Legislature(2003 - 2004)

03/02/2004 08:00 AM STA

Audio Topic
* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
HB 466-PERMANENT FUND INVESTMENTS                                                                                             
                                                                                                                                
[Contains discussion of HB 156.]                                                                                                
                                                                                                                                
Number 2383                                                                                                                     
                                                                                                                                
CHAIR WEYHRAUCH  announced that  the next  order of  business was                                                               
HOUSE BILL  NO. 466,  "An Act relating  to investments  of Alaska                                                               
permanent fund assets; and providing for an effective date."                                                                    
                                                                                                                                
Number 2365                                                                                                                     
                                                                                                                                
ROBERT  D.  STORER,  Executive Director,  Alaska  Permanent  Fund                                                               
Corporation  (APFC),  Department  of  Revenue,  stated  that  the                                                               
department is  held to the  prudent investor  rule.  He  said the                                                               
permanent fund "has  an extra layer"; in addition  to the prudent                                                               
investor rule,  there is a  statutory list that defines  what may                                                               
be invested in.   He indicated that the list  includes one clause                                                               
that "gives a little additional  flexibility."  He noted that the                                                               
modern prudent investor  rule started with the  enactment of [the                                                               
Employee  Retirement and  Income Security  Act of  1974] (ERISA).                                                               
He explained that  although ERISA has to do  with private pension                                                               
plans and  corporations, everyone uses ERISA  where applicable in                                                               
regard  to public  funds.   Mr. Storer  read selections  from [29                                                               
U.S.C. 1104 - Fiduciary Duties], which read in part as follows:                                                                 
                                                                                                                                
     (a) Prudent man standard of care                                                                                           
                                                                                                                                
     (1)                                                                                                                        
                                                                                                                                
          Subject to sections 1103(c) and (d), 1342, and                                                                        
     1344  of this  title, a  fiduciary shall  discharge his                                                                    
     duties with  respect to a  plan solely in  the interest                                                                    
     of the participants and beneficiaries and                                                                                  
                                                                                                                                
     ...                                                                                                                        
                                                                                                                                
     (B)                                                                                                                        
                                                                                                                                
          with the care, skill, prudence, and diligence                                                                         
     under the circumstances then  prevailing that a prudent                                                                    
     man acting  in a like  capacity and familiar  with such                                                                    
     matters would use in the  conduct of an enterprise of a                                                                    
     like character and with like aims;                                                                                         
                                                                                                                                
     (C)                                                                                                                        
                                                                                                                                
       by diversifying the investments of the plan so as                                                                        
     to minimize the risk of  large losses, unless under the                                                                    
     circumstances it is clearly prudent not to do so;                                                                          
                                                                                                                                
MR. STORER  said that although  it was typical  in the 70s  for a                                                               
public fund  to have a  statutory list defining  what investments                                                               
can  be   made,  currently  virtually   all  public   funds  have                                                               
eliminated  the  statutory  list  and "just  follow  the  prudent                                                               
investor guideline."                                                                                                            
                                                                                                                                
Number 2186                                                                                                                     
                                                                                                                                
MR.  STORER directed  the committee's  attention to  a [six-page]                                                               
handout  [included in  the committee  packet], entitled,  "Alaska                                                               
Permanent  Fund."   He  noted that  pages two  and  three of  the                                                               
handout show all the times  that the legislature has expanded the                                                               
investment  flexibility and  given  the [APFC]  more latitude  to                                                               
achieve  its investment  goals.   He indicated  his understanding                                                               
that it is  a "misstatement" on the bottom of  page three that it                                                               
reads that HB  156 was sponsored by the  Senate Finance Committee                                                               
in 1999.   Notwithstanding that,  he highlighted  that paragraph,                                                               
which read as follows:                                                                                                          
                                                                                                                                
