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During the global financial crisis, the banks (if not the bankers) bore the brunt of the financial losses. In the next downturn they won’t.
That’s because their capital and liquidity positions are now vastly stronger than in 2007 and the regulators (meaning well) have made it unprofitable for banks to take many of the risks they used to.
Pension schemes are taking these risks instead. They do this largely in pursuit of better yields in a world of quantitative easing (QE) under the guidance of their investment consultants.
A prime example is the current herding into private corporate credit. This used to be the preserve of the banks and not even available to pension schemes. However, QE and consequent low interest rates have made for a private equity bonanza financed with debt provided by huge investor appetite for high yielding loan assets – most notably from pension funds.
The number of US publicly traded companies has almost halved since the financial crisis as a result. If you want to invest in the equity of these now private companies, you need to invest in private equity (also popular with pension funds).
Reduced pricing, higher gearing & disappearing covenants
Now this might be OK if the investment managers that are acting like banks had more discipline than the banks had at the peak of previous cycles - but the same historic trends of reduced pricing, higher gearing and disappearing financial covenants (putting lenders in less control when companies underperform) are now readily apparent. The problem this time is the asset managers who book the loans aren’t on the hook for any loan losses (except reputationally), pension funds are.
Furthermore, these new lenders don’t have the provisions for loan losses and capital cushions that banks (even before the financial crisis) did and do. As most have only been investing in these assets since the global financial crisis, their experience of payment defaults in the declining rate environment has been extraordinarily low. Consequently, they haven’t needed to employ work-out/recovery teams who have a very different skill set and approach to those who gathered the assets. The combination of fewer covenants and no recovery teams mean the quoted recovery rates on even secured loans that default will be lower than forecast.
That doesn’t mean the best managers won’t have a high quality portfolio where losses during the next downturn will be limited, but warning signs should be flashing for investors in strategies touted by less savvy participants in a market that is totally untested by most current investors in a recession.
Project finance - an opportunity for pension trustees?
The other major consequence for pension schemes of post financial crisis regulation is banks no longer find it profitable to make markets in corporate bonds. If pension schemes need to liquidate these bonds in an even mildly stressed market, liquidity will be very thin so pension trustees need to plan liquidity requirements carefully.
On the other hand, in the case of project finance - another area largely vacated by banks for cost of capital reasons - one might argue the long term financing of projects such as real estate, infrastructure or energy are better suited to pension schemes than banks. Banks are driven by short term earnings rather than the long term liability matching perspectives of pension schemes.
When we recover from the next recession, the Pensions Regulator will issue a raft of new guidelines on pension scheme portfolio risk exposures and the bank regulators will have time on their hands to advise them on it. After all, the banks will be fine next time round.