds make use of third party fiduciaries for the selection of individual pooled funds, under the long-term migration of assets from indirect to direct, these fees will be removed.  Migration from indirect to directly managed portfolios. The greatest savings will arise from the migration of assets from indirect to direct management. Based on the costs set out earlier in this report, these savings are estimated to be around 0.5% p.a.

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 Pooling of direct mandates. It was demonstrated above that a small level of cost saving could be achieved by way of the scaling of directly invested mandates. However, the potential level of saving is likely to be lower, potentially in the range of 0.05% to 0.10% p.a. For the purposes the illustration below, we have assumed a saving of 0.05%, this being the difference between the average quoted cost for management of a £250m mandate and a £2,000m mandate.

It is important to note that in setting out these three areas of potential saving, no allowance is made for the costs associated with any transitional arrangements and hence the analysis set out below is intended to illustrate the potential cost savings that could arise over the very long term (i.e. 10 years or more).

MM consolidation Migration from Scale from direct Total indirect to direct pooling Direct n/a n/a 0.05% 0.05% Indirect (Internal) n/a 0.5% - 0.5% Indirect (external) 0.2% 0.5% - 0.7% Source: Hymans Robertson calculations

In practice, some savings may be easier to achieve than others. For example, consolidation of multi-manager mandates may allow savings to be achieved through the imposition of a lower oversight fee and a stronger negotiating position with regard to underlying funds. The migration from indirect to direct will however take far longer to achieve as we discuss below.

Based on the underlying exposure to each form of management, we have estimated the savings that will emerge over the very long-term assuming that UK property investment is migrated towards direct investment, noting that this is based on the data received from funds. This is as follows:

Potential Saving (p.a.) Current AUM (m) Potential Saving (p.a.) after 10+ years Direct 0.05% £5,800 £2.9m Indirect (Internal) 0.5% £1,500 £7.5m Indirect (External) 0.7% £2,900 £20.3m Total £10,200 £30.7m Source: Hymans Robertson calculations

Based on the estimated overall LGPS allocation to property of £12.7bn, the potential annual savings scale up to c£36 million. These potential savings should however be set against the costs of change which we discuss separately.

Other cost savings Cost savings may be achievable in other areas. For example, with fewer portfolios, costs such as valuations, IPD analysis, audit etc. have the potential to be reduced on account of scale or eliminated where costs are applied on a “per portfolio” basis. We have not taken into account any such savings that could arise.

Implementation issues We have identified a number of concerns associated with the potential consolidation of portfolios below.

Transition costs In the UK, acquisition costs for property (with Stamp Duty Land tax to the fore) are normally in the range of 5-6% of value, while disposal costs are typically c.1%. These costs are similar for both direct property and primary market trades in indirect property.

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To benefit from the efficiencies of management that larger portfolios may bring, consolidation would inevitably require an amount of repositioning and consequently at least some transaction costs will be incurred. However, portfolios will have some level of natural turnover which could facilitate change.

Similarly, if indirect assets are to be replaced by direct investments, a similar level of cost would likely to be incurred. Whilst indirect investment offers the potential for a matched trade, and this a reduction of transaction costs, the sheer scale of the LGPS would likely mean that a great deal of the consolidation (if rushed) would have to take place through redemptions and subscriptions, i.e. at full cost. This is clearly undesirable.

To illustrate the potential quantum of costs, if it is assumed that consolidation resulted in 50% additional turnover, this would give rise to transaction costs of 3% or approximately £360m. This is equivalent to around 9 years potential management fee savings, emphasising the importance of transition risk management.

Transition risk Given the illiquid nature of property investments there is a risk that transition out of a direct portfolio would be a slow process, particularly if a portfolio was naturally wound down over a number of years. If a portfolio is left to wind down there is a risk that the strategic investment allocation within the portfolio is lost, which could compromise the level of investment return and potentially increase volatility.

In addition if a portfolio is wound down whilst another is built up (via a pool) there is the additional risk of unwanted increased exposure, if the positioning of the new pooled investment is similarly under/overweight or has similar directional allocation to the assets remaining in the legacy portfolio. This could result in a doubling up of investment risk in an unmanaged way, which again could result in lower investment returns and an increased risk of volatility.

To avoid this eventuality funds would either need to maintain an ‘evergreen’ direct portfolio (with any significant new allocations to direct property made through a physical pool) or have a plan in place to sell or transfer their current direct property portfolio in a relatively short timeframe, which introduces the risks of market timing and significant transactional costs described elsewhere in this report.

Timeframe Regardless of the pooling approach considered, process of consolidation will inevitably take a significant amount of time. In order to minimise the costs incurred, and to ensure that there is sufficient liquidity to implement the process successfully, it would have to be assumed that the process would take a number of years to carry out successfully. This will apply to both holdings in the direct and indirect market.

Indirect investments The most cost-effective way to deal in fund units is by finding buyers and sellers on the secondary market. However, this relies on their being a willing counterparty to the trade at an acceptable price, a process which will take time as discussed further below.

If there is insufficient liquidity on the secondary market, holdings in funds can be reduced by way of a primary redemption. This will also take time, particularly for a significant level of redemption, given the need to realise the underlying property assets of the fund. However, this gives rise to the risk of redemptions being deferred or a gate imposed on the fund.

Closed-ended funds do not have any formal obligation to create liquidity unless there are liquidity windows or until the funds are formally wound up. A sensible approach is therefore likely to be to retain units until capital is returned. For commitments made recently, this may require a period of up to 10 years.

Direct investments For direct investments, assuming portfolios are not to be retained outwith the pool, pooling could involve consolidating several segregated direct portfolios into a larger direct portfolios. In practical terms, it would take an indeterminate amount of time to carry this process out – presumably through a series of in-specie transfers.

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More significantly, it is also highly unlikely that these larger, consolidated portfolios would have the structure and characteristics of the optimum portfolio.

For instance, these consolidated portfolios could be overweight and underweight in certain sectors or they might consist of a large number of sub-scale properties (a ‘long tail’) – a factor that we believe would make it difficult for the portfolio to outperform its benchmark over the long term. Re-shaping and re-positioning the portfolios would take time – and there would be significant costs involved.

Liquidity – indirect investments As previously noted, the illiquid nature of property will act as a considerable constraint on any programme of repositioning and consolidation. Whilst we have largely addressed market impact in our comments on timing above, it is worth elaborating on the scale of LGPS investment in pooled funds, particularly open ended vehicles which have no fixed date for the return of capital

The chart below illustrates the combined scale of LGPS investment, either directly or through multi-manager portfolios, in UK pooled balanced funds with total assets in excess of £0.5bn as at 31 March 2015.

Source: Investment Managers; IPD

In aggregate, the LGPS accounts for approximately 23% of total exposure across these 13 funds, representing combined assets of £4.3 billion. The scale of the LGPS presence in the indirect property market creates liquidity problems, particularly with regard to secondary market transactions.

Assuming that such a process would be to reduce the number of fund holdings with the aim of increasing direct investment, there would need to be significant activity on the secondary market to enable this process to be carried out. The chart below illustrates the total volume of secondary market trades over the period from 1 January 2011 to 30 June 2015. It should be noted that this data includes both the balanced funds set out above, plus transactions in other funds.

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Source: Association of Real Estate Funds

In recent years, total transaction volume has exceeded £1bn per annum, recognising that the property market has been relatively buoyant during this period. However, an element of this volume is likely to have been created by LGPS funds and the volume in respect of only pooled balanced funds is likely to be somewhat lower than this.

Even if it was assumed that the potential volume in pooled balanced funds was £500 million per annum, it would take at least ten years to absorb unit sales. Further, given the presence of other investors in the market, there would likely be a need to compromise on price – i.e. through selling units in funds at steeper discounts to NAV.

This suggests that pooled fund investment is likely to remain for some time although more innovative solutions can be explored, for example, seeking to acquire the entirety of a pooled fund (and then collapsing the fund structure) or in-specie asset transfers.

Taxation implications The transfer of assets between fund structures is typically subject to Stamp Duty Land Tax (SDLT). The rules governing asset transfers for qualifying underlying investors are currently being considered by HMRC in terms of seeding relief and clawback provisions and legislation may be brought in which could help facilitate a more efficient movement of assets between structures without triggering SDLT.

Legal title Direct property assets are legally owned and registered to individual Funds. Any process of consolidation, even if assets are to be retained, for the collective ownership of the pool. This could give rise to SDLT unless exemptions are provided.

Within a virtual pooling arrangement, if ownership is to be collectivised, arrangements would need to be made to ensure that the returns associated with a given property were for the benefit of the virtual pool, rather than for the owning entity.

Governance Aside from the manner in which assets are to be pooled, pools will also need to consider an appropriate governance mechanism. This body will be responsible for both oversight of the pool and the appointment of managers, advisers and other specialists in addition to various operational matters. The separation of oversight and operational functions is likely to be appropriate although, in considering this further, pools should consider and be informed by the governance framework in place for other property vehicles.

ESG issues As a physical asset, property has a visible impact on the environment, consuming resources in both its construction and ongoing use and is calculated to be responsible for around 30-40% of global carbon dioxide emissions. The Intergovernmental Panel on Climate Change identified buildings as offering the most significant opportunity for cost- effective emissions reductions worldwide.

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As with other asset classes, whilst there are a small number of vehicles that deliberately target investment in “sustainable buildings”, investing through pooled funds typically requires that investors engage with the property investment manager in order to influence best practice with regard to responsible property investment.

Direct investment allows investors the ability to frame their own policies to be implemented by the investment manager, for example, requiring developments to target a BREEAM10 Excellent rating. This approach also allows greater engagement with and control over the property investment manager in respect of the cost/benefit trade-off associated with any course of action. Some of the positive impacts from the effective implementation of a responsible property investment strategy include lower operating costs, higher property values, energy conservation and waste management, urban regeneration and community engagement.

Recommended approach A single national pool is not recommended given the excessive scale of the portfolio that would arise.

A virtual pool for direct assets (i.e. the pooling of existing directly invested portfolios currently managed by a single manager) has attraction due to protection of returns, avoidance of transition costs that will take years to recover and although some costs savings are expected. However, this approach does not then lend itself to the implementation of regionally structured pools as there is no guarantee of commonality of managers across a single region.

The largest fee savings are expected to come from migration of indirect to direct assets. Pooling will facilitate this through the creation of portfolios of appropriate scale. However, the costs of change mean that this will take considerable time to implement. The preferred solution is likely to be to run off closed-ended indirect holdings and use income and new allocations to build up portfolios over the longer term. Such pools could again be created on a virtual basis within single multi-managers as a “run-off” mandate.

10 BREEAM is a sustainability assessment methodology for property development. See www.breeam.com

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Appendix 1: An approach to amalgamation

Assume five Funds join together in a pool. Property is 8% or £2bn of the total £25bn Pool. There is a collective decision making structure supervised by Members from the Funds with an internal resource underneath which oversees the external managers for both direct and indirect staffed by officers from the Funds together either on secondment or TUPE, and potentially new hires. Within this example, the structure of the pool and place of property is shown in chart below.

The table below shows the initial ownership of the assets by direct and indirect. There are two direct mandates across two managers A and B.

Property structure: Day one of pool

Direct Indirect Total Fund 1 £500m (manager A) - £500m Fund 2 £535m (manager B) £115m £650m Fund 3 - £150m £150m Fund 4 - £390m £390m Fund 5 - £310m £310m Total £1,035m £965m £2,000m The first job for the property team could be to appoint a direct property manager for three portfolios: the two existing direct portfolios within which there is no change in the ownership of the underlying assets and a new portfolio which will be the receiving entity for new money and the reinvestment of cash. Rationalisation of the management of the indirect portfolios could also be achieved. This management pooling would generate economies of scale on fees and streamline the overall management relationship.

The mandate for the appointed manager would need to be clearly defined with regard to objectives. Decision making will have to be on something of a hybrid nature between discretionary and advisory as the manger needs to consider the portfolio construction across both the separate portfolios and respective LGPS funds.

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One of the advantages of this approach is that the internal team will, through increased scale, be able to build the expertise, resource and resilience to deal with these issues.

Over time, the objective will be to manage down the legacy direct and indirect portfolios and build up a new unitised direct portfolio for the Funds in the pool. Allocations to the new portfolio will arise from capital receipts and the recycling of income from existing portfolios and/or new allocations to property.

Within the ongoing pool, indirect allocations may be added or retained in respect of more specialist or overseas strategies. This will take time to build up

Evolution of property allocation Making the following assumptions:

 Returns are 7% per annum of which 5% is income and 2% is capital growth

 Income is paid out to and retained by Funds rather than being reinvested and there are no new allocations to property during this period.

 Portfolios can be sold down over a period of 15 years. This represents an average turnover of 6.7% p.a. which is broadly in line with industry averages.

 Indirect holdings are assumed to be reduced in line with direct holdings, either through redemptions or capital repayments.

 Capital proceeds are assumed to be reinvested 80% direct, 20% indirect.

Under these assumptions, the portfolio is expected to migrate to its long-term target allocation over a period of 15 years, as illustrated below.

Property structure: After 5 years

Direct Indirect Total Fund 1 368 - 368 Fund 2 394 85 479 Fund 3 - 110 110 Fund 4 - 287 287 Fund 5 - 228 228 Ongoing unitised 577 144 721 Total 1,339 855 2,194

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Property structure: After 15 years

Direct Indirect Total Fund 1 Fund 2 Fund 3 Fund 4 Fund 5 Ongoing unitised 2,111 528 2,639 Total 2,111 528 2,639

After 15 years, the five Funds would each have a property allocation which is represented wholly by the pooled portfolio.

Fee Analysis In line with the comments set out in the body of this note, the following fees are assumed:

Indirect assets  Multi manager fee of 0.2% p.a. assumed to apply at outset, reducing immediately to 0.05% on pooling (reflecting an economy of scale);

 Underlying pooled funds fees of 0.75% p.a.

Direct  Tiered fee scale of 30bps <£500m, 25bps £500m-£1bn, 15bps >£1bn, applicable to all assets managed by a single manager.

Property management and transaction costs are assumed to be in line with market averages and are therefore not expected to be materially different depending on the nature of property exposure.

The table below sets out the change in the average fee rate under these assumptions, illustrating that average fee rates may be expected to broadly halve over the period considered.

Total Assets Fees Average fee At start £2,000m £12.2m 0.61% 5 Years £2,194m £10.1m 0.46% 15 Years £2,639m £8.5m 0.32%

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8.5 Infrastructure

Background Asset class  Infrastructure assets have investment characteristics that are attractive to pension funds; long-term, stable and often inflation-linked cashflows. However they also carry risks, including construction, operational, financial, political and regulatory risk.

 While governments might like to see pension funds investing into new infrastructure, pension funds are more interested in lower risk assets and might prefer assets that are already in operation.

Scale, variability, management and access  Infrastructure currently represents about £1.8bn of LGPS assets, invested in both the UK and overseas and across a number of different types of investments. There is considerable variability across individual Funds, with many having no explicit exposure to the asset class.

 Investment in infrastructure represents c.1.3% of total assets.

 The majority of existing holdings are on either a direct fund investing approach (£1,440m) or via a fund of funds approach (i.e. a manager invests, on behalf of investors, into a series of direct funds, £379m invested).

Current costs  Funds’ current route of access and the fees paid is provided below:

Invested Base Fee basis Base Fee Underlying Base Total Fee Fee Direct fund £1,440m 110bp £15.84m N/A £15.84m Investing Fund of Fund £379m 94bp £3.56m £4.17m £7.73m £1,819m £23.57m

Proposal Preferred options  The best fit for the benefit of the LGPS as a whole is a national platform accessible to all of the multi-asset pools (MAPs).

 The national platform would have the ability to invest directly in funds and in direct investments and would offer 2- 3 types of infrastructure investment (e.g. high, medium and low risk). By providing three different target return strategies, it will be able to meet return expectations of the MAPs, which will in turn represent the collective requirements of the 89 allocating funds.

 Further work is required to determine how the national platform should be established and whether it builds on or runs alongside any existing arrangements.

Expected savings  Based on current allocations savings could reach c£13.5m p.a. after ten years.

 If allocations to infrastructure rise to 5% and LGPS assets grow by 3% p.a. compound over 10 years, total monies invested in infrastructure could increase to between £8bn and £13.2bn and the fee savings could increase to c £22m p.a.

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Governance Assessment  Individual Funds will allocate assets (via their pool) to each of the underlying infrastructure types provided by the national platform depending on what they are trying to achieve from their infrastructure allocation.

 Given the illiquid nature of these investments, it is expected that once committed the funds will invest their capital for the long term. Warnings / Notes  The proposed pool structure includes the creation of a ‘Clearing House’ that will enable a meaningful dialogue with central government, to take place in the period leading up to the formal inception of the small number of pools. The Clearing House would also source, undertake due diligence and aggregate investment opportunities in the interim period.

 The increased allocation to infrastructure over time will result in a substantial increase in costs on an absolute basis because it is likely that increases in infrastructure allocation will come from asset classes with lower fees.

 Government can assist the investment in infrastructure by ensuring there is a pipeline of projects that are suitable for investment by the LGPS.

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Introduction Infrastructure investing is typified by investment in assets that have a role that is essential in nature for economic and social purposes. In general, the underlying assets are also physical assets of large lot size. In the most recent Preqin survey, the following factors were deemed the main reasons (in order) for investors investing in the asset class:- 1. Diversification 2. Reliable Income Stream 3. Inflation Hedge 4. Low Correlation to other Asset Classes 5. Reduced Portfolio Volatility 6. High Risk Adjusted Returns 7. High Absolute Returns There is a high degree of correlation between many of these characteristics, indeed points 1) and 4) are different ways of stating the same reason. The inclusion of high absolute or risk adjusted returns is also debatable given recent transactional levels and it would be unusual (but not unheard of) to see LGPS participants in this asset class seeing this as a primary objective of the investment. However, to disregard returns would be inappropriate, given the fiduciary obligation expedient upon LGPS Funds. For the purposes of this report the following characteristics have been set out as the primary reasons for investing in infrastructure and the central tenets to any LGPS infrastructure investment programme:-

 Stable Cashflows

 Stable Valuation

 Capture of Inflation in Cashflows (Indexation)

All infrastructure should demonstrate the above characteristics although some variability in each or all of the attributes might be experienced in individual investments. As a general rule though, the more an investment demonstrates a high probability in achieving these criteria, the more attractive it is to investors and this will be evidenced by (higher) pricing and consequent low yield. Conversely, infrastructure investments that demonstrate variability in the above attributes (i.e. higher risk) will generally attract a higher yield, all things being equal.

The ability to deliver the three key characteristics above will largely be determined by the underlying types of infrastructure investment and their inherent characteristics. These can be broadly classified in the following way:-

Type Characteristics Examples Return Expectations Strategic Assets - Usage GDP sensitive, Merchant Toll roads, Ports, Airports, 10-14% IRR* based risk on some or all income. Railways, Shipping, Aircraft Stable income but some Leasing variability. Strategic Assets Naturally monopolistic Power generation and 8-12% IRR* industries of national distribution, water importance. Long-term treatment and distribution usage contracts. Stable income Social Infrastructure Essential public assets that Typically PFI/PPP assets 6-8% IRR* provide a government/ such as schools, prisons, quasi government universities, social housing,

guaranteed cash flow. transport facilities. Stable income, excellent covenant. *Denotes indicative only (IRR- internal rate of return)

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The above table is not exhaustive and some assets that have not traditionally been regarded as infrastructure have more recently been proposed as entrants into this classification, such as motorway service stations and student housing. What is clear, is that the key determinants are stability, inflation capture and yield. Current scale and market structure Of the 43 LGPS schemes that responded to the data exercise, 22 have some form of exposure to the infrastructure assets class with a market value of £1.8bn.

At 1.3% the average allocation to infrastructure within the LGPS is well behind average global allocations of 4.3%11. Whilst data about the average target allocations for the LGPS is not available, it is expected that these are higher than current allocations, based on this figure being two percentage points (6.3% i.e. 4.3% +2%) higher in global pension funds.

Furthermore, the LGPS as a whole is on the tipping point of becoming cashflow negative (i.e. benefit outflow exceeding contributions), as a consequence of a maturing member profile and reduced new membership. Because of these factors, the demand for infrastructure assets is likely to rise rapidly in the medium term.

Although it is highly probable that allocations to infrastructure will rise across the LGPS over time, the following factors are noteworthy, as they represent the biggest threats to increased allocations:-

 Assets becoming overpriced versus historical levels – currently most funds globally are planning to maintain or increase allocations to infrastructure (89%). More recently, sentiment has changed from the end of 2014 where no respondents the survey planned to decrease allocations to infrastructure, to June 2015 where 11% of respondents are planning to decrease allocations. This would appear to be driven partly by current pricing levels, where 56% of those surveyed felt that pricing issues would create an issue for the asset class in the next 12 months.12

 Pricing relative to other asset classes – many investors are comfortable with holding UK infrastructure assets as a proxy for UK Government debt due to being comfortable that the increased yield adequately compensates the increased risks and decreased liquidity versus Gilts and Linkers. If this yield differential becomes more compressed, it is probable that investors will be less likely to make this call and may in turn move back to UK Government debt or other yielding assets. The geographical exposure for LGPS infrastructure investments have been set out below:

Geography Amount (£m) Percentage

UK 127.7 7.01% European 37.6 2.07% Global 527.4 28.96%

Undefined 1,128.4 61.96%

Total 1,821.1 100.0%

11 Title: Preqin Investor Outlook: Alternative Assets H2 2015 Available: https://www.preqin.com/docs/reports/Preqin-Investor-Outlook-Alternative-Assets-H2-2015.pdf (Page 37)

12 (all figures quoted in this paragraph sourced from Preqin).