     HB  156  allowed  the  Fund  to  leverage  real  estate                                                                    
     investments  and increased  asset allocation  limit for                                                                    
     stocks to 55  percent of the total market  value of the                                                                    
     Fund.   HB 156  also created  the "basket  clause" that                                                                    
     allows up  to 5 percent of  the Fund to be  invested in                                                                    
     alternative investments  or to  be applied  to existing                                                                    
     asset  allocations   to  expand   their  limits.     In                                                                    
     addition, HB 156  allowed the Permanent Fund  to be the                                                                    
     sole owner  of any real estate  property, regardless of                                                                    
     value.                                                                                                                     
                                                                                                                                
MR. STORER noted that page four  of the handout shows the history                                                               
of the fund's  various asset allocations.  For  example, he noted                                                               
that  during  the early  70s  and  80s,  the permanent  fund  was                                                               
invested  exclusively in  fixed income  securities, "even  though                                                               
it's a long  term fund."  He revealed that  he began working with                                                               
the APFC  in May of  1983, and in June  of that year,  the [APFC]                                                               
funded its first "equity managers."   He remarked that as of late                                                               
1987 the fund  was invested in only about 13  percent in the U.S.                                                               
equity market  alone and  the [APFC] did  not have  permission to                                                               
invest in the international equity  market.  He stated, "What you                                                               
see  ... right  now  in  the asset  allocation  is slightly  more                                                               
conservative than other public funds,  but a mature fund that ...                                                               
constructs  their portfolios,  essentially, the  way most  public                                                               
funds invest their money."                                                                                                      
                                                                                                                                
Number 2061                                                                                                                     
                                                                                                                                
MR.  STORER  said  HB  466 proposes  an  increase  in  investment                                                               
flexibility.  The  changes, he noted, will  potentially allow the                                                               
[APFC] to increase its returns and  to meet future needs in terms                                                               
of   increasing  diversification,   as  well   as  to   implement                                                               
strategies  more   efficiently  at  a  lower   cost  and  address                                                               
contemporary needs as they occur.                                                                                               
                                                                                                                                
MR.  STORER revealed  that next  week the  [APFC] will  propose a                                                               
change in its asset allocation,  which is something it does every                                                               
March after  a review of the  capital market in the  beginning of                                                               
the  year.   He turned  to [a  one-page handout  included in  the                                                               
committee packet], entitled "Fund's  asset allocation and control                                                               
bands."  He  explained that the column of numbers  on the left is                                                               
the target number  - for example, 37 percent  U.S. equity market,                                                               
while  the column  of  numbers on  the right  shows  bands -  for                                                               
example, plus or  minus 7 percent.  He explained  that the [APDC]                                                               
tries  to create  targets  and then  create  "bands around  those                                                               
targets."   The  corporation does  not want  to balance  "a lot,"                                                               
because that  can result in creating  transaction costs; however,                                                               
it does want  to "discipline it mechanically,"  which "forces you                                                               
to rebalance."                                                                                                                  
                                                                                                                                
Number 1922                                                                                                                     
                                                                                                                                
MR.  STORER stated  that the  September quarter  of 2002  was the                                                               
worst  quarter in  the  history  of the  permanent  fund, with  a                                                               
negative  7.5  percent   rate  of  return  due   primarily  to  a                                                               
plummeting stock  market, which  forced the  [APFC] to  add about                                                               
$750  million  in  the  equity  market to  "get  back  closer  to                                                               
target."   He  added, "We  got permission  from the  board around                                                               
October 10.  I  think we missed the bottom of  the bear market by                                                               
about four days and so we  captured very high returns."  He noted                                                               
that "this  was not any special  insight on what was  going on in                                                               
the  bear  market," but  was  an  example  of how  a  disciplined                                                               
approach works.  He stated that  his point in bringing this up is                                                               
that "after  four years of  study, we're about to  implement some                                                               
strategies that will use the basket clause."                                                                                    
                                                                                                                                
Number 1861                                                                                                                     
                                                                                                                                
MR. STORER continued as follows:                                                                                                
                                                                                                                                
