Alternative investments in the 'new normal': Part I

Korea Post’s chief performance officer is Jurng Chuljoong. In a letter to AsianInvestor, he details his views on alternatives and where he sees investment opportunities. These are his personal views and do not necessarily reflect those of Korea Post.

Here, in the first of a two-part series, he unveils his thinking on real assets including resources, real estate, infrastructure and forest land. Tomorrow he discusses private equity, special situations, alternative energy, venture capital and hedge funds.

Korea Post is one of the country’s largest government-controlled institutional investors. It has two units: postal savings, with $62 billion in AUM, and postal insurance, with $32 billion.

The former has a 50% allocation to fixed income, 40% to cash and others, and 5% each to stocks and alternative investments. The latter has 65% in fixed income, 16% in cash and others, 7% in stocks, 7% in loans and 5% in alternatives.

The Korea Post Savings Fund announced plans to go into alternative investments at an AsianInvestor summit in Seoul in July last year, while the ex-head of real assets at Korea Post, Song In-kyu, predicts Korean institutions are set to become major allocators to the asset class.

The low returns of so-called growth assets such as private or public equity, coupled with market volatility, demands we come up with new sources of return or ways to reduce underlying portfolio volatility.

David Swensen, CIO of Yale University's endowment fund, says we should take advantage of liquidity premium and invest heavily in long-duration assets; and that we should blend cash yield and capital gains to create a more efficient portfolio. Making the most out of unique capital structures such as mezzanine and investing in intrinsic value assets is another route to minimise volatility.

The good news is the competitive landscape among financial investors is improving thanks to the downfall of private equity-like hedge funds and the closing of principle investment business among investment banks, in accordance with the Volker rule. Frequent dislocations during the restructuring/deleveraging process will also provide us with exceptional deals. 

At the same time, it is worthwhile for us to secure a beachhead in regions displaying strong growth potential and downside resilience. If we can hedge political risk in some emerging markets by aligning with reliable partners such as sovereign wealth funds (SWFs) or public corporations, we can navigate the territory and cast investment terms that suit our risk appetite.

Real assets
Asian institutions have relatively low exposure to real assets. But not only do they help to attain target returns, they also provide stable (re-investible) cash-flow. Limited downside volatility offers a margin of safety that helps us to endure in difficult times. Unlike commodity indices, which give simple price exposure, structured real asset investments provide price exposure plus intrinsic rate of return. Furthermore, this type of asset requires reasonably low management cost, so it suits institutions whose resources for managing an investment portfolio are relatively slim.

Resources
The impact from technological innovation in excavating shale gas is large enough to promote re-industrialisation of the US and hone its competitiveness. It might also replace some high-cost fossil fuels, lowering global inflation pressure. These evolutions will provide us with chances to participate in building gas-run power plant projects sponsored by US policy, led by proven GPs.

Real estate
This has been one of the favourite assets among pensions because of its low volatility and diversification effect. If levered at a proper level, property will survive the ups and downs of multiple economic cycles and generate anticipated capital gains over the long run. Recently Korean pension funds have demonstrated pent-up demand for US property.

However, windows of opportunity are already closing, requiring prudence as opposed to a big appetite. For now it would be sensible to invest in core-plus strategies in municipalities that will formulate more favourable zoning policies to increase tax revenue and revive local economies. Additionally, a value-added strategy, driven by re-tenanting or repositioning, is worthy of attention. But be sure to stay with managers with local expertise that can control subsequent capital expenditure and know the intricacies of the target town.

In the case of Europe, there are opportunities in distressed or highly leveraged buildings. However, we would lower [return] expectations below 20% and focus on Northern Europe. Investment in leading shopping malls, based on local demand and secure tenants, seems attractive where financing is possible.

In terms of the investment structure, debt or mezzanine offers better risk-adjusted returns than pure equity. As we are still in the learning process and building direct investment experience, we believe it’s better to start with small or medium-sized co-investment with reputable GPs.

Infrastructure
Ideal projects would have high barriers to entry (regulation or supply constraints) and stable (in-elastic demand) or inflation-hedged (growing) cash flow, backed by hard assets. Most SWFs prefer mature or brownfield projects rather than greenfield due to development uncertainties.

The fiscal crisis has weeded out competition and brought new opportunities such as secondary deals and more diverse PPP programs to investors. But a more prudent approach is required when it comes to leverage levels and possible changes in regulation. In terms of manager selection, active GPs adept at operation improvement and recapitalisation would be preferred.

Forest land
Unlike shorter duration, cyclical, perishable commodities such as corn, wheat and coffee, timber has a lasting organic growth contributor to return. In other words, returns from timber investment are mostly generated by its biological growth, rather than spot prices at the time of production. Timber harvests can be delayed if market conditions are unfavourable. Also it has a negative correlation with oil and gas, contributing portfolio balance. Timber Investment and Management Organisations (Timos) rarely raise funds and some are accessible via relationship only. The best approach is to tie with an SWF that has local government influence and Timos with a long track record of raising and harvesting. As we expect vigorous activity in housing construction in the next few years, at least a preliminary study on this asset class is worthwhile.