The level of governance resources at pension funds is one of the leading drivers behind how they approach real estate investments. Richard Lowe talks to schemes about their experiences

No two pension funds are the same. This is certainly true of the varying levels of governance resources to be found at schemes throughout Europe. Today many have decided to outsource their real estate management to a third party, while others continue to run investments in-house. The degree to which pension schemes rely on consultants varies as well.

"Pension funds are of different sizes and have different support mechanisms," says Vanessa James, investment director at the €5.27bn London Pension Fund Authority (LPFA) in the UK."We have three people here - and soon to be four - who work full-time on investment to do with the pension fund. Other schemes may have only one person and other schemes have 10. The amount you can do depends on [the number of staff] and how they are resourced. Some schemes that have only one person may pay a lot for advice from consultants or industry specialists."

In March 2008, IPE Real Estate published an article by Steven Grahame, senior investment consultant at Watson Wyatt, in which it was suggested that pension funds should formulate a real estate investment strategy that is appropriate to their governance resources and not aspire to a model that is too complex for their resources.

"All too often, we see investment solutions proposed that are technically efficient but which are beyond the governance capabilities of the fiduciaries," Grahame argued.
And it is for this reason that LPFA employs fund of funds managers for certain asset classes and in relation to real estate opted to move away from a portfolio of property unit trusts to a single global mandate run by a third-party investment manager. It was announced in the summer that the pension fund would act as the seed investor in a new global fund of funds product, effectively handing over its property exposure to ING Real Estate to manage using its global expertise and knowledge.

In contrast, a fellow UK local authority pension fund, the €11.7bn West Midlands Metropolitan Authorities, maintains the management of its real estate investments in-house. It does, however, have a 22-strong in-house investment team, both front and back office, and has a training programme in place.Brian Bailey, director of pensions at West Midlands explains that if you have the economies of scale as they do at the large fund, "you can afford to invest in a back office expertise and the technology and so on."
He continues: "You can afford to have a couple of levels of training in that, developing and progressing people. If it was a much smaller fund, I don't think it would be feasible to try to do a significant amount in-house.

"If you want in-house capacity, you have to have a team that is bigger to, shall we say, survive. You cannot have a couple of highly paid people and then one or two leave, because then you are in difficulty. We have a structure that trains a lot of people coming in and a number of those progress to the senior positions. Of course, you will get some turnover, so it is quite a challenge to maintain an in-house capacity."

The West Midlands Pension Fund is certainly unusual among UK schemes in that it is able to select real estate funds directly, without the aid of consultants. In the 1980s it developed an in-house team to select private equity funds, building up what Bailey calls "a robust due diligence process" that included the expertise to deal with all legal aspects associated with investing in limited partnerships (LPs), which was the main structure for such funds.

When West Midlands looked at investing indirectly in overseas real estate (it already had a sizeable direct UK portfolio), it was clear this process could be extended to cover it, since the investments were predominantly structured in the same sort of vehicles.
"We prefer to select funds directly," Bailey says. "When we started looking at overseas property, the due diligence we had for private equity fitted quite well, with only a few adaptations needed. Many of them are LPs and we have an expertise, so we were comfortable in assessing them ourselves."

Other pension funds, however, will have seen the attraction of outsourcing investments, due to levels of resources or other factors. The €1.7bn Superannuation Arrangements of the University of London (SAUL), for example, outsourced all of the management of its alternative asset class exposure in one block to Morgan Stanley Investment Management in 2007."People use different methods to deal with the amount of governance that has to be put on these things," says James, "depending on how much they can do internally and how much they can outsource."

WPV, a €1.1bn German pension fund for chartered accountants, manages its investments in-house, using consultants to help with manager selections only when investing outside of Europe."The investment decisions are what the management has to do," says Hans-Wilhelm Korfmacher, managing director at WPV. "It is a main competence and it is the main thing for the management of a pension fund. Of course, you can use the help of a consultant in order to search for the right manager - we do this for some assets - but the decision has to be by the management of the pension fund, not by someone else."

The two largest pension funds in Europe, after Norway's Government Pension Fund, are the two Dutch giants ABP and Zorg en Welzijn (previously PGGM), both of which now own separate administration and asset management bodies - APG and PGGM, respectively - that are able to take on business from third-party investors.Meanwhile, the largest pension fund in Denmark, ATP, established two subsidiaries to manage its real estate portfolio - ATP Ejendomme manages its direct investments and ATP Real Estate manages its indirect investments - although these two bodies are not in the market for third-party business.