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Although the majority is “undefined”, it is clear that with 31% allocated to Global and European, an appetite for foreign assets exists. It is highly probable that some appetite for foreign assets will continue and will need accommodating within the pooling solutions that are taken forward.

Most infrastructure investments within the LGPS are held through closed ended private equity style vehicles in both a direct (direct investment into a fund) basis (“direct fund investing”) and through funds of funds. This is largely reflective of the asset class being fairly new in nature and the expertise to undertake true direct investing i.e. acquiring the underlying infrastructure assets directly, not being available within LGPS funds in the formative period.

Many funds have experience of direct fund investing and more recently, some true direct investing and co-investment has taken place in a small number of the larger funds (GMPF, LPFA, Merseyside, Lancashire, WMPF). Nevertheless, at 20.8% of invested capital, the exposure to the asset class through fund of funds, is high.

As the asset class and the underlying assets become more readily understood, this progression to a more direct model (whether it be direct investment into funds and, over time, to direct investing) seems to be the most natural evolution, due to the following factors:-

Current fees The weighted average base fee for a direct fund investment is 110bp and a total £1.44bn is invested by this means. The weighted average base fee for a fund of fund investment is 94bp and a total £379m is invested by this means. Using a proxy of 110bp for estimating the underlying fees of the fund of fund investments we arrive at a total fee of £23.57m. Invested Fee basis Base Fee Underlying Base Total Fee Fee Direct fund £1,440m 110bp £15.84m N/A £15.84m Investing Fund of Fund £379m 94bp £3.56m £4.17m £7.73m £23.57m

From the outset of the emergence of the asset class, fee structures tended to replicate those seen within the private equity industry, even though returns in infrastructure did not match the latter. This created a conflict of interest between managers and investors.13

As might be expected, terms have generally shifted toward the interests of investors and on face value it would appear that at 86%14, there is currently a high degree of investor satisfaction in the alignment of interests between managers.

Nevertheless, for the LGPS as a whole, accessing the asset class still remains a fairly expensive means to achieving stable cashflows, with the average base fee for direct fund investment at 137 bp and average FoF base fee at 91bp (this figure does not include underlying base fees which apply at a sub fund level).

The potential to drive these figures down further through a combination of greater negotiating power on the direct side and reduction or complete removal of Fund of Funds investment is particularly attractive.

13 Title: OECD Pooling of Institutional Investors Capital – Selected Case Studies in Unlisted Equity Infrastructure Available:http://www.oecd.org/finance/OECD-Pooling-Institutional-Investors-Capital-Unlisted-Equity-Infrastructure.pdf (page 8)

14 Title: Preqin Investor Outlook: Alternative Assets H2 2015 Available: https://www.preqin.com/docs/reports/Preqin-Investor-Outlook-Alternative-Assets-H2-2015.pdf (Page 42)

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Pooling considerations

Duration Most closed ended infrastructure funds will have a fund life of between ten and twelve years, whereas the assets themselves may have much longer lives, even extending into perpetuity. The ability to match these assets with pension liabilities that also extend well beyond this time-span is of obvious benefit to the LGPS as a whole. However, even if the investments are held outside of a limited partnership type arrangement, the contribution of these assets to, or in addition to, an illiquid limit of 30% (based on current LGPS regulations) will be material, as LGPS funds mature and increase allocations to infrastructure assets.

Control Having a meaningful stake in an investment, whether minority or majority, gives more ability to influence decisions during the life of an investment. These decisions may be of an operational nature or capital nature, including exiting the investment. Whilst by their very nature, infrastructure assets are fairly illiquid, the ability to determine the timing of an exit without being tied to rigid exit or extension provisions provides additional benefit to the investor.

Direct investing – factors to consider Whilst there appears to be obvious benefits to a move to more direct model of investing in infrastructure, the following factors will need addressing, if the LGPS is to move to this model:-

 Resourcing – as stated above, some of the larger funds have experience of direct investing. This has tended to be a recent move as individual funds have become more confident and competent in this space. To move to a fully direct investing model would likely result in increased costs in the initial stage, in order to adequately resource transactional and subsequent operational capability. Two of the UK’s largest non-LGPS funds have taken this route (USS and BTPS) and have seen increased fixed costs in establishing an internal capability. This increase in fixed costs can only become worthwhile if the quantum of assets under management results in dilution of management costs per pound invested. More work will be required to determine break-even point and optimal AUM levels. Certainty over future allocations would be essential to the success of a move toward direct management.

 Governance – if a large pool of assets is achieved, governance mechanisms will be required to enable establishment of investment strategy, investment parameters, remuneration of staff and other similar matters. One of the hurdles to the establishment of the Pensions Infrastructure Platform (“PIP”) was the difficulty in reaching agreement between the the participants involved (of which there were 10 initially). It is clear that this would have implications for most pools, but if a national pool option was chosen, representation from all 89 LGPS funds is likely to prove untenable.

 Accountability – this issue is probably the most difficult to reconcile with LGPS investment officers when arriving at a viable alternative to the current arrangements. The ability to terminate a relationship with a manager, whether through a fund maturing, a secondary transaction or removal through divorce mechanisms, provides a means to reward and incentivise good investment performance, as well as an increased likelihood of improved performance through survivorship bias. A formal pooling arrangement of a binding nature may prove all but irrevocable, which creates a potential conflict with the principles of fiduciary responsibility. Given that a new team might experience a period of ‘norming’, as well as experiencing a steep learning curve, patience with any new arrangement would be essential, and any transitional arrangements would have to be carefully designed.

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Options analysis There are a number of high level options available for pooling, each with their own advantages and disadvantages. Most of these options have some cost savings potential over the existing arrangements, albeit in varying degrees.

Options discarded at an early stage National Framework with one External Manager Pooling all future commitments into a national framework to attract a very competitive bidding process from managers wanting to secure the mandate.

This should:

 provide a competitive fee basis through the procurement exercise

 flexibility to identify manager with requisite skillset

 ability to define geographical and sector exposures to meet collective requirements (although this may result in small number of respondents)

 bespoke governance structure

Staffing would remain the responsibility of the manager.

However,

 higher fee level than direct investing is likely, despite competitive procurement process.

 number of managers amenable to this business model is likely to be more limited than through conventional fund investing,

 blind pool15 risk (there may be some ability to influence this through the governance arrangements although this may in turn jeopardise LP status).

 there would be no diversification of manager risk

Criteria Comments Sub-criteria Comments Size Should be scalable but Practicality x Size may prove too may encounter capacity cumbersome and constraints with the deter managers manager Savings ? Savings through scale Speed of  If savings can be are probable but not Savings made through efficient proven procurement, the benefits should be relatively rapidly achieved Governance  Governance likely to be Simplicity  Should be easy to set improved through up and administer bespoke arrangements although some push- back from managers is likely Through pooling assets to achieve larger mandates, economies should be achieved versus current arrangements.

15 Investors make a binding capital commitment to the fund, which is drawn as and when the firm finds a new investment to back. This is known as “blind pool” investing as the assets are typically unknown when a commitment to the fund is made.

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The main risk to this assumption might be that the number of managers with sufficient capacity and/or a willingness to adapt to this business model may be very limited, which in turn may result in a less competitive fee basis.

Governance could be enhanced, dependent upon ability to negotiate acceptable arrangements.

However, despite enhancements in these two areas, this method of investing is ultimately likely to be more costly and allow less direct governance than direct/co-investing.

It is doubtful that a single manager could give the breadth of coverage of the various infrastructure sectors and geographies and therefore concentration risks would be high.

It is also unlikely that the perceived cost savings will be as high as in the other options and this, combined with the factors above, have resulted in this option being discarded.

This option has been rejected because the number of managers with sufficient capacity to take on such a large pool of assets is likely to be so limited as to reduce the competitiveness of any bid. Sector and geographical exposures likely to be more limited and therefore increased concentration risk likely.

“Shared Resource Model” This arrangement is similar to what is currently in operation where investing is undertaken separately by the various Funds, but with negotiation of fees for LGPS as whole. Due diligence could be shared or undertaken individually but other ancillary functions such as legal, taxation and monitoring would be conducted and resourced jointly where more than one Fund makes the same investment.

This model would provide minimal disruption versus current arrangements. Some cost savings should be deliverable against historic levels.

However cost savings would be at risk of non-delivery if overlap in investments is limited between various funds, negotiating power uncertain, requires some overlap in timings into the same investments, confidence in other Funds’ due diligence required.

Criteria Comments Sub-criteria Comments Size Scalable Practicality ? Simple but reliant on continued good communication which may dwindle if impetus is lost Savings x Savings not certain Speed of Savings x No guarantee of savings and even if achieved impact is likely to be minimal Governance x Governance Simplicity  Straight forward enhancements extension of current restricted by arrangement limited bargaining power

The limited scope for meaningful improvements against current and historic arrangements make this proposed option the least attractive of those considered.

This option has been rejected because of the limited scope for meaningful savings and ‘looseness’ of the arrangement.

PROJECT POOL 093

Options given further consideration National Framework with Small number of External Managers Pooling all future commitments into smaller but still sizeable pools (potentially £500m to £1bn) to attract a very competitive bidding process from managers wanting to secure the mandate.

As with the single provider national framework, this should:

 result in a competitive fee basis through the procurement exercise and may even be more competitive due to higher number of managers feeling suitably resourced to undertake the mandate.

 allow managers with requisite skillset to be identified,

 provide the ability to build geographical and sector exposures to meet collective requirements more easily than through a single mandate,

 allow a bespoke governance structure can be created,

 provide manager diversification.

Staffing would remain the responsibility of the manager.

This model requires oversight of the procurement process and subsequent monitoring of investments.

However

 Higher fee level than direct investing is likely, despite competitive procurement process,

 number of managers amenable to this business model is still likely to be more limited than through conventional fund investing,

 blind pool risk (there may be some ability to influence this through the governance arrangements although this may in turn jeopardise Limited Partner status).

Criteria Comments Sub-criteria Comments Size Should be scalable Practicality Fairly easily set up but may encounter capacity constraints with the manager Savings ? Savings through scale Speed of Savings If savings can be made are probable but not through efficient proven procurement, the benefits should be relatively rapidly achieved Governance Governance likely to Simplicity Should be easy to set up be improved through and administer bespoke arrangements although some push- back from managers is likely

Through pooling assets to achieve larger mandates, economies should be achieved versus current arrangements.

PROJECT POOL 094

Geographical and sector control may be made easier.

Governance could be enhanced, dependent upon ability to negotiate acceptable arrangements.

However, despite enhancements in these two areas, this method of investing is ultimately likely to be more costly and allow less direct governance than direct/co-investing.

This option has benefits that may have merit in a hybrid option such as gaining access to geographical or sectoral exposures that may be difficult for a single manager.

“Satellite Model – Centres of Excellence” This arrangement is similar to model being incubated by GMPF and LPFA, whereby a specialist infrastructure team is built out to co-invest initially and then move to a more direct model over time.

The pool could be part of a MAP, or allocated directly from the underlying funds, or sit within a national platform.

This solution provides

 Opportunity to pool assets with other LGPS funds, to directly invest or co-invest into infrastructure assets.

 Some control over decision making, with veto rights applicable to early participants.

Early estimates on cost are that the collaboration will halve the management fees currently encountered in a standard primary investment with a fund manager.

Blind pool risk removed for those with veto rights.

The model will be run at low cost to investors, without loss through profit and performance payments.

However this model

 Is likely to need considerable further specialist resource toward staffing. Sourcing channels growing, but not currently as extensive as established managers.

 Will require sufficient capacity to assess individual opportunities, for those with veto rights.  Could result in two or more centres of excellence bidding up the same assets.

 Has limited performance track record.

 While scoring well against the government criteria may not allow for all MAPs to be fully engaged in governance and so has no certainty over allocations from underlying funds

Criteria Comments Sub-criteria Comments Size Scalable Practicality Natural evolution toward better cost basis and controls Savings Significant Speed of Savings High degree of certainty that savings should be cost savings can be rapidly achievable through achieved although may incur this approach some increase in costs initially Governance ? Governance Simplicity Straightforward for most mechanisms will be investors but might need bespoke to some higher level of input requirements for veto right investors

PROJECT POOL 095

When fully operational this model should provide a credible alternative that satisfies the Government’s criteria.

It could be used in conjunction with other solutions e.g. National framework, PIP etc., or on a stand-alone basis and in both cases should provide significant benefits to the LGPS. Staffing will need to be developed.

SAP All LGPS allocations to infrastructure form one central pool to be invested by one team.

This model

 Should result in greater ability to build a proficient, well-resourced team due to the ability to spread fixed costs over a larger asset base.

 Provide easier cost savings through economies of scale from increased bargaining power.

 Allow easier portfolio construction easier due to less concentrated positions.

However it would provide a limited ability to remove manager as no viable alternative within the LGPS if this model is followed. There would also be a higher potential for political influence from central government and no certainty over allocations from underlying funds.

Criteria Comments Sub-criteria Comments Size Scalable so long as Practicality Ability to resource strong assets don’t become team enhances too expensive practicality of this option Savings Savings should be Speed of Savings ? Chance of rising fixed sizeable costs initially although this should be rapidly offset by savings as capital deployed Governance Governance would Simplicity Straight forward require adjustment extension of current to negate potential arrangements stalemate effect of too many parties

The potential for a well-resourced team with an ability to extract significant savings through scale is attractive.

Staffing would need to be developed and governance would need thought, to combat the potential death by inertia if too many underlying funds are represented, although this should be fairly easily combated given that this would be a new entity.

This model is considered to be worthy of further consideration as a viable solution.

Some of the other options considered could sit within this option.

“Pensions Infrastructure Platform (PIP)” Fund investment into established collaborative platform set up for pension fund investors on a not for profit basis.

This model provides opportunity to pool assets with other non-LGPS funds, to achieve economies of scale and build out a team with requisite experience and networks, on a not for profit (i.e. at cost) basis.

PROJECT POOL 096

Staffing would remain the responsibility of the manager with a governance structure to satisfy investor requirements.

The model would be cost effective with a low management fee.

However, while PIP scores well against the government criteria it does not deliver what the funds need;

 Blind pool risk exists.

 The current offering is aimed at lower end of risk spectrum, with commensurate return expectations, which may not satisfy the expectations of all LGPS participants.

 Geographical exposure is currently heavily biased toward the UK.

Criteria Comments Sub-criteria Comments Size Can accommodate Practicality Should provide easy significant and cheap access to investment infrastructure Savings Significant Speed of Savings Achieved in first savings have been investments – achieved versus continuation probable standard fund terms Governance ? Governance Simplicity In line with standard standards high but primary fund investing within limited partner structure

The PIP is about to enter the build-out (direct investing) phase and has established sourcing networks.

The PIP cannot satisfy all Funds’ expectations regarding geographical and sector exposure but can provide a cost effective means of accessing the asset class when used in conjunction with other options. Preferred Option

Improved access and lower cost is most likely to be achieved through a national platform accessible to all of the multi-asset pools (MAPs). It would have the ability to invest directly in funds and in direct investments and would offer two to three different types of infrastructure investment (e.g. high, medium and low risk). By including three different target return options, the national platform will be able to meet the return expectations of the MAPs which in turn will represent the collective requirements of the 89 allocating funds, some of which have successful investment programmes in place already. It is expected that a national platform potentially built on or running alongside existing centres of excellence, could achieve the best LGPS wide engagement.

Further work is required to determine how the national platform should be established and whether it builds on or runs alongside any existing arrangements. Some adaptations will be required to get the full benefit from the national arrangement. This includes the creation of a ‘Clearing House’ that will enable a meaningful dialogue with central government, to take place in the period leading up to the formal inception of the national pool. This bridges the opportunity gap that might occur as the LGPS pools together. In addition, the government can assist the investment in infrastructure by ensuring there is a pipeline of projects that are suitable for investment by the LGPS.

The Clearing House would not just be a conduit of communication but would also source, due diligence and aggregate investment opportunities for funds wishing to participate in the deals in the interim period.

PROJECT POOL 097

Upon launch it would then become an integral part of the pool and would continue the aforementioned activities as well as undertaking fund investments, in a manner that matches the return objectives of the like-minded multi asset pools. The following diagram depicts how the pool would work once the clearing house is fully assimilated into the national pool:-

By having a clearing house function, direct deals (represented by yellow lines), can be allocated into individual buckets. The national pool will also be able to make direct fund investments and co-investments (as depicted by the blue arrows to PIP, GMPF/LPFA etc) and invest overseas.

Governance would replicate the governance mechanism in the section below but voting and oversight would become an officer responsibility. Governance Two key criteria are set out as being essential to any pooling arrangements proposed, these being:-

 At the local level, provide authorities with assurance that their investments are being managed appropriately by the pool, in line with their stated investment strategy and in the long-term interests of their members;

 At the national platform level, ensure that risk is adequately assessed and managed, investment implementation decisions are made with a long-term view, and a culture of continuous improvement is adopted.

Whilst there may appear to be some inherent inefficiencies in retaining the role of separate committees to determine asset allocations for each of the 89 funds, the benefits of local accountability for such decisions is sufficient to override this factor. Nevertheless, it is likely that the role of “allocator” will require less dedicated resource than at present and a number of posts within each scheme may therefore become available for transfer to increase resourcing at the investment pools or be able to focus on other aspects associated with their individual funds.

PROJECT POOL 098

Pools will need to incorporate the requirements of the investment committees and respective investment strategies of each underlying fund (“Allocating Fund”). The following diagram depicts a model that could work in marrying the needs of each allocating Fund with the requirement for more cost efficient investing.

The diagram is meant to depict the following:-

 Thinner blue lines - showing individual infrastructure commitments from each of the allocating funds into one larger multi-asset pool. These individual allocations are then combined to be further allocated to the specialist infrastructure pool.

 Purple lines - denoting the governance routes to ensure that the criteria of accountability for the local electorate is achieved. Each of the Allocating Funds could have one vote in the Shareholding Company, although each could have the ability to elect stand-in persons to a “Steering/Advisory Committee” for the purposes of continuity, training and cover. This committee could in turn have general oversight of the multi-asset pool although the investment function could be entirely devolved within set parameters. The Steering/Advisory committee could be similar to those commonly seen in limited partnerships although the role would be more extensive than ruling on conflicts of interest and would involve devising an appropriate strategy statement, setting investment parameters and ensuring compliance to these documents.

The above diagram denotes how capital flows will be aggregated before flowing through to the specialist infrastructure pool/platform.

Governance of this pool will replicate the governance structure above except that voting power could come via the MAP and will therefore be an Officer function. This will still be in line with the guidance received from the Shareholding Company and therefore the governance requirements of the allocating funds will flow through to the specialist infrastructure pool.

PROJECT POOL 099

SRI / ESG

Due to the longevity of infrastructure assets, investors need to ensure that they take into account all possible issues that these investments might face over the long-term.

Applying ESG considerations to the management of infrastructure assets assists in the assets performing as required and enhances the returns to the LGPS, and ultimately to its beneficiaries.

Pooling infrastructure assets, whether indirect or direct, allows for greater influence to increase sustainability/ESG performance and therefore add value.

In terms of best practice in practical implementation, Global Real Estate Sustainability Benchmark (“GRESB”), which provides sustainability data for the global real estate industry, has recently launched its Infrastructure assessment framework which offers investors an industry-wide assessment tool to enable systematic evaluation and industry benchmarking of the sustainability performance of their infrastructure assets. It provides a consistent framework for investors to collect and compare key environmental, social and governance (ESG) indicators and related performance metrics across their global infrastructure portfolio. The broad sustainability categories are Management, Management Systems, Policy & Disclosure, Climate Change Risk & Resiliency, Using Natural Resources and Waste & Pollution.

The framework is aligned with international reporting frameworks such as the GRI and PRI.

It would be recommended that the LGPS adopt this best practice implementation framework or one of similar quality if a comparable alternative can be identified. Fee Savings To obtain fully costed savings would be too onerous an exercise to undertake for the purposes of this report because it would entail creating some form of business plan to arrive at suitable staffing structures and associated costs. This would also require a range of assumptions to be made regarding asset allocations and asset growth. Therefore the PIP model has been used as a proxy for where costs might get to in the SAP, by adopting a migration to a direct investing approach. Please note these are estimates.

It should be noted that the PIP expects to run its multi strategy fund at a maximum of 50bp p.a. which is significantly below the weighted average direct fee in the study of 110bp p.a.. This figure represents a blended average fee for equity investments and debt investments, where debt exposure will attract a much lower fee basis than equity. It would appear that the 110bp figure from the study may also include some debt element or be heavily biased toward current market levels, with typical fees of circa 100bp. A saving of circa 50 to 60bp per annum may therefore be achievable on new money invested, versus the current average figure.

It is important to stress that no short-term savings are expected due to the tight legal structure governing the majority of these investments and savings will only come over time as commitments are recycled or allocations increase. In addition to this, costs will rise in the short-term as capability is built out and other overheads such as those associated with FCA registration increase.

