Senior Living Business: Asset Allocation And Investment Strategies
Half of Recently Surveyed Providers Risk Alternative Investments
In the past three or four years, investors (including senior living providers) got caught up in the popularity of alternative investments—non-correlated asset classes such as private equity or hedge funds—in the expectation that they could double the returns that they would earn elsewhere. That may have been true when the total amount of money invested in hedge funds was about $100 billion; but as those investments approached $1 trillion, all chasing the same returns—and then the market sank—the hedge funds went down, too.
In addition, investors thought that money put into alternatives was liquid—that they could withdraw their money in the next quarter or two. But money invested in private equity funds doesn’t come back for five to seven years, at least. And hedge fund agreements use language similar to just about every partnership document, which says that if the situation becomes difficult from a liquidity perspective, the fund reserves the right to give money back to investors on its own schedule. As a result, investors ended up with capital calls from their private equity investments or lockdowns on their hedge funds. And what they thought were liquid assets quickly became illiquid.
"That’s not to say that alternative investments are bad," said Brian K. Andrew, COO of 1492 Capital Management, LLC, in Milwaukee, Wisconsin, and former president of Ziegler Capital Management. "However, those two issues kind of got lost in the excitement of alternatives and the expectation of higher returns from non-correlated asset classes. Well, those investments are not non-correlated, and liquidity can be a problem."
Demystifying hedge funds
Investors generally considered hedge funds to be an absolute return strategy that wasn’t supposed to turn negative at any point in time and, therefore, would provide downside protection. The appeal of hedge funds was their substantial amount of leverage, which used borrowed money to make investments and create higher returns. But in a stressed market like we saw over the last 18 months, two things happened: 1) a significant amount of money flowed out of hedge funds; and 2) the ability to borrow money against a portfolio of assets literally disappeared last year. The leverage disappeared, too, and hedge fund returns turned negative—almost as bad as equity investments in the stock market and definitely not like the fixed-income alternative that investors thought they had bought. In the end, it wasn’t much of a hedge.
"Senior living providers need to look for transparency," according to Andrew. "They need to see, on a regular basis, what the hedge funds own; and they shouldn’t invest in a fund that won’t disclose that information. A lot of organizations that discovered what they were told about how the fund would perform didn’t materialize—particularly in the last 18 months—were surprised, because they had no idea what they had invested in."
In the hedge fund world, because it’s largely unregulated, transparency is a huge issue—probably even bigger today than it was several years ago. A mutual fund, for example provides a prospectus and periodic reports that detail the fund management, the investment objectives, the portfolio, expenses, past performanc and so on. Hedge fund managers, however, are required only to provide an annual performance report; they’re not required to share what the fund owns, so the level of transparency varies dramatically from fund to fund.
"We’ve worked with a lot of senior living providers over the last five years, and I don’t think I’ve ever had a finance committee ask me about a hedge fund." added Nicholas Bauer, a senior consultant in the health care group at MBO Cleary Advisors, Inc., also in Milwaukee. "Investment advisors position hedge funds as a fixed-income alternative, which is clearly not the case in the kind of stressed markets that we experienced this last year. And because of the illiquid nature of the hedge fund, the providers couldn’t exit the strategy when the market declined and they needed the capital."
Also, a lot of senior living providers don’t have large enough investment portfolios to directly access really good hedge funds and, therefore, buy into a hedge fund of funds vehicle. That effectively outsources the manager due diligence, as well as the selection of the various hedge fund managers, to another advisor.
"We educate providers to shy away from hedge fund of funds," said Bauer. "But as long as the investment advisor discloses the illiquid nature of those vehicles and the organization’s board or finance or investment committee understands that hedge fund of funds have an increased fee structure and transparency issues, the board or committee will have a comfort level about whether to take on that type of risk relative to the expected returns."
If a client wants fixed-income returns, the only way to guarantee that is to buy fixed-income securities, Bauer stressed. And liquidity is of the utmost importance for senior living providers. If they need to access the capital, they want to be able to do it in a very short period of time.
Bauer recommends boards and committees look for investment managers that aren’t necessarily tied to a specific benchmark but can float between large cap and small cap, between growth and value, and also may be able to buy international or natural resources as part of the strategy. "Another way to have non-correlated exposure while maintaining liquidity is through an exchange traded fund (ETF)," he said. "That offers great exposure to commodities and natural resources, while maintaining liquidity and also compressing the fee structure."
Specify the asset allocation strategy
An investment policy statement helps an organization’s board make investment decisions by specifying an asset allocation strategy, as well as the role of the investment advisor, with regard to how the organization’s portfolio is managed, measured and monitored over time. The investment policy should include a return requirement — generally, the cost of capital is a minimum required rate of return—and risk tolerances that recognize the broader impact of the investment portfolio across the organization (e.g., on liability structure and bond covenants).