ATP Real Estate, for example, does all the due diligence and manager selection in-house for ATP's indirect exposure. To commit to a new fund, ATP Real Estate has to present the investment proposal to ATP's investment committee for approval.Michael Nielsen, managing director at ATP Real Estate, says this process is standard across Danish pension funds. However, what is unusual is the alignment programme put in place for ATP Real Estate.Nielsen has spoken openly about the importance of alignment of interest between fund managers and investors, and, to promote consistency, the practice has been extended to the four partners of ATP Real Estate.

"We have an alignment programme in place [for] ATP Real Estate Partners," Nielsen says. "In that entity we have ATP as the absolute main limited partner, but we also have the four partners of the team investing in ATP in that partnership."He adds: "ATP has taken the same approach as we do with managers. ATP also wants our investment team aligned with ATP to make sure it works as hard as possible to fulfil the expectations of the programme."

Nielsen says that, as far as he knows, ATP is the first pension fund to have launched such a model. "It works more or less the same way as the incentive programme for the fund managers," he says. This includes co-investment but also a carry programme whereby the team is awarded a bonus for achieving better returns than predicted.
Nielsen believes that real estate as an asset class does pose its own challenges to pension fund governance, compared with, for example, equities and bonds. Although he cannot speak with an overriding perspective of all asset classes, Nielsen does think real estate involves particularly intensive due diligence, because it is so illiquid.

"We don't have much liquidity in this asset class. It is a long-term investment," he says. "If you buy a number of shares you can sell them the next day. It is not the case for real estate. The investigations and preparations for investment are much more deep and thorough than buying, for example, listed funds or shares."If we compare it with unlisted private equity, it is more or less the same process, because that is also a long-term investment and a rather complicated investment. We have a very detailed business procedure, which we have to go through before we can do our presentation for the investment committee."

However, Korfmacher believes that WPV's real estate investments do not pose more of a challenge for the pension fund's governance resources, because it has never invested directly in the asset class. It is the practice of investing directly that creates significant challenges, he believes."It is the same as investments in other asset classes - choosing the country, the profile and so on, and then choosing the right partner who does the business - because we didn't decide to invest directly," he says. "Other pension funds started with direct investments in real estate and now they have the situation that they have to change from direct investment to indirect investment. We started with indirect investment and so our process has not changed very much."

Fred Green, head of investment at the €2.5bn Teesside Pension Fund in the UK, believes real estate is more challenging in terms of governance, because it is both labour-intensive and cost-intensive. However, this applies mainly to direct investing, he says."We have looked at this recently," he reveals. "We are out to tender at the moment for a direct manager, but we did consider not continuing with direct arrangements and to look at an alternative, because of the disproportionate amount of time we spend on property."Green believes that investing directly in real estate in the local area can generate difficult issues for local authority pension schemes. One example would be if it were to evict a local tenant.

"In certain instances that might be a problem. It could be an embarrassment even," he says. "We haven't come across it ourselves, but when it comes to evicting tenants, for instance, do we really want to be named as a landlord who has evicted somebody?"
This is one of the reasons, Green says, why Teesside Pension Fund does not invest in real estate in its local area. "We have an embargo on that, because we don't want to get involved in those sorts of things," he says. "There are specific issues that local authorities have to consider when investing in direct property. Obviously, the overriding concern is to get the best return you can."

There are, however, local authority schemes that are keen to be involved in developing and regenerating local areas as part of their social and responsible governance programme. The €14bn Greater Manchester Pension Fund, for example, aims to "develop commercial buildings in order to create/preserve jobs and to boost the North West local economy", according to its annual report and accounts.

But Green says Teesside Pension Fund has taken the conscious decision not to take such an approach. "As far as we are concerned, the pension fund's sole responsibility is to make the best returns we can," he says. "We don't want to get involved in anything else. I have complete respect for the people who make those decisions, but we don't think it is part of a pension fund's job to do that."

Nielsen believes that pension fund governance has "developed a lot" over recent years, but "there is still a way to go"."We meet and see and discuss investment cases with other investors and we all have a different approach. Whether the way we do it is the best way is difficult to say. But I have the understanding that all institutional investors have their own process," he says."It is not an area where investors are very transparent in general - how they do their due diligence, their selection process, etc. - it is a rather closed and internal area."