PROJECT POOL 100

Savings versus the current fee basis Zero Asset Saving of 5 years at 4% Saving of 5 years at 8% Saving of Growth 55bp per Asset Growth 55bp per Asset Growth 55bp per annum annum annum 4.0% New £8.0bn £44m £9.73bn £53.5m £11.75bn £64.6m Investment 4.25% New £8.5bn £46.8m £10.34bn £56.9m £12.49bn £68.7m Investment 4.5% New £9.0bn £49.5m £10.95bn £60.25m £13.22bn £72.7m Investment

Please note these levels are indicative. They include a number of assumptions and represent a considerable increase from the current level on infrastructure investment.

Practicalities of Delivery

Transition costs Unlike the more liquid asset classes of public equities and bonds, cost savings are unlikely to be achieved in the short-term. This is due to the time lag of deploying capital, whilst still encountering the fixed cost of resourcing the appropriate investment team.

It is also highly probable that fixed costs will rise in the short-term, due to recruitment of appropriately experienced and qualified individuals and retention and development of the existing internal capability.

Due to the rigid contractual nature of the legal agreements governing most fund investments, it is unlikely that negotiations will result in meaningful reductions in fees on existing investments. The workout of legacy investments will therefore do little to counteract the likelihood of rising internal costs in the initial transition stages.

It is clear that, as legacy investments mature, the easiest saving to achieve and demonstrate will be the removal of the first tier of management fees associated with the fund of funds investments. Based on the exposures, and average management fees from the study, we expect these savings to amount to £3.56m per annum (£379m * 94bp). This should adequately offset the increased overhead referred to in the preceding paragraph but will only arise over a long period as the funds mature.

Timeframe If it is accepted that the fixed costs are likely to rise in the short to medium term, it is with medium to long-term horizons that we must build and develop the infrastructure capability. The most critical risk of adopting such an outlook lies with the uncertainty over future allocations to infrastructure as an asset class, i.e. significant resources are spent on building out capability in order to more efficiently invest in the future, only to find that allocations fall from underlying funds in the pool.

There is little that can be done to remove this risk, given that asset allocation remains at the individual Fund level.

Market impact (direct/indirect) By nature, infrastructure assets are large in terms of overall value and, because of this, the value of the potential pipeline of new assets is large. As an indicator of this, a study of the UK’s National Infrastructure Plan suggests that there is a demand for £48bn of new projects per annum. This pipeline only includes projects above £50m and therefore we would expect the figure to be substantially higher if smaller projects are added to the mix. In addition to these sources of greenfield projects, there will undoubtedly be continued supply of secondary trades in mature assets in coming years, even if the direct participation of pension funds results in assets being locked away for longer periods of time.

PROJECT POOL 101

If the LGPS were to move from the current 1.3% average allocation to 5% over the next five years (which would represent a significant increase), it is likely that the net effect, allowing for a degree of recycling of capital, would be new investment of somewhere around 4% to 4.5% of assets. The following table gives ranges in value of new capital to be invested over a five year period if we follow the preceding assumption, at varying levels asset growth:-

Zero Asset Growth 5 years at 4% Asset 5 years at 8% Asset Growth Growth 4.0% New Investment £8.0bn £9.73bn £11.75bn 4.25% New Investment £8.5bn £10.34bn £12.49bn 4.5% New Investment £9.0bn £10.95bn £13.22bn

It is estimated that around $400bn (c£265bn) per annum has been invested in infrastructure deals globally over the past three years16 and although it is not clear what level of gearing would apply to the deals, a reasonable estimate would equate the equity value of these deals to be somewhere around £100bn. At the above levels of deployment over a five year period, the LGPS would represent approximately 2% to 2.5% of the global market.

Given that asset prices have risen recently, it would seem that demand has been higher than supply in recent transactional activity. The further demand created by the above levels of investment may therefore be expected to tip equilibrium in favour of further tightening of yields, all things being equal. However, with global infrastructure requirements estimated at $5tn a year (World Economic Forum) it would be reasonable to assume an increase in supply to at least counter the increase in demand.

In addition to the likely increased supply, markets should demonstrate some self-corrective behaviour if any one asset class moves too rapidly against other asset classes. However, the long-term bull run of Gilts in recent years suggests that prolonged bull markets are not inconceivable for infrastructure as an asset class.

On balance it would seem therefore that a five year investment plan of the magnitude in the preceding table may be practical and should not significantly impact on the market. Furthermore, it would allow time for build out of the team and migration toward more direct investment.

Taxation implications This report does not cover the taxation implications of the preferred options. The preferred options are outlined as deliverable concepts that meet the Government’s desires for increased efficiency and savings. Taxation and other similar matters will need to be accommodated through efficient legal structuring and correct choice of entity.

What does the government need to do to facilitate the changes? Three factors that may prove to be problematic and may have a considerable adverse effect on costs and efficiency are:-

 FCA registration: this factor creates a further level of complexity and cost

 AIFMD: this is another issue which needs resolving in order that the pools can freely deal with other counterparties.

 MiFIDII: this issue needs consideration to ensure the underlying Funds are able to invest in the asset class.

The Government can help mitigate costs by overcoming the problems referred to above.

An additional factor that can be at least partially addressed by the government is the lack of appetite among pension funds, including LGPS funds, for greenfield infrastructure, due to the high risk nature of these projects.

16 Title: Preqin Investor Outlook: Alternative Assets H2 2015 Available: https://www.preqin.com/docs/reports/Preqin-Investor-Outlook-Alternative-Assets-H2-2015.pdf (page 41)

PROJECT POOL 102

The government can address this by providing an environment where greenfield projects are structured to enable pension fund participation. The following case study is a recent example of such structuring:-

Case Study – Thames Tideway Tunnel (TTT) The recent successful tendering of the TTT is a useful case study of where innovative structuring enabled competitive bidding by different consortia of investors in a project with an expected capital value of circa £3.2bn. The tunnel was of national importance due to it serving central London and the fact that the existing sewerage system, which was built in the 19th century, is operating at full capacity, with many instances of raw effluent discharge into the Thames each year. Unless remedied in a timely manner, the continuation of such discharges would result in fines being imposed under European environmental laws. The importance of this project was therefore high, to both London and the wider UK, given the need for unimpeded economic and physical growth in the nation’s capital. Construction of a project of this nature is technically challenging, despite the geology of London being fairly well understood through the recent excavation activities in construction of the Crossrail infrastructure project. The likelihood of cost overruns was therefore paramount in investors’ assessment of risks and if this risk remained unaddressed, would serve to deter many investors from participation in any part of the capital structure. The Government adopted an innovative approach to addressing this and other key issues and, although risk was not totally removed, the deal was structured so that ‘tail end’ risks were limited to a defined level. The components of this risk sharing package included the following elements:- • Cost overruns limited to 30% above the expected construction cost, after which the Government becomes responsible for the cost overrun • Capital deployed attracts a yield from the date of deployment, removing any j-curve effect • The government guaranteed to provide temporary loan capital in the event of abnormal capital markets impeding the successful placing of long term debt issuance • The asset is structured as a typical PPP/PFI deal for the period to 2030 whereupon it then behaves as a regulated water asset for the remainder of its useful life, providing a return based on its regulatory capital value at a rate determined by the water regulator, OFWAT This enabled modelling of returns with more certain parameters when investors bid for the asset. In return for the Government limiting certain risks to levels that were unlikely to ever be called upon, the bidders were able to bid more aggressively than they would ordinarily. Included in the bidding consortia were LGPS funds (that without this innovative structure in place would not have become involved in the bidding process) and overseas investors from the private and public sector.

PROJECT POOL 103

SUMMARY  Several pooling options were considered and compared against the qualifying criteria, as tabled below:-

Option Size Savings Govern- Practicality Speed of Simplicity Comments ance Savings 1. Procurement of  ?  x   Discarded Single Mandate 2. Procurement  ?     Viable Small number of managers 3. Satellite Model –   ?    Viable Centres of Excellence 4. Shared Resource  x x ? x  Discarded Model (current model but more sharing) 5. SAP     ?  Viable and likely to achieve high level of engagement across LGPS 6. Pensions   ?    Viable but not Infrastructure currently designed Platform (PIP) to meet specific needs of LGPS funds

 Upon launch it would then become an integral part of the pool. The following diagram depicts how the pool would work once the clearing house is fully assimilated into the national pool:-

PROJECT POOL 104

 By including three different target return buckets, it will be possible to marry return expectations from the underlying pools, which will in turn represent the collective requirements of the 89 allocating funds. By having a clearing house function, direct deals can be allocated into individual buckets. The national pool will also be able to make direct fund investments and co-investments, as well as investing in UK and Overseas infrastructure.

 Assuming that allocations to infrastructure rise to 5%, total monies invested in infrastructure assets could rise to between £8bn and £13.2bn. However, it is appreciated that it will take a significant period of time for the LGPS to achieve a 5% (invested) infrastructure allocation.

 If this is achieved, savings of between £44.0 and £72.7m per annum might be realised when compared to current arrangements for direct fund investing. However, this will still result in a substantial rise in costs on an absolute basis.

PROJECT POOL 105

8.6 Private Equity & Other Alternatives

Background Asset class  Private Equity is an ownership interest in a company that is not publicly owned, quoted or traded on a stock exchange. Private equity extends the equity opportunities available to LGPS schemes in listed markets and offers them the opportunity to exploit returns to illiquidity – private equity funds typically have lives of ten years or more and secondary liquidity is limited.

 Hedge Funds are structured as pooled funds, predominantly based offshore, and can use different strategies in order to earn an active return, regardless of market return. They invest across all geographies, asset classes and financial instruments including derivatives.

 Multi asset funds apply more obscure investment strategies in a variety of asset classes and instruments. They are relatively unconstrained and target absolute returns with a low correlation to equity markets or other risk assets.

 Other alternatives cover a multitude of investment opportunities – examples would be private debt and commodities – usually intended as return-seeking investments. Scale, variability, management and access Current costs Private Equity Private equity currently represents about £6.2bn of LGPS The complicated nature of assets invested by 32 Funds. Investments are split between fees in private equity meant £3.5bn in direct investment, £2.1bn in FoFs and £0.6bn that it was not possible to where no split was given. obtain consistent data. Investment in Private Equity represents c.4.4% of total assets. LGPS schemes currently access private equity not as direct owners of company equity but as limited partners in private equity funds which make the direct equity investments. Investment is made in three ways: • directly, using internal resource to select funds; • directly, using an external advisor to select funds; • indirectly, as limited partners in funds of funds (FoFs), which in turn invest in a range of funds. Individual schemes may invest in more than one way (e.g., a direct internal investor may make occasional use of FoFs; a FoF investor may make an occasional direct investment). Multi Asset Funds Multi Asset Funds currently represent about £4.6bn of LGPS The current weighted average assets invested by 25 Funds. fee is around 0.6% p.a Investment in Multi Asset Funds represents c3.2% of total assets. Multi Asset funds invest in a variety of asset classes and investment instruments. Although equities are often included, the intention is that the funds deliver a different risk-reward profile to equities. LGPS Schemes use them to diversify their growth assets (and to access alternative assets where size precludes direct investment), typically aiming to achieve equity-like returns with lower than equity volatility.

PROJECT POOL 106

The market and LGPS investment has been growing strongly in recent years. However, the pooling of assets may reduce the strategic needs that have driven this trend. Hedge Funds Hedge Funds currently represent about £2.1bn of LGPS assets The complicated nature of invested by 12 Funds. fees meant that it was not possible to obtain consistent Investment in Hedge Funds represents c.1.5% of total assets. data. There can be different rationales for hedge fund investment. • Some strategies have a relatively high correlation with equities and the motivation for investment in these can be similar to the motivation for investment in multi-asset funds. • Some investment will be deliberately chosen to focus on strategies that have a low correlation with equities to provide an alternative source of return independent of market returns. • Other investments may be more specialised in nature. Other Currently about £2.3bn of LGPS assets in invested in other alternatives by 24 Funds.. Other alternatives represent c.1.6% of total assets. Investment in other alternatives can be split into two groups: • those with a private equity-type structure, e.g. private debt; and • those where open-ended fund investment is possible, e.g. commodities. Proposal Preferred options Expected savings Private Equity All LGPS schemes should move to a direct Industry estimates have been used to investment model, using a small number of estimate potential cost savings. pools. The base fees paid to funds of funds Governance considerations argue that the managers are assumed to be 0.8% p.a. pools should follow the MAP option adopted Eliminating these would save around £29m for other asset classes, although regional p.a. This excludes any saving of performance concentration (of investment or resource) fees paid to managers. might result in a smaller number of pools Internal management would be subject to the hosting investment from outside the MAP. application of full due diligence equivalent to Consolidation at a national level would, due that done on external managers. Where it is to capacity constraints, limit opportunities in chosen, costs would be of the order of 0.03% small and mid buyout funds, which are p.a. (similar to the current assessed cost preferred on performance criteria to large based on the assumption that any economies buyout funds. of scale are matched by an increase in resource). If internal management was adopted across all private equity investment, there would be a further estimated saving of £5m on fees paid to external advisors; the cost of internal management would be an estimated £2m p.a. Even if we assume six private equity pools, maintaining overall exposure at current levels would require annual commitments from

PROJECT POOL 107

each pool of the order of £400m -£500m. This scale would give the pools additional leverage in negotiations with private equity funds. We estimate savings of 0.15% p.a. as a result, equivalent to £15m p.a. The overall estimated cost saving is around £47m p.a., reducing by around £3m p.a. for each pool that uses external management. These savings would be delivered gradually over the next ten years or so as legacy investments run off. Multi Asset Funds The relatively small scale of investment At current levels of investment, pooling could suggests that one of the governance solutions deliver fee reductions of between 0.05% p.a. proposed elsewhere should be adopted for and 0.1% p.a.. This would be equivalent to an these funds. annual saving between £2m and £5m. Funds could be offered by all MAPs, one SAP or hosted by one or more MAP.

Hedge Funds More work is required to determine the If three segregated mandates are set up, two common ground in current LGPS investment internally managed and one using external to determine the scope for pooling. advice savings of £2m p.a. could be achieved. This excludes any benefit from the elimination of Fund of Hedge Fund performance fees and the negotiation of lower fees with underlying hedge funds.

Other Alternatives with a private equity-type Because of the uncertainties involved, no structure would be incorporated into the estimates have been made as a result of any proposed private equity solution. It should pooling. however be noted that the scale of investment might suggest that a SAP is adopted. It is not clear whether there is sufficient overlap across the underlying strategies to justify pooling. The scale of commodity investment would suggest a SAP is appropriate. Single pools would either be aggregated at national level or hosted by one MAP.

Governance For private equity, MAPs provide the best balance between fee savings and investment flexibility.

All of the categories considered would use the MAP/SAP structure established for other asset classes, but concentration of investment and management resource means that it is unlikely that all MAPs would offer sub-funds in all categories. Provision of sub-funds would be at the discretion of individual MAPs in response to perceived demand.

Warnings / Notes The illiquid nature of most of these assets means that transitioning of legacy investments into pools is impractical – they should simply be allowed to run off. Pooling would therefore apply only to new investment, and so most of the savings estimated would be delivered gradually over a period of years.

PROJECT POOL 108

Private Equity and Other Alternatives

Due to the range of alternative asset classes covered by this chapter, the format has not followed the same template as the other asset classes within this report. Instead each alternative asset class should be viewed as a sub-chapter in itself.

Current scale and market structure The LGPS has £15.2bn invested in private equity and other alternatives. The allocations to different asset types are set out in the table below:

Number of Schemes Value (£bn)

Private Equity 32 6.2 Multi Asset Funds 25 4.6 Hedge Funds 12 2.1 Special opportunities 6 0.8 Debt strategies 6 0.6 Commodities/Natural resources 4 0.2 Other/undefined 8 0.7

PROJECT POOL 109

Private Equity

Introduction Private Equity is an ownership interest in a company that is not publicly owned, quoted or traded on a stock exchange. From an investment perspective, it generally refers to equity-related finance designed to assist a step-change in a private business. Examples would be to bring about operational change, to finance an acquisition, to help grow the business or to take a public company private.

Primarily, there are four approaches to investing in private equity:

1. Direct investment in a private company: This approach is normally reserved for particularly large investors. Most investors have limited access to sufficient good transactions to enable adequate diversification. Resource constraints typically limit ability to transact directly. Most investors employ a specialist manager. 2. Publicly traded closed-end private equity funds - This approach offers some liquidity to investors because such funds can be bought and sold like other quoted assets. However, the number of such funds is limited. 3. Direct investment in individual funds (primary funds) - Direct investment affords investors a much wider range of opportunities than publicly traded closed-end funds, although access to the most successful managers and opportunities can be limited. This approach also requires a significant time and resource commitment to research the abundance of opportunities, and perform detailed due diligence on prospective investments and managers. Investors tend to pay fees on committed capital during the investment period (typically years one to five) and fees on invested capital during the realisation period (years five to ten). 4. Fund of Funds (FoFs) - A FoF invests in a range of individual private equity funds. A FoF manager tends to have more resource available to review a wider range of funds than many individual investors. However, investors pay an additional layer of fees and expenses for this offering. In addition to the fees described in (c), the investor will also pay a fee to the FoF manager. Again, this will typically be based on committed capital during the investment period and on invested capital during the realisation phase. Current LGPS investment falls within categories 3 and 4.

Current scale and market structure The table below split of the total £6,234m investment in private equity between direct funds and FoFs and between internal and external management.

Table 3 INTERNALLY MANAGED EXTERNALLY MANAGED Total Direct FoF Both Total Direct FoF Both AUM (£m) 3,278 2,759 125 394 2,956 769 2,024 163 Number of mandates 19 12 6 1 87 21 64 2

Current fees We assume an average base fee of 0.8% p.a. (including the amortised cost of partnership and management fees) is currently paid to FoF managers on committed capital. The remuneration of FoF managers would generally include performance fees as well.

The cost of external advice in respect of direct investment in private equity funds is assumed to average 0.6% p.a. The cost of internal management of direct investment in private equity funds is estimated to be considerably less than this, potentially as low as 0.03% p.a.

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Options analysis Two options were considered - SAP and MAPs.

The options are distinguished by the scale of pooling (national for SAP, regional and/or likeminded for MAP, or a pooling of resources without aggregation of assets) and the responsibility for fund selection (internal v external). Whether MAPs should all adopt a broad investment strategy or specialise in different areas is also considered.

The following points are considered important:

 The options considered below all involve direct investment in private equity funds and assume no future use of Fund of Funds (however, in practice, there may be marginal investment to achieve diversification in some areas.)

 The new arrangements would apply to new commitments; legacy portfolios would remain intact. This means that the cost savings discussed later would be achieved gradually over a period of about seven years. We take the existence of an appropriate vehicle or vehicles as given.

More specifically:

 Scale – Both MAPs and SAP would deliver economies of scale relative to current arrangements, reflected in fee reductions and better commercial terms on underlying commitments. These savings would probably be maximised via a SAP, but the benefits of sheer scale should not be overstated. Efficient deployment of resources in monitoring opportunities is the most important factor and we believe the bulk of any savings could be delivered by MAPs. However, aggregation could introduce capacity constraints: - Managers of private equity funds often aim for a broad investor base to avoid an undesirable amount of influence over terms and strategy from very large investors. This could be particularly relevant in venture capital and small- and mid-market buyout funds, where a significant commitment may be worthwhile on performance criteria (see Appendix). This constraint would bite harder for a national pool. - The number of external managers capable of deploying up to £3bn in annual commitments for a national pool is limited; greater competition and better fee negotiation might be achieved by adopting a multi- manager structure in which different managers would be given different specialist mandates.  Governance - MAPs have the potential to offer a better fit with governance solutions adopted for other asset classes. Whilst it is assumed that there would be six MAPs of approximately equal size it is possible, for example, that pools may be set up only where there is existing internal LGPS resource and this smaller number of pools would host investment from other areas.

 Fee Saving – Fees paid to external advisers would be at a lower level than currently paid to FoF managers, but still considerably higher than the cost of internal management. Changing advisers could be complicated if performance fees were payable in respect of existing commitments, although this could be mitigated through the terms of the adviser’s agreement. Although several LGPS schemes currently manage their private equity investment internally, there may be MAPs where there is no resource. An external adviser may be the only option in these cases, at least until an internal capability could be established. A looser collaboration, involving the sharing of common processes: operational and investment due diligence, legal, tax, monitoring, etc., could also deliver economies of scale, although it would be difficult to avoid some duplication of internal resource and to guarantee common manager selection. It was therefore excluded from further consideration. In estimating cost savings we make the following assumptions: - Investment classified as ‘Both’ in table 3 is treated as Direct for internal management (giving a total of £3,153m) and FoF for external management (giving a total of £2,187m). - Undrawn commitments represent 65% of the amount invested both directly and in FoFs. (Assuming an average payback of 1.5 times investment, approximately this level is required to maintain investment levels.)

