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Centrica, one of the UK’s largest energy suppliers, suffered a tough 2017. Regulatory pressure to reduce charges to customers is eroding t operating margins. It released a profit warning in November and closed the year as the worst performing stock in the FTSE 100.
In 2016, the company saw its net pension liability jump from £119m (€135m) to £1.14bn owing to falling bond yields. The discount rate was reduced from 3.9% to 2.7% over the same period. To manage the pensions deficit, the group agreed to make annual cash contributions of £76m over the next 14 years starting in 2017. This may sound bleak but the truth is that Centrica’s three defined benefit (DB) schemes are backed by a strong trustee board and a modern investment strategy.
It has pooled the assets of the three schemes, which total £8.4bn, into a single entity. Overseeing the fund’s investment strategy is CIO Chetan Ghosh.
He joined Centrica in 2009, after working for more than a decade as pension actuary and investment adviser to UK pension schemes. During his tenure as CIO, Ghosh has modernised strategy, introducing de-risking solutions and a value-focused approach.
The pension schemes are relatively young. They followed Centrica as it was spun out of the BG Group in 1997 with active members and their past service. The absence of pensioners, or deferred pensioners, means at spin-out the liability profile was relatively immature. This allows the schemes to seek more returns than the average UK DB scheme, says Ghosh.
A quarter of Centrica’s pension assets are invested in matching assets compared with half for the typical DB scheme. The fund employs a range of liability-matching solutions. “We always had liability hedging assets, but since I came on board we introduced an liability-driven investment (LDI) mandate. More importantly, we have taken a more holistic approach to how we want to meet our liabilities in the future,” says Ghosh.
The fund is far from fully hedged, with 40% of the assets providing protection against interest rates and inflation sensitivity. However, the fund looks less at mark-to-market valuations focusing instead its cashflow profile.
Ghosh explains: “After all, liabilities are a series of future cashflows. That is why we have focused on finding assets that can deliver those long-dated cashflows.” This approach referred to as cashflow-driven investing (CDI), has become a guiding principle, according to Ghosh.
“The majority of UK DB schemes focus only on managing their mark-to-market position with respect to liability valuations, but this is only one of two purposes that a liability-matching portfolio can serve. The other is to actually provide the cashflows to meet the liabilities, which is what we focus on,” he says.
For DB schemes that are near to a fully-funded status it might make sense to focus on traditional LDI using through Gilts and swaps. However, argues Ghosh, CDI could be solution for a number of DB schemes. “I think there will be a lot more activity in this area going forward, quite possibly to the extent that CDI activity exceeds new LDI mandates,” he says.
An example of an asset class that for CDI purposes is ground rents, and the Centrica funds hold assets in that space. The real challenge is not to understand the principle but to find the assets. Ghosh explains: “Our trustee board very promptly grasped the idea. Finding to the assets has been the real challenge. Luckily we were early adopters as we saw the competitive advantage of moving first, which we did, and managed to build our allocation at prices that have been reasonably attractive.”
The supply/demand dynamics for cashflow-generating investments have changed dramatically, according to Ghosh. “When we first invested in the solar power sector, deals were being closed at net internal rate of return (IRR) levels of around 9%. Ground rent deals were at 7%. Now you are looking at 5% for both asset classes. That is the level of compression the market has seen,” he says.
This makes it challenging for pension funds that might now wish to build an allocation. However, Ghosh points out that these assets still offer a yield pick-up compared with traditional LDI assets such as Gilts and swaps, so the investment case still holds.
Ghosh says the fund has considered investing in corporate credit as part of a CDI strategy. However, he says the pool of available assets with long enough maturity is too thin for this to be scalable. It would be difficult if many small schemes were to go down that route. “Our approach is to try and build up allocations when there has been a market dislocation, which is when you find good idiosyncratic opportunities. Absent a big market shock, it is hard to get those idiosyncratic opportunities in the corporate bond space,” argues Ghosh.
Another challenge with implementing a CDI strategy is finding the right investment advice. “It is hard for the big consultancies to devote a lot of research resources into these markets, when they know take up by clients will be limited,” says Ghosh. His fund, however, has built a network that is capable of providing the right kind of advice.