     We   are  ...   banging   up   against  our   statutory                                                                    
     limitations very soon.   ...  That means  if the equity                                                                    
     market  continues -  if these  strategies  that we  ...                                                                    
     employ  using  the basket  clause  work  - we  will  be                                                                    
     forced  to  liquidate  the assets.    Not  because  the                                                                    
     capital markets  tell us  to do  [so], not  because our                                                                    
     advisors  are  saying  we need  to  liquidate  or  take                                                                    
     profits or redirect  that money.  We will  be forced to                                                                    
     liquidate because  statutes will  not allow us  to gain                                                                    
     the benefits of the ...  full rising market.  So, there                                                                    
     is  a  big  negative,   I  believe,  to  our  statutory                                                                    
     limitations,  which forces  us to  take potential  gain                                                                    
     off the  table, because  of statutory  limitations, not                                                                    
     what the financial markets are telling us.                                                                                 
                                                                                                                                
Number 1794                                                                                                                     
                                                                                                                                
MR.  STORER turned  attention  to the  last page  of  the of  the                                                               
previously  noted  six-page  handout, which  addresses  potential                                                               
questions.   He noted  that one  question may  be, "Will  you ...                                                               
take on too much risk?"  He continued:                                                                                          
                                                                                                                                
     We've all  said we  have this target  [of] hitting  a 5                                                                    
     percent  real  rate  of return  over  time,  and  we're                                                                    
     comfortable  making that  statement.   But what  if, to                                                                    
     achieve   a   higher   rate    of   return,   ...   our                                                                    
     constitutional amendment  doesn't pass and we,  one way                                                                    
     or another, ...  believe we should strive  for a higher                                                                    
     rate  of  return  ...  and accept  more  risk  than  is                                                                    
     prudent?"   And that is a  risk.  You can't  say, "That                                                                    
     will  never happen,  it has  never happened,  I see  no                                                                    
     evidence it will happen."                                                                                                  
                                                                                                                                
     I  ... have  worked  with about  every  trustee of  the                                                                    
     permanent fund with the exception  of about four in the                                                                    
     beginning.    ...   I've  worked  with every  executive                                                                    
     director.    I've  worked  for   or  with  every  chief                                                                    
     investment officer [of] the  Alaska Permanent Fund, and                                                                    
     I will tell you, in  the history of the permanent fund,                                                                    
     there  has never  been an  inclination of  striving for                                                                    
     too much  risk.  When  you become a fiduciary  and have                                                                    
     responsibility of  managing the fund, it's  inherent in                                                                    
     the  process that  you take  your responsibility  very,                                                                    
     very  seriously,  and  so  there's   no  history  -  no                                                                    
     suggestion - that the permanent  fund would be prepared                                                                    
     to reach too far for a return.                                                                                             
                                                                                                                                
Number 1700                                                                                                                     
                                                                                                                                
     How will  the board  of trustees use  this flexibility?                                                                    
     That  becomes a  tougher  question.   One is  obviously                                                                    
     because [of]  the statutory  limitations; we  would use                                                                    
     it to allow  our investments [to] rise to  what we hope                                                                    
     are their  potential.  As  I noted at the  beginning of                                                                    
     my  presentation, we're  trying  to  set the  permanent                                                                    
     fund up  to meet future  flexibility, and so  there's a                                                                    
     "nonpredictive"  element about  how you  would use  it.                                                                    
     ...                                                                                                                        
                                                                                                                                