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- To maintain overall exposure at current levels would require annual commitments from each MAP of the order of £400m - £500m. This scale would give the pools additional leverage in negotiations with private equity funds. This would be reflected in reductions in base management fees on commitments to underlying investments. The level is difficult to estimate and would vary over time depending on market conditions, but we use an average of 0.15% p.a. on all commitments for illustrative purposes. - Internal management costs will remain at current levels, with any economies of scale matched by an increase in resource. The components of estimated annual savings are

 Elimination of external FoF investments £29m Calculated as £2,187m * 1.65 * 0.8%. Base fees are payable on amounts committed.

 Current cost of external advisers for direct investment £5m Calculated as £769m * 0.6%.

 Negotiated base fee reductions £15m Calculated as £6,234m * 1.65 * 0.15%. Here, too, fees apply to amounts committed.

The estimated annual management costs of the new arrangements would be

 £2m (£6,234m * 0.03%) if all investment was internally managed.

 £19m (£6,234m * 0.3%) if all investment was externally managed.

The overall estimated cost saving would therefore be around £47m17 p.a. if all pools were internally managed. This would be reduced by around £3m p.a. for each pool that used an external manager (assuming six approximately equal pools). These savings would be delivered gradually over the next ten years or so as legacy investments run off.

Comparison against government criteria, The options compared in the table below are:

Pooling Option Scale Savings Governance Speed of Practicalities of delivery delivery

SAP, one external adviser

SAP, several specialist external

advisers

SAP, internal management

MAP, internal management,

common strategy

MAP, internal management,

specialist strategies

17 £29m +£5m +£15m - £2m

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Pooling Option Scale Savings Governance Speed of Practicalities of delivery delivery

MAP, external management,

common strategy

Preferred option A MAP, internal management, common strategy approach is the preferred option.

 MAPs are preferred to a SAP because they offers a better balance of cost, freedom from capacity constraints and governance fit with the solutions proposed for other asset classes.

 Internal management is preferred on cost grounds to external advice, although it would be subject to the application of full due diligence equivalent to that done on external managers.

It is recognise that MAP, external management, common strategy approach may be the best solution, at least initially, for pools where there is no existing in-house LGPS resource.

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Multi-asset funds

Introduction Multi-asset funds apply more obscure investment strategies in a variety of asset classes and instruments. They are relatively unconstrained and target absolute returns with a low correlation to equity markets or other risk assets. The manager universe can be vast depending on type of strategy and exposures sought. In particular, Diversified Growth Funds and risk parity products have been growing in number and assets under management (AUM) in recent years. These products are offered by both specialist boutiques and large asset management firms. Investors can access these strategies through pooled funds or segregated mandates (typically greater than $50m). More liquid strategies are generally available through UCITS-compliant funds.

Current scale and market structure Current fees The current weighted average management fee is 0.6% p.a.

Options analysis These are all actively managed funds, taking a wide range of investment approaches. However, they would typically target long-term returns similar to equities, expressed as a premium over cash or inflation.

The scale of investment does not justify a separate governance structure for any pooling arrangement.

A SAP is likely to deliver the greatest cost savings. However, the skills required for manager selection are perhaps more aligned with resources otherwise available for, say, active equity management selection at MAP level, than those available if a SAP had been adopted for infrastructure investment.

An alternative would be to allow MAPs the discretion to offer a multi-asset sub-fund, subject to demand. Those that do can host investment within the MAP then do not offer the option.

Potential cost savings If average mandate size rose to around £500m (say all of six MAPs offer a sub-fund with two underlying mandates) it is estimated that an annual fee reduction of 0.05% could be achieved, equivalent to a saving of £2m.

If average mandate size were £1bn (in a multi-manager national pool), it is estimated that the annual saving could rise to 0.1% or £5m.

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Hedge Funds

Introduction Hedge Funds are structured as pooled funds, predominantly based offshore, and can use different strategies in order to earn an active return, regardless of market return.

They invest across all geographies, asset classes and financial instruments including derivatives.

Single strategy hedge funds are seen as high risk given their inability to move between strategies. Redemption policies inherent in their fund structures make it difficult for investors to achieve an optimal exit.

Multi-strategy funds provide a number of hedge fund teams under one manager; they are often more expensive than single strategy managers. Even more expensive are Funds of Hedge Funds (FoHFs). These help with diversification but add an additional layer of fees and netting risk. (Netting risk is the risk of paying big performance fees to underlying funds that outperform but also experiencing losses on other funds, such that the investor incurs performance fees for an overall negative result.)

There can be different rationales for hedge fund investment. Some strategies have a relatively high correlation with equities and the motivation for investment in these can be similar to the motivation for investment in multi-asset funds. Some investment will be deliberately chosen to focus on strategies that have a low correlation with equities to provide an alternative source of return independent of market returns. Other investments may be more specialised in nature.

Current scale and market structure Investment in hedge funds represents £2,069m of LGPS assets.

Pooled Segregated FoHF Total assets (£m) 1,280 180 609 Number of mandates 18 1 6 It is assumed that investment classified as pooled is direct investment in hedge funds selected using internal resource and segregated and FoHF investment use external advice.

Current fees We assume an average base management fee for existing segregated and FoHF investment of 0.8% p.a

Options for pooling More work is required to determine the common ground in current LGPS investment to determine the scope for pooling.

If the split between internal and external management remains as it is but three segregated mandates of approximately equal size are set up, two internally managed, one using external advice, the investments could be hosted by MAPs.

The MAP would need to ensure appropriate internal resource is available or a concentration of externally managed investment exists.

Fund of Hedge Fund investment could be eliminated.

Potential cost savings No change in cost is assumed for internally managed funds. As for private equity, any economies of scale are assumed to be matched by increased resource.

Replacing the current base management fees with an estimated 0.5% p.a. for an external adviser to a larger segregated mandate of approximately £800m would save £2m p.a.

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Larger pools may also have the ability to negotiate lower fees with underlying hedge funds, and the elimination of FoHFs will also save any performance fees. However no explicit credit is taken for either of these in the figures above. Other Alternatives

Introduction ‘Other Alternatives’ covers a multitude of investment opportunities, usually intended as return-seeking investments. The most substantial of the categories are:

• Private debt funds - These invest in both senior and mezzanine (high yield) company debt. These companies may or may not be private equity-backed. Target returns can vary widely, from 5%-15% p.a., depending on the part of the capital structure in which they invest. • Specialist opportunities funds - These cover areas such as marine shipping, aircraft leasing, energy, healthcare royalties. Such funds tend to target similar returns to those of private equity.

Options for pooling The small scale and diverse nature of these investments means that it is not clear that there would be any benefit to be gained from pooling. To the extent that it is achievable, it is useful to split the various categories into two groups: those with a private equity-type structure, e.g. private debt and those where open-ended fund investment is possible, e.g. commodities.

The first group would be incorporated into the proposed private equity solution, although the scale of investment would argue for only one pool, potentially hosted by one of the private equity pools.

Nothing in the second group would require more than one pool, probably hosted by one of the MAPs.

Potential cost savings Because of the uncertainties involved, no significant saving as a result of any pooling have been assumed.

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Appendix – asset class performance

Private Equity Private Equity fund performance is widely dispersed across fund size, vintage and strategy. The chart below details net IRR quartile performance between funds of less than $2.5bn in size compared to those greater than $2.5bn. Larger funds have lower top-quartile performance than smaller funds. Larger funds are also more correlated to public markets than smaller funds.

Diversified Growth/Multi Asset Funds

The range of approaches taken to the management of these strategies and their relatively short history means that the performance data is not very informative Hedge Funds As can be seen from the data table overleaf, performance across hedge fund strategies can vary wildly. In 2008 and 2009, performance dispersion between the best and worst strategies was in excess of 40%. Dispersion between managers is even greater.

Other Alternatives There is no meaningful performance data available for this fund type.

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8.7 Internal Management

Scale, variability, management and access

 Investments by internal teams currently represent £30 billion of LGPS assets across nine Funds.

 Investments by internal teams represent circa 15% of total assets.

 LGPS funds with internally managed capabilities have outperformed the average externally managed LGPS funds by 0.5% per annum after fees over the last 28 years. The outperformance has been delivered with relatively low risk18.

 The resources deployed by participating funds are substantial – akin to those of an investment management firm – with 80 investment professionals employed, many highly experienced with over twenty years in investment management.

 Internally managed funds are committed to responsible investment, reflecting their belief that it will enhance long term investment performance.

Current costs  Internal management is significantly cheaper than external investment management. Proposal

Preferred options  The best solution will be the creation of MAPs with internally managed capabilities for both internally and externally managed funds.

Expected savings  There may be no short term cost savings from pooling itself.

 However the case for internal management rests on its cost effectiveness compared with external alternatives. According to CEM the bulk of the savings achieved by large pooled funds result from internal management.

 In actively managed quoted equities, the savings from lower fees and transaction costs are estimated to be 0.5% per annum, providing a significant starting advantage over external investment management.

 Internal passive management has been delivered very cost effectively, with good investment performance achieved within tight tracking error parameters.

 Internal management costs are largely fixed compared with ad valorem fee arrangements typically levied by external managers.

 Pooling resources could also lead to cost savings through the sharing of staff, research and due diligence. Governance Assessment  The governance arrangements in the new pools will need to be robust and ensure that all aspects of the underlying management arrangements - internal and external - remain fit for purpose.

 Internal management is long term in a manner that is directly aligned with the LGPS funds they serve, reflecting the fact that the teams are solely responsible to them. Internal teams also seek to act as 'intelligent clients' in all aspects of funds' investment activities.

 Looking ahead, the resourcing of the internal management capability will need to be flexible enough to cater for the changing needs of the LGPS funds they serve.

18 page 129

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Over time, LGPS funds will mature and it is likely that more capital will be allocated specifically to match liabilities. A multi asset internal investment management model is suggested so that resources can be allocated to meet future requirements.

Warnings / Notes  Looking ahead, the resourcing of the internal management capability will need to be flexible enough to cater for the changing needs of the LGPS funds they serve. A multi asset internal management approach is suggested so that resources can be allocated to meet future requirements.

 A key risk factor facing internally managed teams at LGPS Funds is key person risk. A related one is succession planning. Getting different teams to work effectively together could be a challenge for the future. Building up capability through pooling arrangements with teams that have compatible objectives, beliefs and values should create greater resilience and so help to address these risks.

 It is essential that there is a roadmap for the development of pools with internal management capabilities. In the short term this will focus on setting up the new pools in line with the government's timetable (years 0-2). Achieving synergies should then be the focus, followed by the development of capacity and new capabilities / products (over the following five years). Over time, centres of excellence/ specialisation should be developed.

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Introduction

This note will set out the key findings of the three sub scope workstreams supporting the internal management workstream.

The three sub scope workstreams cover –

 Current internal management arrangements and how these can be developed

 Benefits, Costs and Performance

 Pooling options for internally managed funds

The note will go through the key findings of each of these in turn.

Current internal management arrangements and how these can be developed Of the 1019 funds (£57 bn) involved in the internal management workstream, 9 (£55bn) manage some assets internally. Berkshire is the exception – it is externally managed but is interested in joining an internally managed pool.

Of the 9 internally managed funds, approximately 55% of assets (c£30bn) are managed internally and internally managed equities amount to c£24bn. With the exception of Berkshire (externally managed), Merseyside and Nottinghamshire, most funds manage at least 50% internally. Teesside manage most assets internally (c90%).

Quoted Equities UK equities. All 9 funds manage large-cap UK equities internally, most actively but two funds passively. Two funds (Merseyside and Nottingham) also use external managers (approximately £2bn out of £12bn invested in large cap UK equities). There is scope to increase internal management for participating funds. For pooling solutions, further work would be required to explore the active risk of the various strategies and how to optimise the mix of active styles. Consideration of the proportion of assets in passive and active strategies and the number of holdings would be warranted, but dependent on governance structures.

3 funds manage small and mid-cap UK equities internally (SYPF, WYPF and Lothian), while at least 4 funds use external managers by selecting pooled funds. 1 fund uses external passive management. The Lothian strategy is not regarded as scalable, but there appears to be room for greater use of internal management if the SYPF and WYPF approaches are scalable.

Overseas equities. There is a wide range of approaches to ex-UK Regional equity management:

 Internal passive management (WMPF all regions & Notts for some)

 Internal active management (WYPF in all regions, SYPF & Teeside most regions, E Riding & Merseyside Europe, Lothian US & Europe)

 External managers are used to a greater or lesser degree by 6 funds for passive and active management with pooled vehicles selected by some funds

Scope for external to internal passive is evident (eg Merseyside and Derbyshire). Further work on pooled funds could lead to segregated mandates, consolidation of portfolios, renegotiation of fees with managers and potential for moving external assets to internal management. Optimising the mix of active styles could be considered also.

All 8 funds that allocate to Emerging Market equities use external managers either segregated mandates or selected pooled funds to some extent. All use active management, but Merseyside & Nottinghamshire use passive management too. Initially, exploration of pooled funds (including fees within them) and negotiation of fees could be easy wins.

19 The ten internal funds include the Lothian Pension Fund which has assets of c £5.5bn of which approximately two thirds is internally managed.

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Segregated mandates and consolidation of number of funds could be outcomes. With SYPF and WYPF directly managing emerging markets investments (and Lothian holding stocks in global portfolios), there is an internal option and emerging market equities could be included in global equity mandates.

Global equities. All funds have allocations to regionally managed equity portfolios, but only 2 (Lothian and WMPF) have significant allocations to globally managed equity portfolios. (Nottinghamshire has a small investment in an external global equity pooled vehicle). Both funds use external active management and internal active management, the latter being a relatively new development. Lothian has 3 internal global portfolios, one for >3 years, the others introduced recently; WMPF introduced an internal active global portfolio less than a year ago:

 Internal active management (Lothian 80% of global equities; WMPF 40%)

 External active management (Lothian 20% of global equities; WMPF 40%, balance in external passive)

For quoted equities as a whole, there is potential to increase internal management in both active and passive. Also to explore mandate consolidation and to develop new internally managed products and capabilities. These include non- market capitalisation weighted driven processes and the development of emerging markets products.

Fixed interest Internal management is common across the funds for sovereign bonds, both index-linked and conventional. However there is a wide variety of internal bond mandates, with different groupings of bonds within single mandates (overseas, conventional etc.) and approaches to currency hedging. A common approach would need to be established and this might be quite difficult, although not insurmountable. There is a limited amount of externally managed sovereign bonds and fee savings are likely to be very modest anyway.

Use of external management is more common in overseas, corporate and more esoteric bonds (multi asset credit etc.) and exposure is typically gained through pooled funds. There is some internal management in corporate bonds. WYPF manages corporate and overseas bonds internally (as well as gilts) and there is some scalability but the degree to which this can be shared with others would need greater analysis. Liquidity may prove to be an issue. It may be possible to negotiate fee reductions in common pooled vehicles and new areas like multi-asset credit could be ripe for co-operation.

Worth exploring the scope to develop internal fixed interest management capability over time to cover a wider range of markets than currently is the case.

Property There is a big emphasis on UK, both Direct and Indirect, with very few funds having exposure further afield than Europe. Direct exposure is c£2bn.

UK direct is managed externally, through either discretionary or advisory mandates. Management costs are not very expensive. Fee savings could be achieved by consolidation of providers, although savings would be modest. Pooling could permit investment in larger property lot sizes although any conflicts of interest / allocation issues would need to be managed.

Indirect holdings are significant at c£1.5bn with significantly higher fees (c1%). Most funds seem to have had most of their indirect holdings some time and they are mostly illiquid, so they just wait for them to mature and be realised in due course.

Pooling of resource across the funds, could enable greater specialisation and/or potential to add specialist resource to:

 scrutinise external advice on / management of direct properties;

 enable stronger due diligence and scrutiny of the indirect exposure and/or potential development of a strategy to exit (if appropriate);

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 invest new monies (and proceeds) in a cheaper way, including co-investment opportunities.

Alternative investments including Infrastructure All funds invest in alternatives via funds. There is exposure to different areas, including infrastructure, private equity, hedge funds and ‘special opportunities.’

Pooling could enable greater specialisation, access to more investment opportunities and to larger ones, better fee terms and/or access to co-investments at significantly cheaper fees. It could also allow LGPS funds to access and operate within the more complex secondary markets for such interests, leveraging from those funds already active in this sector, to acquire investments at significant discounts and with the benefit of additional market intelligence.

Resource The 9 funds responsible for c.£55bn of assets (c.£30bn invested internally) employ approximately 8020 investment professionals (Chief Investment Officer, portfolio manager, assistant portfolio manager, investment analyst and trainee investment analyst). There are currently 9 vacancies.

All funds have seasoned investment professionals (20 years+) in key roles managing assets. This body of expertise is valuable but succession planning and key person risk are issues for some funds.

Of the 80 investment professionals, approximately 28 (35%) of them are involved in UK equity selection. Roughly 23% of the £55bn in assets is invested in UK equities.

Despite roughly 40% of total assets being invested in overseas equities, there are far fewer investment professionals (c. 18 FTEs) involved in overseas equity selection, reflecting the fact that a greater portion of the overseas equities is managed externally.

Roughly 16% of the £55bn of assets is invested in debt (UK and overseas conventional, index-linked and corporate). There are 3 vacancies currently for fixed income portfolio managers at the funds and current arrangements suggest that this area could be under-resourced. Succession planning is an issue particularly in internal debt resource.

Representing just over 7% of the £55bn, there is very little direct property investing undertaken, although WYPF has recently dedicated one fund manager to building up direct exposure. Resources are generally targeted at appointing and monitoring externally managed properties (including advisory mandates) or indirect property funds.

For the 11% of assets invested in other asset classes, which includes Private Equity, Infrastructure, Hedge Funds, Commodities and Other Assets, there are c. 7FTEs. The balance of assets is allocated to cash (just under 3%).

Staff are based in different locations but centres of specialisation / excellence could be created through the building up of teams. These can be configured by asset class (ie fixed interest, global equities) and by management approach (passive index tracking, actively managed products).

Resourcing should be developed over time to meet the changing needs of LGPS funds served, to include making capability available to non-participating funds. A multi asset investment model is suggested so that resource can be made available to meet future requirements.

20 Of which 7.5 employed by Lothian, including 1 on UK and 3 on global equities

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Responsible investment and effective stewardship Funds with internal management are committed to responsible investment, reflecting their view that it enhances long term investment performance. One of them (WMPF) has a responsible investment officer and several are PRI signatories in addition to being LAPFF members. Such resourcing enables responsible investment to be integrated into the investment process and investment decision making with particularly close alignment to participating funds. It also enables bespoke and effective voting in respect of shareholdings and engagement with companies on governance and responsible investment issues.

The creation of new pools would be used to strengthen participating LGPS Funds’ responsible Investment capabilities and the effective stewardship of assets in a manner that is consistent with the key recommendations of the Kay review and the UK Stewardship Code.

Others Observations/Opportunities  Consolidation of providers and associated efficiencies including custodian, investment advisers, performance measurement, investment systems (Bloomberg, Reuters, Datastream etc.), brokers etc.

 Stock lending. Some funds don’t currently lend stock. There may be opportunities to improve terms (revenue shares) with custodians or develop capability to do the lending internally.

 Compliance and governance configured differently at different funds – would need to be addressed in new pooling arrangements.

 One fund (Lothian) has an in-house lawyer with experience of governance and investment matters.

Benefits, Costs and Performance Benefits There are significant potential benefits, both financial and non-financial, from increasing the level of internal management as well as the level of collaboration within the LGPS.

Financial  The cost of internal management is significantly lower than external management as evidenced below under Costs. Using this cost data suggests that for every £1bn of assets transferred from active externally managed to internally managed arrangements there could be cost savings of c. £2.5 – 3m p.a.

 In addition, internally managed funds with active management tend to have significantly lower levels of portfolio turnover (1/3) compared to externally managed funds. As there are both explicit and implicit costs associated with portfolio turnover it is not possible to estimate the total potential cost saving from reducing portfolio turnover. However, reducing the portfolio turnover from externally managed levels to internally managed levels for £1bn of UK equities could result in a saving of £2 – 2.5m p.a.21

 At the current time, the internally managed funds within the LGPS deploying active management have separate commission agreements with research providers and generally pay commission rates of 0.15 – 0.2% per equity transaction. It is estimated that this could be reduced by 25 – 50% if they were able to take advantage of some form of pooled arrangement. This could result in a saving of £1.1 – 2.2m p.a.22 based on current internally managed equity assets. If the expected separation of commission and research provision occurs there is the potential for an increase in the costs of broker research in the medium term. It is possible that some form of pooling arrangement could defray these additional costs.

21 It should be noted that these costs are accounted for when comparing the relative performance of LGPS funds. 22 This is based on the £17bn of internally managed equity assets identified by Hymans, the portfolio turnover rate calculated by State Street Investment Analytics in their October 2012 report, and the expected saving in commission.

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 Internally managed passive capabilities should also have a role to play in the new pooling arrangements. The best of these have delivered good investment performance within tight tracking error parameters at a lower cost than the equivalent externally managed service.

 Internally managed funds have out-performed externally managed funds over the long term as evidenced below in the section on Performance. This suggests that not only would there not be a detrimental impact on performance if a greater proportion of funds were internally managed it may actually have a positive impact.

