Making high post-Brexit returns in forestry, private credit and private equity investments

CIO: Given your 17.1% returns following the post-Brexit referendum, in looking to the future given Brexit negotiations are still in process, what is your advice to other CIOs on investing in the post-Brexit environment?

Joy: Many factors, not just sterling weakness (which added about 4% to our overall return), contributed to a very strong return. My advice would be to be genuinely diversified, to be defensively positioned (i.e., not at the top end of their risk spectrum— although the vast majority of institutional investors appear to run with static asset allocations despite widely varying opportunity sets/risks, we don’t do that), not to bias the portfolio based on a view on Brexit (as no one really knows how it will go), and to be active, not passive.

CIO: Your portfolio has returned 9.6% on average for the past 30 years. What are the top three things you think are key to managing a successful portfolio?

Joy: I would say that the key pieces of the jigsaw are simple to identify, but often not easy to implement, most often because of poor governance. I would suggest:

• High quality and appropriate levels of internal resources at the executive level and trustee level. At a trustee level, ensure you have the right balance between stakeholder representation and investment expertise.
• A clear and disciplined process focused on the needs of the individual organization, but essentially price-driven.
• A willingness to be different—tread your own path unfazed by what other peers are up to.

CIO: Your timber investments have returned 15.4% over the past five years, and you’re now one of the largest owners of forest land in the UK after the Forestry Commission. What do you look for when you seek a forestry investment?

Joy: When we decided to invest in forestry in 2010, it was to diversify our farmland holdings, which have compounded atover 15% p.a. for more than 10 years and form almost 10% of our aggregate fund. Every week, we were seeing articles in the Financial Times about farmland being an attractive place to invest globally. However, to us, it was expensive, whereas forestry was much more attractively priced—and in fact, in some areas, we were seeing forestry land being turned into farmland. Whenever you see that, given the costs involved, the relative pricing is out of line.

As I described earlier, the overriding determinant of our decision to buy an asset is its price.

We are very happy with our overall forestry weighting, and are not particularly looking to add—in fact, we are hoping to take profits on a small holding in the US. Other factors would be the age profile of the forests, and how that complimented holdings, proximity to mills, etc.

We have a strong preference for developed markets. A lot of other investors have gone for emerging markets, but in our view, they underestimate the operational challenges/risks and costs of getting trees to the mill for processing, which can impact returns materially. So we only invest in the UK, US, and Australia, and this has served us well.

We originally were unsure if we could access the UK market, but there have been two large £50m-plus transactions in the last few years, and we were able to buy both at what has been attractive valuations.

Sustainable forestry is key to our strategy, and hence we also take the certification of our forests seriously so as to ensure that they are managed in a sustainable and ethical way.

CIO: Your private credit and private equity investments have returned 33.1% and 26.1%, respectively. Given the demand for these asset classes, can you share details of your strategy? Outside of performance, what characteristics do you look for in your GPs? Going forward, are there certain sectors/geographic locations you are currently focused on?

Joy: In private credit, we look for situations where we can achieve at least a 10% return per annum while taking a reasonable level of risk. We look for subsectors within the asset class which we think have market inefficiencies which can persist over time and generate an outsized return, and then identify quality managers which can best take advantage of those opportunities. Currently, we like the opportunity set in complex and special situations lending. These are more difficult to understand, execute, and deploy a lot of capital, so the market remains much more inefficient than lending to private equity-sponsored companies.

For private equity, we have increased our focus on sector- and country-specific managers, as we feel these firms have a competitive edge in their niches versus generalist and pan-regional firms. We are almost exclusively doing lower mid-market with virtually no large buyout. That is because our size allows us to do it. Currently, we prefer Europe and other geographies to the US, as entry multiples are lower and there are more inefficiencies and earnings improvement opportunities which are available if you have the right manager.

In terms of manager characteristics, probably the number one factor which stops us re-upping with an existing relationship apart from significant team turnover, would be a loss of discipline over capacity. Time and time again, when managers are raising their fourth or fifth fund, they lose discipline and take too much money in what is essentially a capacity- constrained asset class.

CIO: The debate on whether ESG investing helps bottom line returns continues. You’re a PRI signatory— how do you address giving up returns vs. responsible investing and the associated fiduciary obligations?

Joy: Firstly, I simply don’t think you have to give up return to be a responsible investor. I think it is the right thing to do, and I wished more investors dedicated the necessary resources to do it. I think the Exxon vote showed that with patience and sensible arguments, it is possible to build a mainstream coalition to achieve change.

We avoid certain investments (e.g., tobacco, cluster munitions) on ethical grounds because we do not think they are appropriate investments for us. We think, for us, this is the right thing to do, and our fiduciary duty given the values of the Church and our beneficiaries. We have no expectation that operating such exclusions will lead to better financial returns, and we are aware that they may at times impact negatively on financial returns. That said, the exclusions may help to reducelong-term social and environmental risk in our portfolio and our clear experience is that our investment universe is perfectly big enough for our managers to outperform regardless of our exclusions.

In the case of responsible investment, we expect our managers to take account of ESG factors to the extent that they are financially material for the strategy we are invested in and incorporation of ESG factors will improve investment returns. We also expect managers to incorporate ESG factors into their active ownership activities when they are financially material. Our experience is that views, and incorporation, can vary according to investment style/strategy, which is what one would expect—there is no one universally applicable approach to ESG issues.

In our own active ownership activities (voting and engagement), we seek to advocate both ethical business conduct and best ESG practice. We believe that if business operates ethically and in line with best ESG practice, it will generate both better long-term returns for shareholders and better outcomes for society. That’s where engagement examples like Exxon come in.

I think the Exxon vote showed that with patience and sensible arguments, it is possible to build a mainstream coalition to achieve change.

Overall, our investment returns are testimony that ethical investment and being PRI signatories are consistent with strong investment returns.

This is something we are committed to as active owners of public companies. We think society is increasingly demanding this of asset managers and owners, and that responsible investment is becoming more mainstream—it’s there already in Europe, Australia, etc., and it would be great if it could be more mainstream in the US too.

CIO: What keeps you up at night in terms of the investment landscape? Where do you think the challenges and opportunities lie?

Joy: My ‘worry list’ would be as follows:

• Managing stakeholder expectations over the long term after such a great run—the length of the cycle and the level of valuations of risk assets which, in turn, offer weak prospective returns mean, in our view, that future returns will be much lower.
• The complacency in markets and lack of apparent concern about risk by investors.
• The investor-unfriendly structuring of an increasing number of deals.
• Geopolitical tensions and, closer to home, the lack of certainty regarding Brexit and ongoing concerns regarding the Trump presidency.

—Reported by Christine Giordano