Out of Balance

Declines in the market are forcing pension plan sponsors to take a hard look at how they allocate their money — and not simply because they’re dissatisfied with performance. They are struggling to deal with a mismatch known as the "denominator effect" that happens when a fund’s total assets decline faster than the valuations of certain asset classes, including alternatives like commercial real estate, causing them to exceed stated allocation limits. "If you have a 10 percent target allocation to real estate, and the public equities and bond markets take a tumble, things can get out of whack very quickly," says Steven Corkin, a principal at Boston-based real estate investment firm AEW Capital Management.

It took only a matter of months for this effect to take hold in 2008; major equity market indexes fell 35 percent or more through November, with much of that decline occurring after August. Plan sponsors’ logical reaction in past cycles was to adjust real estate allocations, which are typically in the 6 to 10 percent range, downward. Corkin, however, sees more and more of his clients maintaining their holdings this time around. "Real estate has been a strong performer on a relative basis and has become an important part of the overall asset allocation," he says.

The California Public Employees’ Retirement System, for one, increased its three-year real estate allocation in late 2007 from 8 to 10 percent, and it’s holding to that level, a spokesman says. He adds that investment staff "generally have authority to invest within plus or minus 3 [percentage points] of the 10 percent target through 2010," monitored periodically by the board of trustees.

But others, particularly institutions without new or expanded allocations, are constrained by the rapid-onset denominator effect. "Many are out of the market entirely," says Martin Rosenberg, a principal at Cleveland-based consulting firm Townsend Group. "Some investors have limited capacity and are using it to re-up with existing managers. Few have the ability to make other commitments."

AEW’s Corkin estimates that 55 to 60 percent of plan sponsors are fully allocated to real estate, while the rest are still looking to put in money. "There is strong interest and enthusiasm about current market opportunities," he says. "For their core real estate strategies, investors are excited about buying strong, institutional quality assets at more attractive pricing. They are also seeing unprecedented opportunities to get high risk-adjusted returns from opportunistic strategies." In 2008, property values dropped by about 20 percent from the highs seen in 2006 and 2007, according to data from the Real Estate Roundtable.

One challenge for plan sponsors in a volatile market is to know and project where they stand in terms of their target asset allocations. Pension plans have to commit in advance to achieve their desired allocation, as their commitments are drawn down over time, Corkin explains. "And relatively small shifts in the overall portfolio can throw off allocation."

Liquidity matters also need attention. "It is important for plan sponsors to have a good sense of when capital will be returned from existing fund investments," says Corkin. "Capital is getting drawn down slower and is being returned more slowly in today’s market. We are trying to be realistic on both ends so that our investors know where they will be."

The Townsend Group, which is tracking approximately 625 managers that are trying to finance closed-end funds, believes that many will fall short of their fundraising goals. "We are seeing funds being formally withdrawn," notes Rosenberg. "I wouldn’t be surprised to see a third of the funds that came to market this year fail to close."

Present conditions give plan sponsors more sway in negotiations with managers than they had 18 months ago in discussing fees and fund structures. Back then, says Corkin, "most general partners were not willing to change terms. Today many are willing to negotiate terms that are more reflective of current market conditions."

Corkin expects that the denominator effect will accelerate purchases of secondary interests in real estate funds from plan sponsors moving to reduce their allocations. One of the few firms specializing in these secondaries is San Francisco–based Liquid Realty Partners, which has purchased more than $1 billion in real estate private equity interests since 2002. CEO Scott Landress says volume is running at record levels. "Fears regarding capital call defaults, inverted investment allocations, pending insolvencies and the general economy are motivating many limited partners to sell their stakes," he notes.