When Ghosh joined Centrica nine years ago, the asset allocation was organised as: 60% in long-only equities; 4% in UK property; 24% in corporate bonds; and 12% in government bonds. The CIO has developed three themes: adding diversification, increasing matching assets and setting up an automatic de-risking plan, whereby funding level gains are secured to fund a lower risk strategy.
“It took us about six years to work through the investment landscape and take our own views on the viability of each asset class within our portfolio,” says Ghosh.
Today, the return-seeking portfolio includes private equity, emerging market debt and insurance-linked securities as well as listed equities. Ghosh explains that the fund does not belong to either the active or the passive camp, but does believe that finding manager outperformance is a challenge “Having said that, probably 70% of our equity portfolio is managed actively. The reason why would make that statement and still have such a high proportion of active equity is that we source managers that fit our strategic needs.”
He continues: “We know that equity is an asset class that can unduly hurt us in bad times. That’s why we have favoured managers that are very good with capital preservation when markets fall steeply. They might not necessarily do as well on the upside, and might even be flat over a market cycle. But that’s fine, because we will have had a much better journey path. For this approach, you need active management. You won’t get that from a passive manager.”
This is core to Centrica’s pension fund strategy. “We have a long time horizon and need to grow capital, but we don’t want to experience periods when that capital falls by 30%. We want to have some stability,” says Ghosh.
The best way to uphold this is to avoid holding assets that are overvalued. “One practical example relates to high-yield bonds. We added the asset class to the investable universe in early 2015 and invested in Q1 2016, when it was attractively priced. We subsequently sold our holdings when we realised that it had become aggressively priced and the downside would be significant if the market sold off. We have every intention of going back when it gets cheaper,” he says.
With hedge funds it is a different. “They are not in our investment universe. In many managers there is a complete lack of transparency and great freedom to use leverage, which we think is a very dangerous combination. That said, if we were to find an exceptional manager who offers transparency, we might be prepare to allocate.”
All the money is managed externally, but Ghosh has a team of six at his disposal, which is more than what many UK DB pension funds, even large ones, can dream of. One person is dedicated to asset allocation and two work on the implementation of the strategy through listed and non-listed asset classes, respectively. There is a finance and operations specialist as well as two junior support staff. “We don’t have any ambition to make the team bigger, because we enjoy the benefits from our close interaction. We are humble about the fact that the level of resources we have is a real luxury versus the average UK pension scheme,” says Ghosh. If there were a need to recruit, it might be hard to convince people to move to Windsor, but the opening of a London office is not out of the realm of possibility, says Ghosh.
Our approach is to try and build up allocations when there has been a market dislocation, which is when you find good idiosyncratic opportunities. Absent a big market shock, it is hard to get those idiosyncratic opportunities in the corporate bond space”
The fund prizes collaboration with asset managers. Ghosh says that, when giving out mandates, the fund does not seek to change the DNA of the manager. However, he adds: “We think that is a dangerous practice. That said, we will encourage managers to remove unnecessary constraints to their strategies if it allows better outcomes. Often managers find it fulfilling to have the constraints removed, so that they can focus on generating returns. Usually we partner with people who understand the concept of growing the asset base without losing money.”
As an example, Ghosh points to the fund’s local currency emerging market debt investment. “The manager universe is full of managers that manage close to the benchmark. We had to talk to our manager and encourage them to do something that is less benchmark-oriented and thus modify mandate guidelines,” says Ghosh.
Similarly, as part of the fund’s allocation to senior loans, Ghosh asked a manager to increase its allocation to European assets beyond its original constraints in order to take advantage of the opportunities available. “Generally, we find that managers engage with our request that they are flexible in how the mandates are managed,” concludes Ghosh.
Flexible mandates are particularly needed when the focus is on capital preservation. And capital preservation is not only a way to grow the asset base, but also to manage liabilities, argues Ghosh. “If you permanently lose capital, it’s going to hinder your ability to pay out future cashflows,” he says.
Ghosh emphasises the benefits of seeing liability management as a cash-generating activity rather than a hedging one. “There are some schemes that genuinely need to manage the mark-to-market position because they are in the end-game. But I think there is a middle ground of schemes that are overly focused on mark-to-market and could readily adopt our way of thinking,” he says.
It is hard to predict whether CDI will enjoy the same support that LDI has done over the past decade. It is possible, however, that if more investors embrace Centrica’s approach, the supply of viable cashflow-generating investments could grow, to the benefit of the industry.