 The LGPS could benefit from increased scale as a result of collaboration which would enable funds to take advantage of fee discounts for larger investments, particularly in Alternatives. It should be highlighted that this does not require the formal pooling of assets and investment managers, under pressure from LGPS funds, are already starting to offer fee discounts based on the total investment by LGPS funds rather than individual funds. A review of a number of Alternative investments fee structures suggests that there could be a c. 0.25 – 0.4% p.a. reduction in investment management fees if the LGPS could achieve a suitable scale. This could result in a cost saving of £2.5 – 4m p.a. for every £1bn of investment in Alternatives.

 The LGPS could also benefit from the ability to participate in direct or co-investments which tend to have low, or even no, management fees. This is the area where the largest cost savings are likely to be achieved provided there are sufficient internal resources to perform due diligence on the investment opportunities. It is also the area where the pooling of existing internal resources or increasing the level of internal resources could have the greatest impact. It is conservatively estimated that the fees associated with a co-investment are likely to be at least 50% lower than traditional management fees within Alternatives. Based on the cost data collated by Hymans this could result in a 0.5 – 0.65% p.a. reduction in management fees which would equate to a cost saving of £5 – 6.5m p.a. for every £1bn of co-investment. However, there needs to be proper resourcing to perform due diligence and oversee co-investments, the most attractive of which can be hard to access. Concentration risk needs to be considered, too.

 There may also be the opportunity to reduce the costs of service providers, such as legal and tax advisors, through the LGPS procuring these services on a joint basis. For example, a group of funds collaborating on a single alternative investment would benefit from a single set of commercial, legal and tax due diligence. That would result in significant savings in professional fees and would be further supported by the ability to use in-house expertise and the already established National LGPS Frameworks initiative.

 The existence of a suitably qualified and experienced internal investment resource should lead to tighter oversight in handling all aspects of investment management, oversight and external relationships. A greater level of internal investment resources should enable funds to robustly question the advice and services that they are receiving.

Non-Financial  An increased level of internal resources would create greater resilience within the LGPS. This includes reducing the level of key person risk, which can be significant due to the specialist nature of the investment roles, as well as improving succession planning and development of staff. It also enables funds to deal with the increasing complexity of investment management that has been seen in the last decade.

 An internal resource enables funds to provide genuinely independent advice and expertise to its elected members, both on the s101 committees but also the local pension boards. An extension of the above is that an internal investment resource enables the investment of a Fund’s assets to be specifically tailored to that Fund as there is likely to be a greater understanding of the needs of its employers and members.

 Investment management is a specialised area requiring suitable qualifications, extensive knowledge and experience, and possibly the requirement to be registered with the appropriate regulator. As a result, it can be difficult to recruit and retain appropriate staff, particularly in geographic areas where there are no existing private sector resources and especially within local authority pay scales and constraints. It should be recognised that the LGPS needs to offer a remuneration structure that is sufficient to attract and retain appropriately qualified and experienced staff.

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Whilst this may not be compatible with the current local authority remuneration structure internal management would still offer a significant cost benefit compared to the alternative of external management.

 There is the opportunity for due diligence to be shared across the LGPS to reduce the time taken to analyse or monitor investments. This will also enable best practice to be shared across the wider LGPS. A larger internal investment resource may also provide opportunities for greater research, development, and innovation in order to enhance the effectiveness of the LGPS.

 Internal management will also enable funds to execute strategies more effectively, for example in handling regulatory matters that could adversely affect funds and their ability to operate efficiently, MiFID II being a case in point.

Other benefits Internal management teams at the LGPS take long term investment views in a manner that is directly aligned with the LGPS funds they serve, reflecting the fact that they are accountable solely to them. In actively managed equities portfolios, for example, this is reflected in low portfolio turnover (keeping trading costs low as covered above) and a tendency towards fundamental investment, leading to relatively low volatility and low risk portfolios (see below). There has also been a tendency to avoid the latest fashions in markets – for example, funds avoided overinvestment in technology stocks during the ‘dotcom’ bubble, which proved to be beneficial to long term investment performance (if uncomfortable in the short term ). This approach is consistent with funds’ approach to Responsible Investment and in keeping with the key findings of the Kay review.

Team stability is another hallmark of internally managed teams at LGPS funds. The performance records of internally managed funds reflect the work of those teams.

Costs Three key sources have been used in this report to determine the differences in costs for internally and externally managed funds. These are WM (investments costs survey, 2010), Hymans Robertson (LGPS) and CEM Benchmarking (international pension funds). Details are set out in Appendix A.

The key conclusions from the data analysis are that the cost of internal management is significantly lower than the cost of external management. The LGPS data shows external management is 3.4x more expensive in equities and 4.3x more expensive in fixed interest.

This is comparable with the CEM benchmarking findings, in which (depending on the size of the pension fund), external management costs were 2.6 – 3.5x more expensive in equities, 1.7 – 5.1x more expensive in fixed interest and 3.0 – 6.9x more expensive in alternative investments.

Performance Long term performance data has been analysed to determine the relative performance of internally managed LGPS funds compared to the LGPS peer group. The performance analysis is based on the following data from consistent sources:

 Performance data derived from CIPFA stats23 for the period 1987 – 2012; and

 Performance data derived from the WM LGPS league tables24 for the years 2013 – 2015.

This has resulted in 28 years of performance data for c. 2/3rds of the UK LGPS funds (by asset value) and is considered to be representative for the LGPS as a whole. Additional analysis has also been performed on shorter, but still meaningful, timescales as performance data was available for a larger number of funds.

23 “Local Authority Pension Fund Investment Statistics”, compiled by State Street Investment Analytics (formerly the WM Company) 24 Compiled by State Street Investment Analytics (formerly the WM Company)

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A summary of the coverage achieved over the various time periods analysed is shown in the following table:

1987 – 2015 1992 – 2015 2002 – 2015 Number of funds 61 71 81 % of UK LGPS 66% 70% 82% assets

Performance Analysis For the purposes of the performance analysis the LGPS funds where data has been available have been split into three categories as follows:

 Internal – these funds have managed the majority (>70%) of assets in-house over the long term. These funds are the 5 funds identified by WM Company as internally managed funds25.

 Hybrid – these funds have managed a smaller proportion of assets in-house or who have increased the proportion of assets managed in-house in recent years. An element of judgement has been used in categorising these funds26.

 External – these funds have managed the majority (>70%) of assets using external managers.

The performance27 of the three categories of funds over the periods under review is shown in the following chart:

9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 1987 - 2015 1992 - 2015 2002 - 2015

INTERNAL HYBRID EXTERNAL WM AVERAGE

Direct management costs It should be highlighted that the above performance data is net of underlying investment costs, such as pooled fund fees and transaction costs, but gross of direct investment management costs such as investment mandate fees and internal management costs28. Therefore, these costs need to be deducted to arrive at a true net performance figure.

25 “Lessons from Internally Managed Funds”, State Street Investment Analytics, March 2013 – the 5 funds are West Yorkshire, South Yorkshire, Derbyshire, East Riding, and Teesside 26 The hybrid funds are Greater Manchester, West Midlands, Merseyside, Lancashire, LFPA, Lothian, Nottinghamshire, Lincolnshire, Somerset, and Islington 27 Annualised performance over the relevant time periods weighted by fund size 28 The exception to this is the data for 2014 – 15 which is net of all costs

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It has not been possible to calculate the direct investment management costs of LGPS funds over the same time periods as the performance data. However, more recent cost data has been available which, although not directly comparable to the performance data, is considered to be sufficient for this analysis.

The average annual cost data for all 100 LGPS funds in the UK29 for the period 2008 – 14 is shown in the following chart, with funds split into the three categories30 defined above.

AVERAGE INVESTMENT MANAGEMENT COSTS 2008 - 14 (BPS P.A.) 35 30 25 20 15 10 5 - INTERNAL HYBRID EXTERNAL

INTERNAL HYBRID EXTERNAL

Within the annual cost data there is a trend towards a reduction in costs for internally managed funds as a percentage of assets. This is due to a combination of essentially fixed costs being spread over a larger asset base, as financial markets have risen over the period under review, as well as success in reducing external management fees.

The following conclusions can be reached from the above performance and cost analysis:

 Internally managed funds and hybrid funds have out-performed externally managed funds over the long term before the deduction of direct investment management costs.

 After the deduction of these direct costs internally managed funds have out-performed both hybrid funds and externally managed funds by c. 0.1% p.a. and 0.6% p.a. respectively over the last 28 years. Internally and hybrid funds have outperformed externally managed funds by 0.5% p.a. after fees over the last 28 years.

 In more recent years (2002 – 15), where the dataset is more complete, the level of out-performance is more marked with internally managed funds out-performing both hybrid funds and externally managed funds by 0.5% p.a. and 0.7% p.a. respectively, net of all costs.

Impact of risk Although the internally managed and hybrid funds have out-performed externally managed funds over the long term this could be due to assuming a higher level of risk. However, the following graph demonstrates that internally managed and hybrid funds tend to exhibit a lower risk profile than externally managed funds31:

29 Source: Annual Report and Accounts 30 Average direct investment management costs weighted by fund size 31 10 years risk and return data for WM LGPS Universe to 31 March 2015 – source: State Street Investment Analytics

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12 10 YEAR ABSOLUTE RISK & RETURN

11

10

9

8

7

6

5

4

3

10 YEAR ANNUALISED RETURN (%)RETURN ANNUALISED YEAR10 2 4 6 8 10 12 14 16 10 YEAR ANNUALISED VOLATILITY (%)

This chart shows the return and risk exhibited by the individual LGPS funds within the WM LGPS universe over the 10 years to 31 March 2015. The funds have again been divided into the three different categories in the same way as the performance and cost data32. Funds that appear in the top left hand quadrant of the chart have generated higher returns with lower risk than the peer group.

Although the data relating to risk and return provided by WM is for a shorter time period than the data analysed in the performance analysis sub-section above, it is still considered to be representative.

The trend of internally managed funds having higher returns and lower risk is not confined to the LGPS. The following chart33 shows the relative risk and return for all funds in the WM All Funds Universe, which includes private sector pension funds as well as LGPS funds, over the 10 years to 31 March 2015.

32 Risk-adjusted return data has not been available for all of the hybrid funds in the dataset 33 10 years risk and return data for WM All Funds Universe to 31 March 2015 – source: State Street Investment Analytics

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This chart also shows that internally managed funds tend to generate higher returns with a lower risk profile.

Factors affecting performance The key factors that tend to contribute to the long term out-performance demonstrated by internally managed funds are:

 A long term focus which is less concerned with following the latest trends in investment management or chasing quarterly performance targets.

 Investment team and sponsors’ interests are aligned and independent advisers tend to be collaborative.

 A tendency to invest on a diversified, low-risk basis with a lower targeted level of out-performance than active external mandates.

 A tendency to focus on active management but without suffering the higher costs associated with external mandates.

 Ability to react to changing market conditions and make more rapid decisions to either protect the Fund or take advantage of the prevailing situation.

 Significantly lower levels of portfolio turnover in equity markets (approximately 1/3 the level of turnover in externally managed LGPS funds34) reflecting the long term approach to investment which incurs fewer transaction costs.

 Funds do not suffer from the costs of changing investment managers on a regular basis that can adversely impact the long term performance of externally managed funds.

 Funds that have internal investment resources tend to have a greater knowledge, and scepticism, of external managers and other service providers, which enhances the decision making with respect to any externally managed investments.

 Lower direct costs of investment management (covered further in the Costs section above).

34 Source: “In-House Management: A Comparative Success”, State Street Investment Analytics, October 2012

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Pooling options Starting with the key criteria for assessment –

 Size. The participating internally managed funds have total assets of £55 billion with £30 billion managed internally. Meeting the size criterion of £25 billion should be possible if internally managed funds pool together and work with externally managed funds in multi asset pooling arrangements. These could be configured by “like-minded” funds with compatible objectives or on regional lines.

 Cost savings. Internally managed funds have low costs and whilst there may be some savings (from combining contracts and operational economies of scale), there may be no short term cost savings from pooling itself. Comparison with external management costs will be needed to make the case.

 Governance. Governance will need to be strong. The benefits of existing arrangements should be retained (with cost benefits not diluted). The arrangements should be flexible enough to enable the new pools to meet the future investment management needs of the LGPS funds they serve. Best practice is key – sharing of ideas and experience, developing resources to meet future requirements and succession planning being important.

 The governance and oversight arrangements in the new pools will need to be robust and ensure that management arrangements - internal or external – are fit for purpose. For internal management, it will need to be demonstrated that the capability, resources, supporting infrastructure and track records continue to meet participating funds’ requirements. Hymans have agreed to provide a template so that this important area can be analysed further.

 Infrastructure. This asset class is covered by a separate work stream. However, it should be noted that larger funds with scale and resources typically have higher allocations to this asset class than smaller ones.

Practical considerations At present, internally managed funds operate from a range of locations.

Internal management teams could act as asset class / investment management specialists, for example in active UK equities or in passive European equities. One approach could be for funds to take leads in particular areas and to be responsible for co-ordinating recommendations from other funds that would have responsibility for specific sectors. A model portfolio could be maintained. Each internal team would retain responsibility for its own portfolio and override the model portfolio – to meet specific objectives (performance / style etc). Such an approach would demonstrate sharing of knowledge, experience and resources.

Looking ahead, the resourcing of the internal management capability will need to be flexible enough to cater for the changing needs of the LGPS funds they serve. Over time LGPS funds will mature and it is likely that more capital will be allocated specifically to match liabilities. A multi asset internal investment model is suggested so that resources can be allocated to meet future requirements.

In setting up pools, participating funds will need to have compatible objectives, beliefs and values. The best solution will be the creation of pools with internally managed capabilities for both internally and externally managed funds. These will deliver significant savings and achieve economies of scale. Pools could be configured regionally or by ‘like-minded’ funds with compatible aims and objectives.

A roadmap for the development of pools with internally managed capabilities should be developed. In the short term this should focus on setting up the pools in line with the government’s timetable (0-2 years). Achieving synergies should then be the focus, followed by developing capacity and new capabilities and products (over the following 5 years). Over time, centres of excellence/ specialisation should be developed.

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Pooling options An association – Memorandum of understanding (MOU) The template for this approach is the Lothian / Falkirk joint working model, which relies on the secondment of Lothian staff to Falkirk and which has worked effectively on a limited basis and with appropriate governance controls. It would be hard to work effectively if there were more than two parties or otherwise on an expanded service / staff sharing basis, both for operational and regulatory reasons. Further, the government’s size criteria would not be met if there were just two parties.

Satisfaction of Suitability Criteria Criteria Comments Sub Criteria Comments Size X Not easily scalable Political X Unlikely to satisfy national desires Savings X Not significant Speed of savings  Should come through quickly Governance  Clear accountability Simplicity  Straightforward

Delegation of Functions Section 102 of the Local Government Act 1972 provides for two or more local authorities to delegate their functions to a joint committee, which acts on behalf of them. Section 101 of the Local Government Act 1972 provides for one or more authorities to delegate responsibility to another local authority. A joint committee structure could be a solution for merged pension funds but fund mergers are not considered further in this report as these are not on the Government’s agenda. FCA regulation would not necessarily be required.

Satisfaction of Suitability Criteria Criteria Comments Sub Criteria Comments Size ? Depends on Political ? Possible. configuration Savings X Modest Speed of savings  Any savings should come quickly Governance  Clear accountability Simplicity  Straightforward

A corporate structure This is the most suitable pooling option to achieve scale and build up internal management capability. It is suggested that a corporate structure in which all participating funds are shareholders is a suitable model, providing the flexibility for the pooling of staff (with service provision made to the participating administering authorities). The corporate entity will be FCA regulated and resourced appropriate to its business model.

It will be necessary to ensure that the taxation treatment for such vehicles is efficient for participating funds and that any regulation put into place takes precedence over public sector specific laws that may conflict with them.

Work on such structures has already been carried out by other groups of LGPS funds. That should make it more straight forward and less costly to implement than would otherwise be the case. The costs should over time outweighed by longer term savings and benefits.

Keeping the new arrangements as simple and straight forward as possible is essential.

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Satisfaction of Suitability Criteria Criteria Comments Sub Criteria Comments Size  Scalable Political  Should be positive Savings - Initial cost increases Speed of savings X Will not come (ie start up) but through quickly potential long term benefits Governance  Clear accountability Simplicity - Some complexity in setting up and running likely

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Appendix A: Cost Analysis

 WM’s last investment management costs survey, based on 72 institutional pension funds with assets of £14 billion as at 31 March 2010, highlighted the average costs incurred for various external mandates35.

Cost (in bps) Active Passive Equities UK 52 5 Global 44 10 US 52 4 Europe 49 9 Japan 49 - Pacific 31 - Emerging 83 - Bonds UK 27 7 Global 22 - Alternatives Property 58 - Private Equity 173 - Absolute Return 120 - Active Currency 186 - Global Tactical Asset Allocation (GTAA) 95 -

This suggests that the average cost of an external equity mandate is c. 50bps, the average cost of a bond mandate is c. 25bps, the average cost of a property mandate is c. 60bps, and the average cost of an alternatives mandate is c. 150bps. The average cost of a passive mandate is 5 – 10bps.

As the survey was conducted in 2010 it is possible that these fees have reduced due to the increase in investor focus on fund management fees seen in the last 5 years.

 As part of the project facilitated by Hymans Robertson, data pertaining to LGPS funds investment management costs has been requested. Data has been received from 38 funds representing c. 65% of LGPS assets in England and Wales and is considered to be representative of the LGPS as a whole. The data has been split into two sections – Equities and Bonds, and Alternatives due to the way that the data has been presented. The data can be summarised as follows:

35 “Gross and Net Performance Measurement”, State Street Investment Analytics, February 2014

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Equities and Bonds Cost (in bps) External Active Internal Passive Average Active Equities 44 13 8 36 Bonds 30 7 - 26

Note: 72% of Equities and 84% of Bonds are managed externally; 70% of Equities are managed actively (data not available for Fixed Income)

The cost of external active and passive mandates in the LGPS is broadly consistent with the findings by State Street Investment Analytics in their 2010 study. Although this suggests that there hasn’t been a great deal of fee compression over the last 5 years care must be taken with this analysis as the dataset is different.

The data also highlights that internal active management is c. 25 – 30bps p.a. cheaper than external active management and only slightly more expensive than external passive management.

Alternatives Cost (in bps) Pooled Segregated Fund of Funds Average Alternatives Property 95 43 56 70 Private Equity 129 - 88 113 Infrastructure 137 - 91 126 Other Alternatives 88 108 73 88

The cost data demonstrates that, perhaps unsurprisingly, Alternative investments are more expensive than traditional Equities and Bonds. It suggests that the average cost of Property is c. 70bps, the average cost of direct Private Equity is c. 130bps, the average cost of direct Infrastructure is c. 140bps, and the average cost of Other Alternatives is c. 90bps.

Although fund of funds within Alternatives appear to be cheaper than pooled or segregated investments it is likely that this data does not include the fees of the underlying investments within the fund of fund vehicle. Therefore, this should probably be treated as an additional cost of investment rather than being compared to the costs of direct investment, notwithstanding the ability of fund of fund vehicles to perhaps achieve lower fees in the underlying investments.

There is a trend to lower fees within Alternatives, particularly within Private Equity, compared to the State Street Investment Analytics survey but, again, care needs to be taken with this analysis as the dataset is different.

An element of the reduction in fees in Alternatives over the last few years is possibly due to LGPS funds securing fee discounts as a result of making larger investments. This is due to a number of reasons including:

 LGPS funds have increased their allocation to Alternatives (including Property), from 8.9% in 2006 to 16.0% in 201536, which has possibly translated into larger individual investments.

 Funds have become more comfortable with the asset class over time and are prepared to make larger investments.

36 UK Local Authority Annual Review 2014 – 15, State Street Investment Analytics, 2015

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 More recently, investment managers, following pressure from LGPS funds, are offering LGPS fee discounts which are based on the total investment by LGPS funds rather than individual funds.

 Some LGPS funds have participated in co-investments which tend to be significantly cheaper than fund investments.

Dyck and Pomorski37 performed detailed analysis on data provided by CEM Benchmarking Inc. which covered a large number of global defined benefit funds over the period 1990 – 2008 and included 363 funds representing $5trn of assets at the end of 2008, of which 17% of assets were internally managed. Although this data does not compare directly to the LGPS it is considered to be one of the most extensive studies of defined benefit pension funds.

The study concluded that larger funds out-perform smaller funds by 43 – 50bps p.a. due to the following:

 Lower costs as a result of more internal management of assets;

 A higher allocation to Alternatives which have tended to out-perform over the period of analysis; and

 Realising higher net returns within Alternatives through the superior selection and monitoring of managers and the ability to take advantage of co-investment opportunities.

The cost data from the study is summarised in the following table:

Cost (in bps) Mean Median Cost ratio38

Equities 29 30 2.6 – 3.5

Bonds 16 17 1.7 – 5.1

Alternatives N/A 119 3.0 – 6.9

Property 76 76

Private Equity 252 218 This data suggests the following:

 The cost of managing Equities (29bps v. 36bps) and Bonds (16bps v. 26bps) is relatively cheaper than the average costs experienced in the LGPS, as evidenced in the recent Hymans analysis quoted above

 The cost of managing Property (76bps v. c. 70bps) is broadly similar.

 The cost of managing Private Equity (252bps v. c. 113bps) is significantly more expensive although this could be due to a different measurement methodology with the full disclosure of underlying costs in the CEM study.

