Let’s Go to the Video Tape… How do Life Plan Communities Manage their Investments?
Have you seen the latest summer blockbuster? Whether it’s Avengers: Endgame or Once Upon A Time In Hollywood that first comes to mind, their directors will have thoughtfully made the film by drawing on a mix of originality as well as tried-and-tested formulas and emotional arcs that are proven to pave the way for commercial success. Just as there are patterns in movies, there are patterns in investing that can be used when crafting an ideal portfolio.
I have guided the investment portfolios of many life plan communities (LPCs) and have long been the proponent of an approach that balances portfolio risk with operational or enterprise risk. Just as a filmmaker can mine a wealth of archives, tropes and devices to devise their motion picture, I work with databases that contain a vast amount of information about LPCs. This data includes the financial statements of LPCs to compare the operational statistics of the communities to their diverse asset allocation strategies. These resources come in very handy when crafting investment portfolios designed to serve the investment policies of increasingly diverse and multifaceted communities.
The significance of bond rating
I often create peer groups that relate asset allocation to statistics that rating agencies and lenders look at so as to compare apples to apples. One easy way to create a peer group is through looking at bond rating category. From there I can segment further by community size and scope (single site vs. multi-site), contract type or geographic area, among others.
I recently looked at a peer group that shared a BBB category rating from a recognized rating agency. After rationalizing the data, I found solid consistency among group members on a range of operational statistics, but of course there are always outliers. Debt service coverage averaged 2 times but covered a range of 1.4 to 3 times. Maximum annual debt service as a percentage of total revenue averaged 12, but there were some LPCs in single digits and several in the mid-to-high teens. The takeaway? You need to drill down further beyond the credit rating to look at the nuances. How big of a safety cushion does an LPC have? One adaptation I made on the debt service coverage ratios was to look at the percentage decline in net turnover that would result in problems meeting a hypothetical 1.2 x covenant. The average for our sample was nearly 70%, but some communities were as low as 20-30%, which struck me as a thin cushion for an investment grade bond.
How are we doing for risk budget?
I was mildly surprised to see that the average allocation exposure to equities was around 50%. Perhaps this was a result of “return-chasing” and/or market run-up that has elevated risk in many individual portfolios as well. Among the peer group, allocation to equities ranged from a low of 30% to a high of 75%. But it was particularly interesting to learn how the equity allocations matched up with the operating statistics. One would think that the strongest enterprises would be able to “afford” more risk and have the most aggressive allocations to equities. But in fact, I found that some of the highest equity allocations were associated with LPC’s that seemed more dependent on net entrance fees. On the other hand, some communities with lower allocations to equity were among the strongest financially.
Looking at fixed income allocations, I saw a very wide range (from 4% to 65%) around an average allocation of 43%. Fixed income is sometimes perceived to be the big investment conundrum today, as interest rates are low and the prospect of capital gains is diminished (a perception that ignores the surprisingly strong recent performance of the bond market!). This explains the rationale for why there has been a rise in equity allocations. Yet, it appears that equities, as an inherently more volatile asset class, are capable of doing more damage to portfolios than bonds. In other words, replacing some fixed income with equities at this time may be playing with fire.
Exploring the role of alternatives
Which brings us to alternative investments, i.e. those strategies that are designed either for absolute returns or better risk-adjusted returns. The average allocation metric for the alternative category was not as meaningful as the other statistics in the peer group study due to the fact that adoption rates were still low. This may be an educational issue or it may be that recent historical returns of these investments have not stacked up against the stock indices (What has?). In an environment where the traditional portfolio ballast, fixed income, has a questionable risk/return trade-off and equities have been driven up in valuation in part by the comparison to fixed income prospects, one would think that alternative investments, an asset class that is more focused on risk management, would be more in demand.
Just like making summer blockbusters, asset allocation is part art and part science. While this quick data analysis does not reveal the qualitative aspects of the portfolios that are contingent on forward-thinking judgement, I suspect that additional rigor regarding the balancing of enterprise risks and opportunities with market risks and opportunities would be of real value to any LPC. Now that’s a wrap.
We invite you to contact us if you would like to see a complimentary customized peer group study for your community.
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