Another important consideration when putting together an asset allocation model is to look at the capital plan—in particular, how it has changed as a result of what happened to the business in the last year. "You need to consider your debt structure," advised Andrew. "If you have 100% fixed-rate debt, then you obviously know your cost of capital and can build an asset allocation that generates a percentage return in excess of that cost of debt. If you’ve got a combination of fixed- and variable-rate debt, you can hedge the interest-rate risk on the variable-rate side by, for example, putting your fixed-income investments in taxable floating-rate securities. Of course, that’s a function of how much cash is available to invest relative to debt outstanding. The point is to understand the relationship between your portfolio and your debt structure."
The investment policy statement should also detail the specific responsibilities of the board, the finance or investment committee, and management with regard to who makes investment decisions. To the extent those responsibilities are laid out in writing, the less likely any single person (e.g., a new board member) will be able to unduly influence the organization’s investment strategy. It builds in protection. And the more specific the policy objectives, the less trouble the organization is likely to have in difficult times.
Investment policy review
At a minimum, the organization’s investment policy should be reviewed by the board’s finance or investment committee and formally approved by the full board on an annual basis. Interim changes may be warranted in the event that the financial position, the capital plan, or the operating position of the community has changed.
Short-term shifts in the economy, however, generally should not trigger a change in the investment strategy. In fact, the purpose of having a policy in place is to separate the short-term market movement and the emotions it may generate from the long-term strategic plan of the organization.
Nevertheless, it may be difficult for a board to feel comfortable with portfolio volatility if its finance or investment committee meets only twice a year. Therefore, an investment policy statement should define a communication process through which a board delegation: 1) regularly interacts with a specific group of management people who are involved in the organization’s finances; and 2) issues a full report to the board on a regular basis.
"That reporting is important in terms of understanding how the operating environment relates to the portfolio," said Andrew. "And the organization also gains a group of people on the board who can advocate for management when things get tough. Too often, people ignore the connection between their investment portfolio and the rest of their balance sheet and the way that they’re managing the operation. If you know, for example, the percentage of revenues that your investment portfolio is contributing to your operating margin when you’re 95% occupied vs. 89% occupied, your asset allocation should take that into consideration."
Clearly stating lines of communication, frequency and a reporting format in the investment policy statement allows the board to be able to have the right conversations to deal with any investment strategy situations that might arise. "It’s when the board doesn’t hear anything from anybody that it has a problem," said Andrew. "They lose their timing or their leverage."
One caveat about creating the board delegation: The finance or investment committee must ensure that the delegation provides oversight but doesn’t micromanage management and/or the investment advisor.
Bauer also suggests reviewing the investment portfolio on a quarterly basis to determine whether there’s a need to rebalance it. "That timing can be adjusted according to financial changes in the organization, such as cash flow. For example, if you expect to add excess cash from operations to the investment portfolio in a month or two, put off the rebalancing until that time. The same applies when you expect to take cash out of the investment portfolio."
An important factor with regard to rebalancing, though, is the idea of realized losses passing through to the income statement. "We recommend writing into the investment policy that the advisor must consult with the CFO, at a minimum, before actually implementing any rebalancing, particularly if unrealized losses will turn into realized losses," said Bauer. "You don’t want rebalancing to impact debt-service coverage, which could trigger a technical default and, in a worst case scenario, compromise the organization’s cost of capital."
Normally, reallocating your money is hardest to do just when you should be doing it— when the market is down, say, 25% but you’ve also lost 25-30% of your portfolio; or your debt cost has gone up because variable-rate debt isn’t available; or occupancy is down so your operating margins have diminished; or, as many have experienced this year, all of the above.
"That’s why it’s important to address asset reallocation in your policy," said Andrew. "There are times when you might want to review your strategy with respect to your capital plan, from an operational standpoint, or to react to market conditions. So be specific in your policy with regard to your objectives but flexible from the standpoint that the operating environment changes over time."
Rebalancing the portfolio
Rebalancing is a key component to managing returns from an asset allocation strategy and something that also should be clearly stated in the investment policy statement. "People always want to change the investment policy, and they always seem to want to do it at the wrong time," said Andrew. "If the policy says the portfolio will be rebalanced on an annual basis, the only way to change the timing should require a full vote of the board. That prevents the finance or investment committee, whose responsibility is implementation, from ‘doing it’s own thing.’"
This article was reprinted from the December 2009 issue of Senior Living Business with permission from Irving Levin Associates, Inc. Click here to download a printable version of this article
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