The key conclusion from this data analysis is that the cost of internal management is significantly lower than the cost of external management. Depending on the size of the pension fund, external management costs were 2.5 – 3.5x more expensive in Equities, 1.7 – 5.1x more expensive in Bonds, and 3 – 6.9x more expensive in Alternatives.

This is consistent with the analysis of the LGPS data which shows that external management is 3.4x more expensive in Equities and 4.3x more expensive in Bonds.

37 “Is Bigger Better? Size and Performance in Pension Plan Management”, Dyck and Pomorski, July 2011 38 The cost ratio is defined as the costs of external active management compared to the costs of internal active management

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8.8 Flexibility Around Pools

Background

Nature of potential exclusions from pooling • Some asset classes or investment strategies might be accessed more efficiently if Funds were to have the flexibility to invest outside the larger pools. • The areas where there is a strong case for allowing Funds the flexibility to hold assets outside the pools are: 1. Local investments which generally have twin aims of generating commercial returns and supporting the local economy. Investment is frequently through a fund or limited partnership with an appointed manager although some funds are starting to manage such investments more directly. 2. Employer specific investment strategies which are designed to meet the needs of participating employers with different funding positions, covenants, liability profiles and sensitivities to risk. 3. Risk management strategies which are used to reduce exposure to currency, inflation, interest rate and longevity risks. These have been illustrated below.

Buy-in Longevity Interest hedging Inflation rate Currency hedging hedging hedging Liability risk hedged

4. Cash which is held to pay benefits and administration expenses and to manage liquidity between investment managers.

Scale, variability, management and access • Local investments are made by a small number of funds and the scale is difficult to quantify. It is also difficult to quantify the scale of exposure to risk management strategies as contracts often have zero value at outset. A range of approaches from doing nothing, through earmarking investments to allocating employers to one of a discrete number of investment strategies are used to meet specific employer needs. The data gathered from funds indicated that the percentage held in cash was c 1.7%

Current costs • It has not been possible to quantify the costs currently incurred in the management of these strategies. Proposal

Preferred options  If and when pools have appropriate skilled and experienced resource, new local investments should be made through a MAP. In some cases those local investments will be made for all those funds in the pool who are allocating assets to local investments but in some cases certain commercially attractive local investments could be ear-marked by the pool for an individual fund (eg if the investment is not considered suitable by the pool for wider ownership). In the meantime, where appropriate skilled resources remain with individual funds, new local investments may be made outside the MAP where an individual fund can demonstrate commercial return.

 Bespoke employer investments should be exempt from pooling in certain circumstances subject to government guidance and supported by financial analysis. In addition a special dispensation could be provided for Passenger Transport Funds if there is demand.

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The savings that might be achieved through collective provision of solutions are expected to be small (similar to those on bonds) and unlikely to compensate for the loss of tailoring which permits good risk management for employers. If and when pools have appropriate skilled and experienced resource, pools may be able to procure assets required by individual funds to enable those funds to execute their risk management strategy for specific liabilities. Where those investments are specific to particular liabilities (e.g. a buy-in) the assets would be ear- marked by the pool specifically for the individual fund that requires them.

 Hedging strategies should not be viewed as an investment in themselves and they should be permitted to be maintained locally as long as there is “look through” available to the underlying exposures at Fund level. This is consistent with funds maintaining local discretion over strategic allocation and risk management and will allow funds to tailor their risk exposures and will support governance and monitoring requirements. If and when pools have appropriate skilled resource, some of these instruments could be procured by the pool at the request of individual funds who need them to execute their risk strategies. Clearly any such instruments would need to be ear- marked by the pool for the individual fund that requires them.

 Funds should be allowed to hold sufficient working capital locally and any strategic cash should be pooled. There should also be some flexibility in the way that this working capital is invested.

Expected savings • It has not been possible to quantify the expected savings. The focus of this chapter is primarily around risk management rather than direct cost savings. Warnings / Notes • The appropriateness of holding different investments inside or outside of the pool will be heavily influenced by where the investment resources are held (i.e. still retained by the funds or working for the pool). This will likely evolve over time and will vary between pools depending on the experience of participating funds

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Introduction There is wide variation in both the size and type of investments of LGPS funds in England and Wales. At 31 March 2015 assets under management ranged from under £500m in the Passenger Transport Funds to £17.6bn in the largest LGPS fund. Whilst there are many exceptions to the rule, in general the level of internal investment resource and the diversification of investments, increase with the amount of assets under management in the fund.

There is also variation between funds in terms of the mix of employers which participate (public and private sector entities of varying covenant strength) and the maturity of liability profiles (which drives the need for cashflow and in some instances, certainty of returns). As a result, LGPS funds employ a wide range of risk management tools, in order to help manage general investment risks and risks specific to individual or small groups of employers.

Some of the less common types of investments and risk management tools may only be operated by a small number of funds.

This chapter considers the practicality of providing these from within pools and analyses the case for allowing certain types of investment to be made outside of pools and if so, whether any special conditions should be met. It also considers other asset classes where the benefits of pooling may not outweigh the additional complexity that it may bring. For example, cash.

This section of the report is generally qualitative in nature rather than providing numerical analysis.

The following types of investment are considered:

Local Investments Local investments are made by a small number of funds. However they are often not explicitly shown in fund accounts and therefore it is difficult to quantify the allocation to local investments across the Scheme as a whole.

Local investments generally have twin aims of generating commercial returns and supporting the local economy. Examples include direct property investments which include development risk, i.e. construction of a new office block or building housing for sale or for rent. Other local investments could include loans to projects which deliver wider social benefits (such as increasing local knowledge or skills, specifically targeting underserved markets) or providing venture capital to start-up businesses. Such investments would often be diversified by investing via a fund and are broadly similar to a local private equity investment

Local investments do not naturally lend themselves to pooling between funds, primarily due to the investment being made in the area served by the fund making the investment.

Bespoke employer strategies Some LGPS employers have certain characteristics, such as a particularly mature liability profile (i.e. benefit outgo significantly in excess of contribution income) and/or a weak covenant which means that a typical LGPS asset allocation may result in undesirable volatility of funding position and contribution rates. In order to manage this, some funds have earmarked specific lower-risk investments to certain employers and the returns on these investments are used to assess the employer’s funding position and contribution requirements.

There are various approaches adopted across the LGPS in this area. Some funds do not employ bespoke strategies at all. Other funds earmark investments for a small number of employers. At least one fund allocates all employers into one of a discrete number of strategies, depending on the employer’s risk profile. A more complex approach requires robust accounting processes, such as splitting different buckets of assets into units which are allocated to employers in order to effectively ‘ring-fence’ assets between employers as required.

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There are two stand-alone ‘passenger transport’ funds within the LGPS in England and Wales where it is arguably more straightforward to construct an investment strategy which meets the needs of individual employers. The participating employers in these funds are private-sector bus operators who generally have greater representation in the governance of the fund than a typical LGPS employer. In other regions, bus operators participate in the main regional fund but their liability profiles are likely to be broadly similar to the transport funds.

Hedging specific risks, e.g. currency, inflation, interest rate, longevity exposure. Some funds hold non-mainstream investments in order to reduce their exposure to specific risks. These include:

 Currency futures/forwards to offset some of the currency risk in overseas investment (and where this is held by a different manager to the overseas investment itself)

 Inflation hedges, which provide payment to the fund if inflation is higher than expected (to compensate for the corresponding increase in liabilities)

 Interest-rate hedges, which are designed to provide payments to offset the impact on the liabilities of movements in long-term market interest rates.

 Longevity swaps to reduce the risk of members living longer than assumed

 Buy-in contracts to eliminate all financial and demographic risks in respect of specified members (although there is a counterparty risk with the insurer)

It is difficult to quantify the amount of exposure to these instruments across the LGPS due to the contracts often commencing at zero value and therefore appearing relatively immaterial in fund accounts. The level of collateralisation required depends on the specific instruments held.

These risk management options are summarised on the diagram below. The options on the right hand side of the diagram are less commonly used at present, but as LGPS liabilities mature, could be expected to become more attractive to funds as they eliminate more of the mismatch risk between assets and liabilities.

Liability risk hedged

Currency hedging Currency hedging is used by some funds to reduce or remove the currency risk associated with non-Sterling (GBP) denominated (overseas) investments. The intention is to remove unrewarded risk and reduce volatility on the portfolio generated by the relative movement of overseas currencies to Sterling. This has the effect of reducing the mis-match between non-Sterling denominated assets and Sterling denominated liabilities. Currency risk may be hedged passively (maintaining a fixed amount hedge between 1-100%) or more dynamically where an appointed provider seeks to flex the hedge ratio to produce an outcome superior to a fixed (passive) hedge. A dynamic hedge may also be structured to reduce downside (cash drawdown) risk.

In many cases passive currency hedging is an activity undertaken on behalf of funds by their custody provider. Generally dynamic hedging programs are undertaken by appointed specialist providers.

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Both forms of hedging are generally being undertaken independently of the manager of the underlying assets. However on some cases, particularly in the management of fixed income investments, the manager of the assets will manage currency risk holistically within the portfolio. Currency may itself be treated as a source of alpha in certain fixed income portfolios. This paper does not deal with standalone alpha generating currency approaches although these are now rare in LGPS funds.

The hedging of currency risk by funds is a risk management rather than a return seeking tool. In this way hedging forms part of the investment beliefs of individual funds. Certainly there is a mix of approaches towards hedged and unhedged portfolios across the LGPS.

Interest rate and inflation hedging These typically take the form of forward contracts, futures and swap contracts. Often these are accessed via a unitised pooled fund structure due to restrictions on holding derivatives in the existing investment regulations.

Longevity swaps We are aware of one LGPS fund that holds a longevity swap policy issued by an insurance company. These policies are relatively common in private sector DB schemes and typically pay cashflows to the fund holding the policy if the members covered by the policy live longer than was assumed when the contract was struck. Cashflows are paid in the other direction if mortality is heavier than assumed.

This type of investment does not lend itself to pooling due to it being in respect of specific members of a single LGPS fund and it may be difficult to either novate across to a pooled structure or for it to be unwound.

Buy-in policies One of the stand-alone passenger transport funds holds a ‘buy-in’ policy covering a number of pensioner members. This policy pays cashflows which match the payments that the fund is making to the members covered under the policy (so effectively hedges longevity and investment risks). Again, this type of investment does not lend itself naturally to pooling.

Cash It is assumed that most LGPS funds’ Strategic Asset Allocation do not contain an allocation to cash. LGPS funds’ cash holdings are typically split between:

 cash balances, that are used to pay benefits, administration expenses and manage liquidity between investment managers, which should be seen as an extension of the function of administering a pension fund.

 the cash held by the managers themselves, either strategically or to provide liquidity within their mandate or fund. For the purpose of the consideration of options for pooling assets the cash held as part of investment managers portfolios should be considered as part of that asset class e.g. equities or bonds.

Funds approaches to managing cash can differ, for example, due to the specific terms of their custody mandates. Whilst separate bank accounts must be maintained for the management of administrative cash (the first category above), often the treasury team of the host local authority manage the pension fund’s internal cash and will do so according to the priorities for managing public funds of security of investments, liquidity and yield, in that order.

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Options analysis

Due to the range of strategies covered by this chapter, the format has not followed the same template as the other chapters. Instead each strategy should be viewed as a sub-chapter in itself.

Local investments – structures considered Greater Manchester Pension Fund has a successful track record of local investing with total assets under management of £10bn - £15bn and an allocation to local investment of no more than 5%. Pools of c£30bn should therefore be of an appropriate size to invest in this asset class. Similar to infrastructure and property investments, increasing the size of allocation to local investment can increase diversification and reduce costs on a relative basis. However, returns on investments may be lower due to increasing competition from large international pension and sovereign wealth funds.

As scale increases, many of the construction-based local investments effectively tend towards more general infrastructure.

Increasing scale could also make some local investments less viable. For example, many start-up venture capital investments or loans to projects which deliver wider social benefits are likely to be of small unit size and not easily scaleable.

A broad range of options listed below were considered initially before focussing on MAPs with an exemption from pooling for existing investments.

• SAP • MAPs • National Framework • LGPS share class • Exemption Options discarded at an early stage SAP Under a SAP the concept of local investments would not really exist. Investments of the nature described on the previous pages would effectively either be direct property or infrastructure investments, depending upon the financial structuring and the level of development risk taken. These asset classes are covered in detail elsewhere in this report, therefore local investment as part of a SAP is not considered further here.

National Framework A framework is not considered viable for local investments due to the wide variation of potential types of investment.

LGPS ‘Share Class’ A ‘share class’ or virtual pool in local investments is potentially a difficult concept. As LGPS funds can invest directly in local investments, a virtual pool may not be viable in the same way as it is for other asset classes. There may however be some savings from using the same due-diligence providers for projects as other funds/pools and the same marketing/letting agents, contractors etc…

Options given further consideration MAP Local investment via a MAP would involve the MAP making investments in the region(s) which it serves. This may limit the range of potential investments available to each pool, but can bring additional social or economic benefits to the region, which are difficult to quantify. The local knowledge of the pension committees and the officers of the investment vehicle may also add value.

There is the potential for conflict between funds regarding the specific areas in which investments are made, although this can be mitigated by a clear and transparent due-diligence process, using independent external support if necessary.

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Expected governance changes within the LGPS as part of the pooling agenda, which remove detailed implementation decisions from individual fund committees may improve the speed to market of local investments and remove some of the potential conflict between funds of where to make investments. For example, committees may approve an allocation of x% to local investments, but it is up to the operational decision makers of the MAP, hopefully free from any regional bias, to determine which specific projects progress.

There could be some capacity constraints if allocations are significant as local investments are typically close-ended vehicles. In addition, significant resource is required to manage multiple investments, particularly if these investments are increasingly made directly.

The alternative to making investments via a MAP would be for individual funds to make investments outside of the pool altogether, although allowance for funds to do this brings with it the risk of some of the best opportunities being kept outside of the pool and potential loss of scale. There is also a risk that individual funds proceed with projects which were considered commercially unsuitable by the pool, although there are potential safeguards that could be applied, such as requiring a co-investment by an investor with no direct local interest. In any case, in a pooled environment there may not be sufficient internal resources retained by the individual funds in order to undertake projects of this nature independently.

Exemptions Existing local investments are likely best left to run off outside of pools, as they are likely to be illiquid and with potential for tax issues if transferring the ownership into a new entity. The issues to consider in relation to run-off are essentially the same as for property or for private equity and infrastructure, depending on the nature of the underlying investment and the vehicle used.

Comparison and ranking of options Pooling Option Scale Savings Governance Speed of delivery Practicalities of delivery

MAP

Exempt local investments from pooling

Work-stream’s preferred option If and when pools have appropriate skilled and experienced resource, new local investments should be made through a MAP. In some cases those local investments will be made for all those funds in the pool who are allocating assets to local investments but in some cases certain commercially attractive local investments could be ear-marked by the pool for an individual fund (eg if the investment is not considered suitable by the pool for wider ownership). In the meantime, where appropriate skilled resources remain with individual funds, new local investments may be made outside the MAP where an individual fund can demonstrate commercial return.

PROJECT POOL 143

Bespoke employer strategies – structures considered and scale of individual pools Given that bespoke employer strategies will only form a subset of total pool investments (albeit likely an increasing subset), optimum scale is not considered further here.

A broad range of options listed below were considered initially before narrowing these to MAPs potentially augmented by a National Framework and with some exemptions.

• SAP • MAPs • National Framework • LGPS share class • Exemption SAP Under a SAP structure there is potential for a wide range of low-risk investments, for example fixed interest gilts, index- linked gilts and credit investments of varying credit quality and liquidity. This should be sufficient to reduce much of the mismatch risk between assets and liabilities to a suitable level for most LGPS funds and employers.

However, some level of mismatch will remain – for example the duration of the investments is unlikely to match the term of the liabilities the fund is looking to meet.

The likely fairly rigid governance of a SAP may make it difficult for any more exact matching to be obtained via the SAP until a point is reached where there is sufficient demand from funds (i.e. more than just one voice in 89) to create a new ‘asset pot’.

Therefore a SAP structure presents a case for permitting investment outside of pools in certain circumstances (by demonstrating this is more cost effective) or ensuring the ability to hold risk management instruments such as interest rate swaps either inside or outside of the pool.

MAPs MAPs will likely be ‘unitised’, so that participating funds can buy and sell units in each asset class in the MAP to obtain an overall asset allocation appropriate to their needs. Funds should also be able to operate their own system of unitisation at the fund level to provide different allocations to different employers should they wish to do so.

Under a MAP structure, due to the lower total amount of assets in the pool, the choice of low risk investments will be less wide ranging. However, there is greater scope for the funds in the pool to examine fund and employer needs and create investments which are closely tailored to requirements. This task would likely be easier with a lower number of funds participating in the pool and with the pooling funds being similar in nature in terms of employer profile and funding level. As the number of pool participants increases, the situation tends towards that faced by the SAP structure.

National framework A framework approach for selecting managers to operate bespoke investment strategies could potentially be considered. The issues would be similar to the framework approach to accessing gilts and credit, albeit on a smaller scale, which may not be sufficient to generate material savings.

LGPS Shareclass A “share class” or virtual pool could potentially be created, perhaps using one of the funds that currently operates bespoke investment strategies as a host authority or by consolidating external mandates with a single manager. Material savings could potentially be achieved with the former, although they may well be outweighed by the additional compliance requirements.

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Exemption The option remains for specific employers to have their liabilities managed outside of the pool and for risk management instruments to be used to adjust the standard pool investments.

A particular case for a pooling exemption could perhaps be made for the passenger transport funds, given their existing stand-alone status which means they are currently relatively free from cross subsidy from other employers and the private- sector status of the sponsoring employers.

Comparison and ranking of options Pooling Option Scale Savings Governance Speed of delivery Practicalities of delivery

SAP

MAP

Manager Framework

LGPS Shareclass

Exempt bespoke employer investments from pooling

Work-stream’s preferred option Bespoke employer investments should be exempt from pooling in certain circumstances subject to government guidance and supported by financial analysis. In addition a special dispensation could be provided for Passenger Transport Funds if there is demand. The savings that might be achieved through collective provision of solutions are expected to be small (similar to those on bonds) and unlikely to compensate for the loss of tailoring which permits good risk management for employers. If and when pools have appropriate skilled and experienced resource, pools may be able to procure assets required by individual funds to enable those funds to execute their risk management strategy for specific liabilities. Where those investments are specific to particular liabilities (e.g. a buy-in) the assets would be ear-marked by the pool specifically for the individual fund that requires them.

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Hedging specific risks, e.g. currency, inflation, interest rate, longevity exposure. – structures considered A broad range of options listed below were considered initially before narrowing these to the SAP and MAPs.

• SAP • MAPs • Exemption

SAP or MAP Similar to the use of bespoke employer strategies, the wide range of investments in a SAP may reduce the need for funds to hedge specific risks. However, on the other hand, the potential lack of flexibility with the governance of a SAP may make it more difficult to tailor investments in order to reduce specific risks, thereby increasing the need to use the instruments listed above.

In a MAP with a relatively small number of investors there would be more scope to amend investments or introduce new investments as and when required.

It is possible that both SAP and MAPs could offer hedging but it is clear that one size may not fit all as the appetite for and approach to hedging this risk will vary across Funds.

Exemption Hedging programs could be maintained locally (with it to be made clear they are not an investment in themselves) as long as there is “look through” available to the underlying exposure of individual schemes investment allocation within a pooled vehicle. In any case it would seem to be appropriate for this to be available to support governance and monitoring requirements. This approach will provide the greatest flexibility and is consistent with funds maintaining local discretion over strategic allocation and risk management decisions.

In a pooled environment there are potentially issues around whether funds would retain the investment expertise necessary to be able to effectively manage some of these hedging options outside of the pools. There is also an interaction with where asset allocation / manager selection decisions lie between funds and pools. For example, is the decision to hedge overseas currency (and to what extent) an asset allocation decision?

Buy-in policies should be allowed to run-off outside of pooled vehicles as it is likely they will not be possible to unwind without significant cost and the policies are in respect of specific members of a specific fund.

The position with the longevity swap is less clear. It might not be possible to allow this to run off outside of the pool on its own as potentially significant cash payments may need to be made to the insurer if mortality is heavier than assumed at outset and collateral may need to be held for this purpose. PwC analysis released alongside Government’s pooling guidance comments on potential legal issues in certain types of pooling vehicles. This could prevent similar products being held within pools in future, however should demand be sufficient, it is likely that an appropriate product could be developed.

It should be noted that both buy-in policies and longevity swaps will take a long time to run off.

For all of these risk management options, the guidance on whether they should be managed inside or outside of pools needs to be ‘future-proof’. It is likely that over time, as liabilities mature, bespoke employer investment strategies will become increasingly important and the more member specific risk management tools such as longevity swaps and buy-ins will become increasingly relevant.

PROJECT POOL 146

Comparison and ranking of options Pooling Option Scale Savings Governance Speed of delivery Practicalities of delivery

SAP

MAP

Risk management maintained locally

Work-stream’s preferred option Hedging strategies should not be viewed as an investment in themselves and they should be permitted to be maintained locally as long as there is “look through” available to the underlying exposures at Fund level. This is consistent with funds maintaining local discretion over strategic allocation and risk management and will allow funds to tailor their risk exposures and will support governance and monitoring requirements. If and when pools have appropriate skilled resource, some of these instruments could be procured by the pool at the request of individual funds who need them to execute their risk strategies. Clearly any such instruments would need to be ear-marked by the pool for the individual fund that requires them.

Cash Officials of HM Treasury have indicated that they are starting from the mindset that all assets should be pooled unless there is a compelling reason for them not to be. This would also apply to cash. However, HMT acknowledge that there will always be some cash managed outside of the pool due to the timing of contribution income and benefit payments.

There is also a question of where any line is drawn between cash and short-dated fixed income investments – it would be preferable for funds to have some flexibility in the way that short term cash or cash like holdings are invested.

An appropriate general principle may be that funds are allowed to hold sufficient working capital locally, but any strategic cash should be pooled. Guidance in this area should be relatively flexible as the operation of pools and their liquidity requirements will no doubt differ to an extent and their cash management will likely evolve over time.

The cost impact from pooling cash is likely to be immaterial compared to the potential cash drag on other asset classes within the pool if liquidity is not optimised.

Comparison and ranking of options Pooling Option Scale Savings Governance Speed of delivery Practicalities of delivery

SAP

MAP

Administrative cash managed locally

PROJECT POOL 147

Work-stream’s preferred option Funds should be allowed to hold sufficient working capital locally, but any strategic cash should be pooled. Guidance in this area should be relatively flexible as the operation of pools and their liquidity requirements will no doubt differ to an extent and their cash management will likely evolve over time.

PROJECT POOL 148

8.9 Regional/Multi-Asset Pools Background

Definition of a multi-asset pool (“MAP”)  The term multi-asset pool (“MAP”) has been selected to describe the situation where there are a number (possibly six) pools investing in a range of asset classes and each is open to investment from a defined list of LGPS funds. A specific example would be regional and/or like-minded39.

Scale, variability, management and access  All funds and all assets; including internally and externally managed assets, both pooled and segregated, liquid and illiquid. Proposal

Preferred options  Two groupings of funds were considered:

1 Exclusively on a regional allocation

2 Amending the regional groupings to equalise the size of the pools.

Both options consist of 7 groupings to accommodate the subscale combination of Welsh funds.

 If the groupings are defined along regional lines there should be a time-limited opportunity (a ‘transfer window’) when individual funds could request a transfer to another pool. This recognises that some groupings are already establishing themselves and not necessarily along geographic lines.

 If the equalised option is adopted the pools (excluding Wales) will range in size from £26bn to £33bn.

 Regional pools should work in collaboration where economies of scale suggest optimum sizes of investment within specific asset classes are larger than that run by an individual region. This is effectively the MAP Plus model.

Expected savings  The additional savings for a SAP are not considered to be significantly greater than those within MAP, although potential savings may vary by region.

 Influences on fee costs would include fund size (where larger funds have tended to have lower costs), internally managed funds, (where again a lower cost base is feeding through) and the use of alternatives (which generally carry higher fees, especially where a Fund-of-Fund arrangement is in place).

 individual specific asset class findings can be used to understand the potential ranges of Fee Savings from a multi asset pool perspective

Governance Assessment  Outside London which has a structure that can support participation by 32 boroughs, the natural limitation of between nine to twelve40 funds in any one pool it will be possible for each fund to feel that it has a voice in the policy and approach adopted.

 The inclusion within the pool of a team of experienced investment professionals will facilitate informed decisions with a long term perspective.

Warnings / Notes • Each grouping of funds should develop and agree a set of ‘like-minded’ principles that guide the setting of the cultural and governance arrangements; these principles may vary between groupings and will influence the approach to structure, transition and cost sharing.

PROJECT POOL 149

• The asset transitions that are required will be larger than any transitions completed to date which brings enormous and unquantifiable risk and likely costs. There are likely to be opportunities for pools to collaborate to ‘cross’ assets between them and avoid costs prior to trading in the market. To be successful, this will require careful project management and a willingness to coordinate the timing of the transitions.

PROJECT POOL 150

Introduction This chapter focuses on the establishment of regional and/or likeminded pools, predominantly based on geographic regions, but with some exceptions built into the alternative options considered.

For the purposes of this chapter, it has been assumed that all Funds and all assets are in scope, and will be included in one of the MAPs.

In the section on options for accessing the asset types, a Mixed Economy approach (also referred to as “MAP Plus”) has been included within the MAPs model. This model allows for the fact that for some asset classes, larger pools are required to achieve the better economies of scale.

The model is not predicated on either internal or external management structures, which can be determined within each of the regional pools as they agree as appropriate.

Current scale and market structure All options considered include all English and Welsh LGPS Funds and 100% of their assets. Options analysis The options we have considered are as follows:

 The default option. This is as set out in Annex 2 to the paper to the Scheme Advisory Board on 21 September 2015. It consists of seven regional pools, covering London, Wales, the Midlands, and the North West, North East, South West and South East. The Environment Agency has been included in the South West based on the location of its headquarters. The LPFA has been included in the North West given that it has not been included within the London CIV, and to reflect its relationship with the Lancashire Pension Fund.

 The equalised pool option. This is an amended version of the default option to equalise the value of assets held in the five pools excluding Wales and London. There will be more than one way to switch neighbouring authorities between pools, and this will require further consideration if there is a decision that pool sizes should be as similar as possible. N.B. If there is not a political decision to support a Wales only pool, this option would need to be revised to equalise all pools around the £25bn scale criteria.

 The transfer window option. This option has been included to reflect the fact that in addition to LGSS (Cambridgeshire and Northamptonshire Shared Services) and the LPFA/Lancashire arrangements, there may well be other key relationships which are not based on regional locations. This option therefore starts from the default option, but provides a one off opportunity for Funds to make a case to transfer to an alternative MAP. The option entirely based on self-selection has been discounted due to the risk of the orphan Fund which fits nowhere, or pools of excessive size. For example, there may be an argument to group those Funds who currently are predominantly internally managed together into a single (or potentially two) multi asset pool(s), creating a north/central internally managed pool(s) and a north/central externally managed pool. None of the Funds in the South have material if any internally managed assets, but they could, within the transfer window, choose to transfer to an internally managed pool in the Midlands or North of England.

The following points are considered important: For each of the three options, all assets for the Funds within the pool will come under the management of the pool. The idea of Funds retaining individual holdings (though it was accepted that in some cases, only one Fund would access the assets within a sub-fund in the short to medium term) has not been included. However, it is noted that some Funds feel strongly about retaining specific legacy arrangements locally, therefore some flexibility initially should be considered.

PROJECT POOL 151

Other than allowing for the option of like-minded funds pooling together to create a fully internally managed pool, no assumption has been made about the management of individual pools. It should be for each pool to determine (both initially and in the longer term) whether it is managed on an internal basis, invests through external managers or a combination.

This said, there is concern about splitting internal and external management for a single asset class within a pool. Such arrangements could impact on the economies of scale for fees savings, and create governance issues around the decisions of individual funds. However where economies of scale suggest further fee savings, it is assumed that the MAPs would collaborate on investments e.g. a number of MAPs signing up to a passive equity framework, or pooling the regional allocations for alternative asset classes including infrastructure and diversified growth funds to form a series of shared sub- funds, to be hosted by one or more of the MAPs or on a separate National LGPS ‘Investment Platform’. A MAP could therefore be either internally or externally managed for the main asset classes, and join a shared sub-fund or investment platform for an alternative asset class.

More specifically:

Scale - The scale of the pools will vary across the three options. In the default option, (applying 2014 values), the smallest pool was Wales (£11.8bn from Advisory Board papers), with the other pools ranging from £17.1bn in the South West to £37.8bn for the South East. In light of the published criteria which sets a minimum pool size of £25bn, an equalised option has been considered. In the equalised option, Wales remains the smallest pool (assuming political support for a Welsh only pool), with the other pools ranging from £25.6bn in London to £33.3bn in the North East, based on one illustrative model. In the transfer window model it would be possible to set minimum and maximum sized pools, with transfers only agreed if pool sizes remained within the parameters, or a Fund agreed to swap.

Governance - In each case, it was envisaged that each pool would be run by a Joint Committee which would comprise a nominee from the Pensions Committee of each of the participating Funds. All Funds should have an equal voice irrespective of Fund size or any other factor. The Joint Committee would in turn be advised by a joint officer body comprising the Head of Pensions or Investment Manager of the participating Funds. The Regional nature of the MAPs and the numbers of Funds represented in each pool was seen to facilitate such an arrangement and therefore maintain clear governance links between the pool bodies and their constituent funds.

It is considered that a set of draft “like-minded” principles should be developed (along the lines established by the South West project) as a method for assessing new entrants. Recognition of the need for compromise and the process to be followed on non-unanimous issues requires consideration, by MAP groupings. The exact governance principles would be a matter for each MAP to determine. The collective nature of the joint officer body advising a Joint Committee is expected to help to contribute to decisions being taken with a long term perspective, ultimately leading to lower manager turnover. Governance could be further strengthened by the recruitment of a professional executive team although this will clearly add to the costs of the pools.

Fee Savings - The additional stretch savings achieved via a SAP is not considered to be significantly greater than those within MAPs with potential savings varying by region. Influences on fee costs have been fund size, where larger funds have tended to have lower costs, internally managed funds, where again a lower costs base is feeding through and the use of alternatives which generally carry higher fees, especially where a Fund of Fund arrangement is in place.

Individual specific asset class findings can be used to understand the potential ranges of Fee Savings from a multi asset pool perspective

PROJECT POOL 152

Access to Infrastructure - Each fund would determine its allocation to infrastructure, consistent with its investment strategy, and instruct the pool to make investments to meet this allocation. Whilst it would be for each MAP to oversee its allocation to infrastructure, it is envisaged that, where appropriate, MAPs would work together to deliver greater efficiencies in infrastructure investments, whether through MAPs appointing a single manager through a joint procurement exercise, or by creating a shared sub-fund by pooling allocations.

ESG/RI Considerations - Working collaboratively across MAPs should permit greater resource and time to be made available to consider effective engagement with companies and the development of a co-ordinated approach to ESG/RI issues. The larger mandates would assist in developing a more powerful voice and collective action.

Practicalities of Delivery – Transition costs Transition costs should be shared across the funds within a MAP on an appropriate basis (e.g. size of allocation to asset class) and not simply be borne by those Funds who are required to switch their manager – in interests of fairness and to avoid funds arguing for the pool to retain their Manager based on transition costs to themselves rather than on overall efficiency for the Pool as a whole.

These principles should apply to collaboration across MAPs, including consideration of the appointment of a single transition manager to operate across all MAPs. There should be an inherent expectation that all MAPs work closely together during the implementation/re-structuring stage to ensure that as little “leakage” of value occurs as possible and that maximum benefit is obtained from “crossing opportunities” which allow buyers and sellers of the same assets to be matched rather than taking the transactions to market.

Agreement of transition arrangements and the management of existing mandates into the ultimate target mandates over reasonable timelines and careful planning is a fundamental “likeminded” matter.

Post transition, any further costs arising from the asset allocation decisions of an individual fund, would fall to the Fund in question.

How will these options work with broader pooling arrangements

The model is seen to provide a good fit with existing arrangements, incorporating the London CIV as one of the regional CIVs. The model preserves the current relationships between LPFA and Lancashire, and the LGSS (Cambridgeshire and Northamptonshire Shared Services), with the transfer window option allowing amendments to pick up other existing/developing collaborations. The flexibility of the model whereby regional pools can come together to share existing frameworks or develop new frameworks is also seen as a benefit of the regional model.

Work-stream’s preferred option While recognising that at the time of writing this is not the way groupings are developing, the participants on this work stream have a preferred option, which is based on a regional allocation of funds that equalises the size of the pools and allows for a ‘transfer window’ for individual funds to request a move from one pool to another. Assets would be managed within the pools and, to ensure the full economies of scale can be achieved, non-listed, illiquid assets like infrastructure could be accessed through an LGPS-wide structure, e.g. a shared national investment platform.

PROJECT POOL 153

9 Appendices – External Reports

PROJECT POOL 154

9.1 Legal structures – Eversheds Report This paper does not consider non-UK pooled structures. There are, therefore, a number of other available structures available that are outside the scope of this paper. We have summarised some of the main options at a high level, and further detailed work will be required by each pool.

We have assumed in this paper that the Government’s proposed changes to the Investment Regulations are implemented in full.

1. PART 1 - Potential pooling structures

1.1. Authorised contractual scheme The key feature of an ACS is that it is generally transparent for income and gains tax purposes (exceptionally it is opaque for UK capital gains tax purposes). For LGPS, it is as if they invested directly which is a significant benefit. The benefits of pooling through an ACS are that it is more cost-efficient to obtain favourable double tax agreement withholding tax rates (both at source and by reclaims), because of the scale of the assets and the machinery of the custodian and asset servicer.

Structure An ACS is a collective investment scheme which pools assets held and managed on behalf of a number of investors who are the co-owners of the assets. It has no legal personality and does not constitute an entity in its own right.

There are three regulatory categories of fund available in the UK which can be set up as an ACS. These are, UCITS, NURS and QIS. These structures have varying degrees of investment restrictions, regulation and investor protections. A QIS allows for the most flexibility with regard to the choice of investment and borrowing, which, of course, can mean a higher degree of risk, whereas a UCITS, being the most heavily regulated structure, is a relatively conservative investment vehicle (generally speaking a NURS sits in the middle of a UCITS and a QIS). For many years, UCITS funds have been subject to the UCITS Directive, as amended, however this has not applied to NURS or QIS. In order to harmonise the requirements applicable to other types of fund, and to further the principle of investor protection, the AIFMD (which became effective in July 2013) now imposes certain requirements on NURS and QIS funds which are collectively known as AIFs.

It is important to note that the fund structure of the ACS will be dependent on factors such as the existing investment mandates already in place with the LGPS and also the type of client to which the ACS will be made available (some LGPS are classified as retail clients and there are restrictions on them investing in NURS and QIS).

ACSs can be created as umbrella structures with multiple sub-funds. This would enable each LGPS to flex their allocations to different investments by creating different sub-funds.

It seems likely that more LGPS pools would take maximum flexibility by using a QIS. A UCITS is only suitable for mainstream investment in transferable securities. A NURS might also be appropriate for some LGPS.

The ACS is an open-ended vehicle, which means that investors in it have the right to redeem (or withdraw) their investment. This is a key regulatory protection, but does mean that the ACS may not be the most appropriate vehicle for all asset classes. It may be more appropriate to house the most illiquid asset classes (e.g. private equity and infrastructure) in a different structure.

Operation An ACS must appoint an operator (or manager) who is responsible under the contract for the operation of the scheme. The operator is also responsible for decisions about the investment of participants’ funds in accordance with the contractual arrangements. The operator of an ACS structured as a QIS will need FCA authorisation to manage an AIF. This is covered in the section “FCA Regulatory Regime”.

PROJECT POOL 155

An ACS must also appoint an FCA/PRA authorised depositary who is responsible for safeguarding the assets of the participants that are part of the scheme. The depositary will acquire and dispose of assets on behalf of the participants on the instructions of the operator.

In addition to the depositary, the ACS will be required to appoint the other service providers required under the rules.

Tax An ACS is a tax-transparent entity and so is not within the charge to direct taxes in the UK.

Each participant is responsible for any tax arising on its own share of income at its own rate of tax. It has been designed to allow each investor to access its own rate of withholding tax on investments outside of the UK. Due to the economies of scale in an ACS, it is generally cost-effective for the custodian/administrator to arrange for treaty-reduced rates of withholding or tax reclaims in relation to more lines of stock than if the unitholders had not pooled their investments. On the capital gains tax side, investors are deemed to own holdings in an opaque vehicle and are liable to tax, where applicable, only when they dispose of all or part of their holding at a gain. This is to avoid their needing to look through to, and, in the case of taxpayers, pay tax on, each underlying portfolio gain. There is no tax on gains in the ACS itself. Tax- exempt investors include LGPS.

Where stamp taxes are payable on acquisitions of securities then the operator of the ACS will account for these on behalf of the participants. Units in ACSs are outside the charge to stamp duty reserve tax and there is no SDRT liability when unitholders subscribe for units by transferring portfolios of UK equities to an ACS. There is no appropriate stamp duty land tax regime yet; the UK government intends to introduce one this year, and it is likely that an equivalent regime will be introduced in Scotland around the same time. The ACS is registrable as a separate entity for VAT. The ACS is exempt from VAT on fund management services provided to it. VAT will be payable to the extent it receives taxable supplies e.g. depositary fees, but it may be possible to structure fees to mitigate VAT, and this would require consideration as the project progresses.

Our conclusion The ACS is the most suitable fund vehicle for the majority of asset classes. The ACS is a very good option for LGPS wishing to pool their assets. It has been designed specifically for pension funds to invest in, making it the most tax-efficient investment fund for LGPS. The ACS has been designed to maximise international recognition and designed specifically for, amongst others, pension funds to invest in, making it the most tax- efficient structure for LGPS. Where the ACS is structured as a QIS, it also offers flexibility in terms of the types of investments it can invest in. As noted above, as an open-ended vehicle, it may not be the most appropriate for the most illiquid assets, e.g. private equity and infrastructure.

1.2 Exempt unauthorised unit trust

Structure An exempt unauthorised unit trust is an unregulated collective investment scheme and so is not approved by the FCA as being suitable for general promotion and sale in the UK.

An exempt unauthorised unit trust will be classified as an AIF under AIFMD.

Exempt unauthorised unit trusts can be created as umbrella structures with multiple sub-funds. This would enable each LGPS to flex their allocations to different investments.

Operation An exempt unauthorised unit trust must appoint an operator (or manager) who is responsible under the contract for the operation of the scheme. The operator is also responsible for decisions about the investment of participants’ funds in accordance with the contractual arrangements. The operator of an exempt unauthorised unit trust scheme will need FCA authorisation to manage an AIF. This is covered in the section “FCA Regulatory Regime” below.

PROJECT POOL 156

An exempt unauthorised unit trust must also appoint an FCA/PRA authorised depositary who is responsible for safeguarding the assets of the participants that are part of the scheme. The depositary will acquire and dispose of assets on behalf of the participants on the instructions of the operator.

In addition to the depositary, the exempt unauthorised unit trust will be required to appoint other service providers in a similar way to an ACS.

Tax An exempt unauthorised unit trust is exempt from UK capital gains tax because its investors are restricted to UK capital gains tax-exempt investors, such as pension funds (as well as meeting some other conditions). Care should be taken with any new potential investor to ensure it actually qualifies on the facts.

Exempt unauthorised unit trust schemes cannot generally access the favourable pension funds’ rates of withholding tax that LGPS would benefit from by direct investment or by using an ACS.

For stamp duty land tax purposes the exempt unauthorised unit trust is deemed to be a company. As a result there is no SDLT on bringing in new investors or on secondary investment. There is no relief for seeding a new exempt unauthorised unit trust with an existing portfolio, so that stamp duty land tax would be payable in full.

Supplies of investment management services to an exempt unauthorised unit trust do not qualify for statutory VAT exemption under current law, unlike an ACS.

Our conclusion This is a viable option, and is a structure is commonly used for pension funds’ and life companies’ pension business. As the vehicle itself is not regulated by the FCA, it would potentially be quicker and cheaper to establish. However, as set out above, it does come with some limitations. Only UK pension funds, UK life company pension business, charities and foreign sovereigns can invest in these structures, although this may not be an issue here. The tax position can be less advantageous in relation to overseas investments. An exempt unauthorised unit trust might be a viable option if LGPS decide to use more than one vehicle e.g. to house asset classes that do not fit neatly into the ACS.

1.3 English limited partnership

Structure An English limited partnership is a partnership which is registered with the Registrar of Companies under the Limited Partnerships Act 1907. It is subject to the specific provisions of the Act and is governed by the general law of partnerships, including both the common law and the Partnership Act 1890.

It is an unregulated collective investment scheme and so is not approved by the FCA as being suitable for general promotion and sale in the UK. A limited partnership will be classified as an AIF under AIFMD. As a result, it will be necessary to appoint an operator authorised to manage AIFs.

Limited partnerships can be very flexible, as they are not subject to the FCA rules or to company law. A limited partnership has two categories of partner, general partners and limited partners. The general partner, who has responsibility for managing the limited partnership’s business, has unlimited liability for the firm’s debts and obligations.

Limited partners invest capital in the limited partnership. The limited partners must not take an active role in the limited partnership’s business. Limited partners have limited liability up to the amount of capital that they have contributed, provided that they do not become involved in the management of the business.

It is not possible to structure a limited partnership as an umbrella fund with multiple sub-funds. This would have a major impact on LGPS’ ability to flex their respective allocations to different investments. The obvious way to overcome this would be to have parallel partnerships where there are differing allocations.

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This could, however, become very cumbersome over time. Setting up a new limited partnership to permit this flexibility would be costly, time-consuming and create a significant administrative burden and paperwork. Creating a structure with a large number of limited partnerships would also result in a structure that could be difficult to market in future should the LGPS wish to do so, and it might be difficult to establish a single performance record. For this reason, a limited partnership is likely to be far more useful for housing a particular asset class (e.g. private equity), in conjunction with another vehicle (e.g. an ACS) that would house the majority of asset classes.

The limited partnership will be required to appoint other service providers in a similar way to an ACS.

Tax An English limited partnership is tax-transparent for direct tax under UK law. For local authorities and pension funds this results in limited partners being taxed according to their own tax position. This total transparency for UK direct taxes results in any UK taxpaying investor being taxable on each disposal of a portfolio investment by the partnership.

Not all foreign tax authorities treat English limited partnerships as transparent which may result in some local tax. To the extent, however, there are any UK taxable investors, HMRC practice is to treat them as subject to tax on capital gains if investment values rise and if there is any disposal or deemed disposal by them (e.g. on dilution on the introduction of new investors).

English limited partnerships are not ideal from a stamp tax perspective. Purchases of participations theoretically carry stamp duty to the extent that they represent underlying interests in equities. Unexpectedly this applies not only to UK but also to non-UK equities. They are subject to a complex stamp duty land tax regime, such that SDLT at the full rate would be payable on seeding of assets, depending on the factual matrix.

English limited partnerships are not within the exemption from UK VAT on investment management services, so that VAT is likely to arise. Consideration should be given to mitigating this e.g. by the use of profit shares. Our conclusion

Limited partnerships are extremely flexible, and are commonly used by pension funds to invest in infrastructure and private equity. For the reasons set out above (particularly on the limitations to flexing allocations), we do not consider the limited partnership to be a suitable solution for all assets. It could, however, be a suitable vehicle to use in conjunction with another vehicle if a single solution is not selected.

1.4 Pension fund pooling vehicle Pension fund pooling vehicles are a form of unauthorised unit trust. They were introduced in 1996 but never took off. This was partly because they were not widely understood. Unlike the exempt unauthorised unit trust they are tax-transparent for UK tax purposes. However, some foreign financial authorities struggle with them due to their being a form of unit trust.

Our conclusion This vehicle has not been popular and has been superseded by authorised co-ownership schemes, in part because ACSs have all the stamp tax benefits that the pension fund pooling vehicles have.

1.5 Common investment fund

Structure Common investment funds are an administrative vehicle used by private sector pension funds to pool their assets for administrative purposes. Common investment funds receive specific tax treatment from HMRC to preserve, as far as possible, the tax position of the underlying pension schemes.

One of the requirements to receive this tax treatment from HMRC is that the common investment fund cannot be a unit trust scheme. Essentially, this means that it cannot be a collective investment scheme under FSMA.

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Most common investment funds in the private pensions sector are able to satisfy this requirement because there is an exemption from being a collective investment scheme where all participants in the common investment fund are corporates in the same group. That exemption would not apply here, and it is difficult to see another relevant exemption.

As a result, we consider that the only way in which a common investment fund could work would be if the Government created a new exemption that would apply a group exemption to LGPS that pool their assets. Given that the ACS structure was created by HM Treasury partly to enable pension schemes, including LGPS, to pool their assets, we consider it unlikely that it would enact a new exemption.

Conclusion For this reason, we do not consider a common investment fund a viable option.

1.6 A master trust A master trust is a separate pension fund set up for the purpose of enabling multiple pension funds to participate in a single trust. The most common use of master trusts is for defined contribution schemes, where each employer would have a separate section in the master trust. The significant issue for LGPS funds is that they would not have the power to establish a new trust-based pension fund, i.e. to establish a new master trust, under current statute. So LGPS would only be able to do this if the Secretary of State gives you a specific permission.

Conclusion In the context of this proposal, it seems unlikely this would be the preferred route. As mentioned above, each pension fund would typically have a separate section in the master trust so assets are, technically, not pooled.

1.7 Life policy Life policies do not fit well in a pooled structure because the entity with the insurable risk must be the beneficiary of the contract. The risk lies with the LGPS fund, not the (newly created) pool.

Even if it were possible to put life policies within an investment fund structure, it would potentially involve additional costs as there would be the cost of the life policy itself and the cost of investing through the investment fund and so it is unlikely that this would be an attractive route.

If there is a cost (or other) benefit to accessing passive investment through a life policy then this investment could in theory sit by the side of investment fund structures. Alternatively, life policies could be unwrapped and the assets transferred into the pool, although this would likely incur unnecessary costs.

1.8 Joint Committee An alternative option might for the LGPS funds to exercise local government powers to create a joint committee structure to oversee and govern the arrangements entered into by the pool. This would not create a single pool of assets under FSMA, as each LGPS would continue to own their own assets. The LGPS fund could, via the joint committee, decide to invest into the same strategies.

One of the main benefits of a joint committee is that the costs of establishment would be less than those of establishing a pooled investment vehicle.

Further detailed work would need to be carried out by LGPS to ensure that the joint committee does not, throughout its life, (1) inadvertently create a collective investment scheme under FSMA, or (2) manage or advise on investments within the meaning of FSMA, as in each case FCA authorisation would be required.

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2. PART 2 - Transitioning assets There will be tax and frictional costs incurred in transitioning existing assets into the pool.

The main potential tax liability would be stamp tax on UK equities. There is a statutory exemption from liability in the case of the ACS. It can generally be mitigated in the case of the exempt unauthorised unit trust, although it is unlikely to be able to avoid it entirely where LGPS pool UK equities in one unit trust.

The question of overseas transfer taxes is not as straightforward. They are still relatively uncommon (the US, Japan and Germany do not have them), but, in Europe, France and Italy have introduced forms of financial transaction taxes, and Ireland has a stamp duty regime. Several Asia-Pacific countries have a transfer tax.

3. PART 3 – FCA regulatory regime FCA regulation

FSMA, and the FCA Handbook of Rules and Guidance and European regulations (for the most part transposed into the FCA Handbook (http://fshandbook.info/FS/index.jsp)) will be relevant to the operator of any pooled fund and to the pooled fund (if any) itself. We have set out below the key provisions, with commentary.

In most circumstances, it will not be possible for LGPS to pool their respective investment management expertise for the benefit of the pool without becoming authorised and regulated by the FCA. This is subject to our section on “Hosted solutions” below.

The UK Financial Services and Markets Act 2000 The operator of a pooled fund and, potentially, the pooled fund itself will need to be authorised by the FCA under FSMA. We have set out below the key sections of FSMA with commentary:

Section 19 (FSMA) – the general prohibition

This is known as the “general prohibition” to carrying out regulated activities. A person cannot carry out a regulated activity in the UK or purport to do so, unless he is (a) an authorised person, or (b) an exempt person. Authorisation by the FCA to carry on regulated activities is known as “Part 4A permission”.

Breach of this general prohibition is a criminal act (section 23 FSMA).

The list of regulated activities is set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, as amended. The relevant permissions are likely to include managing investments and managing an AIF under the AIFMD, and, possibly, safeguarding and administration of assets. It is likely that the investment management function would also need the permission of agreeing to carry on a regulated activity and arranging deals in investments. Details of the permissions would be listed on the Financial Services Register which is a public register.

Regulatory capital All FCA regulated businesses are required to hold regulatory capital designed to protect the solvency of the regulated vehicle. Regulatory capital must be held within the business in highly liquid assets.

The regulatory capital requirements will be different depending on the scope of FCA permissions received by the operator of the pool. We have set out below a broad summary of the position (although the exact calculation will involve a number of other factors).

Operator capital requirement

The minimum regulatory capital requirement is €125,000 plus 0.02% of assets under management in excess of €250 million, with a maximum regulatory capital requirement of €10 million.

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LGPS should note that there may however be additional capital requirements should they carry on other functions.

Requirement for approved persons When regulated activities are carried out certain “controlled functions” will apply. The full list of controlled functions is set out on the FCA website (http://www.fca.org.uk/firms/being-regulated/approved/approved-persons/functions).

The controlled functions are categorised under three headings: (i) Significant influence functions (e.g. CF1 Director function, CF3 Chief executive function, CF10 compliance oversight function and CF28 Systems and controls functions); (ii) Customer functions; and (iii) Libor functions.

The roles within the FCA regulated operator which are most relevant for the LGPS are likely to be:

CF1 Director;

CF2 Non-executive Director;

CF3 Chief Executive;

CF10 Compliance Oversight;

CF10a Client Assets Oversight (– to be considered);

CF11 Money Laundering Reporting (should be based in the UK);

CF30 Customer Function.

CF10 and CF11 are required functions and each firm must appoint a person with these responsibilities.

The relevant persons who will carry on these controlled functions must be approved by the FCA to do so and are known as “approved persons”. Non-compliance with the requirements for approved persons may result in FCA enforcement action against the individual approved person; this can include a personal fine and being banned from working in the industry for a period. Certain other roles also require the individuals performing them to be approved persons, even though their function is not a controlled function.

FCA rules and guidance In addition to considering the requirements of FSMA, there are also ongoing obligations and rules that the operator must comply with and these are largely set out in the sourcebooks to the FCA’s Handbook (http://fshandbook.info/FS/index.jsp). The FCA Handbook contains sourcebooks setting out the high level standards that are applicable to regulated firms in terms of operating their businesses, interaction with customers, market conduct, remuneration, disclosures, capital adequacy etc (it is important to note that certain rules depend on the structure of the fund involved, for example, different investment restrictions will apply to a UCITS and a QIS and the operator of a UCITS may have differing obligations to the operator of an AIF).

Tax Assuming that the new entity will be a company, then it will be liable to corporation tax at 20% on its net profits. Similarly, consideration would need to be given to how the company is financed.

The VAT position would depend on the nature of the chosen vehicle. Whilst the basic rule is that the role of an operator is the provision of standard-rated supplies for VAT purposes, if the fund, or each fund, to which the supplies of services are provided qualifies as a “special investment fund” for VAT purposes, which would be the case if the fund(s) concerned are formed as authorised co-ownership schemes, then the supplies of services will be exempt.

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4. PART 4 - Hosted solutions An alternative for LGPS pools that wish to create a pooled investment vehicle but either do not want to, or do not have a capability to, build their own FCA authorised operator would be to appoint a service provider to operate the pooled fund vehicle for them. There are a number of service providers in the market who provide this service.

5. Glossary of terms ACS authorised contractual scheme

AIF alternative investment fund

AIFMD The Alternative Investment Fund Managers Directive

FCA Financial Conduct Authority

FSMA The Financial Services and Markets Act

NURS non-UCITS retail scheme

QIS qualified investor scheme

PRA Prudential regulation Authority

UCITS undertaking for collective investment in transferrable securities

VAT value added tax

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9.2 Technical issues of establishing a pooled fund - Northern Trust Report

Key points:  Pros & cons for each potential structure

 Legal implications

 Tax implications (inc. VAT) for set up and running, tax transparency a key requirement

 Economies of scale, cost of establishment and running costs

 -Regulation inc. Operator vs host

 Governance, parties involved and ownership (what do the Authorities own in each structure and risks)

 Control, investment strategy and manager choice (regulatory responsibility)

 Asset classes inc. Alts

 Timescales to set up

 In-house management

 Removing/appointing managers

 Operational considerations

Governance Key parties in most fund structures are Operator/ManCo, Depositary/Trustee, Lawyer, Auditor, and Tax Advisor.

Additionally the fund will require a Fund Administrator, Custodian and Investment Manager(s).

Where the Authorities look to set themselves up as the Operator of a fund they may also choose to appoint advisors to the Operator e.g. Compliance Consultant, however regulatory responsibility must remain with the Operator itself.

As an example see Appendix A for main parties required for an ACS.

In addition consideration should also be given to the need for Transition Management, Securities Lending and FX services.

The majority of Authorities will either have direct relationship with these parties today, in particular Custodians and Investment Managers, or indirect by virtue of investing in Asset Manager’s pooled funds.

Operational considerations Selecting service providers with the necessary skill set will be vital, especially for a tax-transparent fund which should include being able to offer an integrated approach and scalable system solutions across fund administration, depositary and custody services. Please see Appendix B for more information.

Once the external providers have been selected the actual fund requirements will need to be drafted, including whether this should be UCITS, NURS or QIS, what mandates will be included and which Investment Managers will manage these mandates. Please see Appendix C for a template that can be used as a guide in shaping the fund design. The appointed Fund Lawyers will use this as the basis for the fund document, particularly the prospectus.

Where the pool is an authorised fund and the Authorities choose to set themselves up as Operator consideration should also be given as to who will be investing in the fund, only those Authorities linked to the Operator or ‘outside’ Authorities?

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Where an Investor and the Operator are connected parties under COLL 4.4.8 and 3rd party investor into the fund any investor who is a connected party loses its ability to vote.

Timescales to set up An ACS will take between 4 and 10 months to set up. Please see Appendix D for an example of non-UCITS timeline. Other authorised funds will take a similar length of time; usually slightly shorter given there is not the need for the additional tax work to ensure tax transparency.

Both Operator set up and authorised funds require FCA approval, whilst a number of activities can run concurrently there will come a point when the Operator needs to be established to progress the fund authorisation.

Given the number of activities required it will be necessary for the Authorities to have strong project management.

One of the first steps is to appoint the external service providers and complete the fund design. How long is the procurement process?

The time taken for the initial draft of the fund design varies depending on the complexity of the fund but typically takes up to 4 weeks, with revisions occurring throughout the completion of the fund documentation.

The Fund Lawyers will utilise the fund design information to draft the initial fund documents.

The fund’s Operator, Depositary, Tax Advisor, Auditor and Fund Administrator will all review and provide feedback on the documentation. The Fund Lawyer’s will issue revisions, as required until all parties are comfortable with the content.

Once the documentation is in a final or near final (subject to any non-material amendments) form, the application can be submitted to the FCA along with.

The regulations state how long the FCA has to consider and respond to these applications. However, it has announced the intention to turn around ACS applications in two to three months, with effect from April 2014, whilst the statutory authorisation period, however, remains at six months for a non UCITS ACS.

Consideration should also be given to the timeframe required to prepare and submit the Operator application to the FCA. There is the potential for the FCA to look at both the Operator set-up and the fund set-up in tandem; this is at the discretion of the FCA however the fund cannot be authorised until the Operator has been approved. The FCA has between 6 and 12 months to authorise the FCA Operator.

Concurrently with the fund documentation work stream, the Tax Advisors will identify any tax work required; the choice of pooled vehicle will determine the amount of tax work required.

The Operator would also undertake a process, to identify the Investment Managers to the sub-funds of the fund and negotiate and agree the terms of the Investment Management Agreements with the fund’s lawyers to be effective upon launch, based on a template provided by the fund’s lawyers. How long is the procurement process?

The fund structure and accounts will need to be set up across the Fund Administrator’s and Custodian’s systems, this will usually take between 4 and 6 weeks depending on the markets of investment. Some markets may take longer and require the final fund documents prior to opening.

Critical success factors for implementing a fund  Developing clear objectives for implementing and measure success

 Appointing skilled and experienced advisors/partners early in the process

 Designing the fund so that it will appeal to investors

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 Ensuring initial seeding is of sufficient size

 Adhering to detailed project plan for implementation

 Allocating suitable resources for the project

Cost Generally Host Operators use one of two charging methods - high fixed fee and low bps or low fixed fee and high bps. For example on 1bn+ an Operator may charge £6k per month per sub-fund and 1bp or 6bps and no monthly fee.

The following assumptions used are not recommendations and are purely for illustration purposes

Indicative cost of running an authorised fund structure 1. 10 investors in 10 sub-funds (made up of mix of passive and active, global equity, UK equity, global bonds, & alternatives) total £5bn - 4 bps

2. 15 investors in 15 sub-funds (made up of mix of passive and active, global equity, UK equity, global bonds, UK bonds & alternatives) total £15bn - 3.5 bps

3. 15 investors in 20 sub-funds (made up of mix of passive and active, global equity, UK equity, global bonds, UK bonds & alternatives) total £25bn - 3 bps

These costs include Fund Administration (Transfer Agency and Fund Accounting), Depositary and Custody. These costs would reduce where additional services e.g. a proportion of cash, FX and Securities Lending services are also conducted by the appointed Custodian (which is standard with existing LGPS custody arrangements).

It is worth noting these costs are already being paid by each Authority where they are invested into pooled funds today. Similarly where Authorities hold assets on a segregated basis, custodian fees will also be being paid. The average cost for custody being estimated at 1bp.

Where the pooled fund holds alternative assets Depositary costs may be higher.

This does not include Investment Manager fees.

Where Authorities are invested in pooled funds today there is a certain degree of lack of transparency around revenues generated by activity within the pool being passed back to the pooled fund, such as securities lending being performed by the Asset Manager with revenue produced having an expense paid to the fund before being shared with the fund. Where Authorities 'own' the fund 100% of any negotiated revenue will be passed back to the fund.

Other factors that feed into the cost consideration include the frequency of investor dealing and frequency of valuation points.

It should also be noted that Fund Accounting fees typically operate on a sliding scale with minimum fees per sub-fund, therefore the larger each sub-fund in terms of value the more cost effective.

Consideration will need to be given as to the minimum sub-fund size/number of investors that makes this viable. This demonstrates that with scale the fund will become more cost efficient.

Another cost consideration is transitioning assets into the fund, planning for any in-specie transition should start at least six weeks prior to intended transition.

If there is to be a straight forward transition of assets into the fund then a transition manager may not be required, however, there may be costs in the form of transaction/stamp taxes (transfer of UK securities into an ACS are not subject to UK SDRT) and charges from the incumbent custodian.

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If assets need to be ‘transformed’ this would typically be completed prior to move into fund and would usually require a transition manager.

It should be noted that generally Authorities are already paying these charges today each time there is an investment manager or mandate change.

The more choice of mandates available in the fund that mirror the mandates/benchmarks currently invested in by Authorities the less transformation will be required and therefore the less the transition costs going into these mandates. This will be one of the key design considerations, including if there is limited interest in a mandate should this be held outside the pool?

Consideration should also be given as to how to monitor Authorities need for different mandates to meet changing investment strategies over time, whether this is purely at the discretion of the Operator or by means of a joint investment committee made up of the Authorities who invest in the pool.

In-house management Where a formal structure is used to create the pool then technically any investment management can no longer be deemed to be ‘in-house’ as the Authority acting as investment manager is no longer the direct asset owner, therefore consideration should be given as to whether these Authorities need to become authorised by the FCA to perform these functions or whether an alternate mode should be sought such as being an investment advisor to the Operator.

Asset classes Consideration should be given to the best pooling option for different asset classes, it is unlikely one option will be favourable for all.

For passive investment Life Cos offer economies of scale however the construct of the pool may mean that the pool cannot invest in a Life Co therefore the Authorities would have to invest separately, cost to Authorities can be managed through a framework agreement however this is not meeting the principles of investing. Where the pool can invest it is the pool that will be seen as the investor therefore this may harm the Life Cos ability to provide pension fund tax rates, additionally thought should be given to what it means to have the pool as the holder of the policy.

An alternative to Life Cos would be for these providers to set up their own tax-transparent fund to ensure the tax treatment of the pool is maintained however where the Authorities use a tax-transparent fund themselves this does bring the added complexity of double tax transparency which is not generally supported by service providers today.

For alternatives, in particular infrastructure, some thought should be given to running a limited number of LGPS pools specifically for these asset classes to achieve maximum economies of scale, rather than splitting these across the potential 6 LGPS pools. These should be constructed in such a way that the other pools can invest into them.

LGPS POOLING 166

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Appendix A – Key parties

LGPS POOLING 167

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Appendix B – Questions to ask a service provider

LGPS POOLING 168

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LGPS POOLING 169

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Appendix C – Fund fact sheet

Structure Details/Comments

UCITS/AIF - QIS/NURS

Number of sub funds & mandates

Investment managers of sub funds & mandates

Number of investors per sub fund

Anticipated number of unit classes

Anticipated number of investors per unit class

Feeder funds (new or existing funds)

Securities Lending

Custody Details/Comments

Value and make-up of assets per sub fund

Number of holdings per sub fund

Anticipated trading volume

Trade instruction method

Cash instruction method

Alternatives

Derivatives

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Fund Administration Details/Comments

Reporting requirements (financial/regulatory)

Valuation frequency

Valuation point and deliverable

Accounting methodology

Accounting dates & frequency

Business days (UK vs US)

Income distribution frequency

Frequency of investor dealing

Dealing on cleared funds only

Investor communication requirements (format,

delivery mechanisms) Investor instruction methods (SWIFT, paper,

fax) Names to be used on register (Nominee or

Investor)

Anti-dilution levy (or equivalent) requirements

How are fees charged

Unit class fees

Equalisation requirements

Future Requirements Details/Comments

Anticipated frequency of new investors

Anticipated incremental growth of existing

investors

LGPS POOLING 171

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Appendix D – Indicative fund launch timeline for ACS

LGPS POOLING 172

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Acknowledgements

LGPS POOLING 173

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For advice on Structures Chapter

 Eversheds & Northern Trust For provision of data – Fund Managers:

 Aberdeen  Adam Street Private Equity  AllianzGI  Aviva  Baillie Gifford  Barings  BlackRock  Capital Dynamics infrastructure  Capital Dynamics private equity  Capital Group  CBRE  DTZ  Fidelity  Grosvenor infrastructure  GSAM Infrastructure  HarbourVest private equity  Henderson  IFM infrastructure  Infracaptial infrastructure  Investec  JP Morgan  KKR  Legal & general  M&G  Neuberger Berman  Newton  Pantheon infrastructure  Pantheon private equity  Partners Group  Partners Group  Royal London  SL Capital Private Equity  Standard Life  State Street  UBS  Wellington