     If you  ask me right now  what [we would] look  at, one                                                                    
     of  course is  being able  to increase  our returns  by                                                                    
     letting  our winners  continue on.   We  might look  at                                                                    
     some high yield.   High yield is:   the pejorative term                                                                    
     is  "junk bonds."   There's  really  two categories  of                                                                    
     high yields; you  can really divide a  line between the                                                                    
     two.  ...There is a  category of high yield that's very                                                                    
     close  to  investment-grade  corporate debt.    They've                                                                    
     worked out their  problems and they are  in the process                                                                    
     of  probably  being   upgraded  and  become  investment                                                                    
     debts.  That's a  more conservative approach, if that's                                                                    
     not an oxymoron.  Then  there's the other, where you're                                                                    
     taking  bigger   bets  on  companies  that   have  huge                                                                    
     problems and  then you expect equity-like  returns.  We                                                                    
     may,  over the  next year  -  and I've  not posed  this                                                                    
     question with  the board  - but we  may start  taking a                                                                    
     look  at the  more conservative  approach.   Be mindful                                                                    
     that we  will educate ourselves  for as much as  a year                                                                    
     or two years on a subject  before we discard it or make                                                                    
     sense [of it].   As I noted, we got  permission for the                                                                    
     basket clause  in 1999.   We are only now,  after years                                                                    
     of   study,  beginning   to  implement   some  of   the                                                                    
     strategies that use the basket  clause.  So, when I say                                                                    
     ... something  like that, I'm saying  this is something                                                                    
     we may evaluate.                                                                                                           
                                                                                                                                
Number 1549                                                                                                                     
                                                                                                                                
MR. STORER turned  to the question of derivatives.   He explained                                                               
that derivatives  are financial  instruments where  "their return                                                               
is derived from some other  investment instrument."  For example,                                                               
he  noted  that a  measure  for  large-cap  equities is  the  S&P                                                               
[Standard &  Poors] 500 index.   He noted that there  are futures                                                               
and forward contracts  that base their return  on the performance                                                               
of the S&P 500 index.  He continued as follows:                                                                                 
                                                                                                                                
     We  use derivatives  now, in  a sense.   We  will hedge                                                                    
     currency.  When we  bank an international investment we                                                                    
     may  hedge  that  currency  risk   before  we  buy  the                                                                    
     currency  to pay  off the  security.   Our managers  do                                                                    
     that.    So,  there  are  any number  of  ways  to  use                                                                    
     derivatives; they  all aren't  all bad.   When  you see                                                                    
     derivatives  and   you  see  negative   headlines,  ...                                                                    
     typically  it's because  they've  used derivatives  for                                                                    
     leveraging  the  portfolio   in  a  rather  significant                                                                    
     manner, and it's not the  use of the derivative so much                                                                    
     as increasing the risk by using the leverage.                                                                              
                                                                                                                                
Number 1456                                                                                                                     
                                                                                                                                
CHAIR WEYHRAUCH  asked Mr.  Storer if the  basket clause  got its                                                               
name when  it was adopted  in 1999, or was  it a term  that "just                                                               
grew."                                                                                                                          
                                                                                                                                
MR.  STORER offered  his  belief that  it became  a  term of  art                                                               
"during that process."                                                                                                          
                                                                                                                                
CHAIR WEYHRAUCH said  when he hears the word  "basket," he thinks                                                               
of a  basket used in  a grocery  store and "picking  and choosing                                                               
small amounts to  go throughout the line."  He  asked Mr. Storer,                                                               
"Is that  how the public would  view what a basket  clause is, in                                                               
terms of  the larger scale  when you're dealing  with investments                                                               
in the permanent fund?"                                                                                                         
                                                                                                                                
MR. STORER  mentioned diversification.   He stated, "So,  even if                                                               
one  gets  the   ability  through  the  basket   clause  to  make                                                               
investments, we  are still  driven by  diversification.   And our                                                               
point would  be to fill that  basket with a bunch  of diversified                                                               
options that  would not  put risk in  any (indisc.  - overlapping                                                               
voices)."    In  response  to a  follow-up  question  from  Chair                                                               
Weyhrauch, he  confirmed that  "we're asking  to make  the basket                                                               
bigger," or to increase the flexibility.                                                                                        
                                                                                                                                
Number 1365                                                                                                                     
                                                                                                                                
REPRESENTATIVE  SEATON asked  if part  of [the  intent] is  to be                                                               
able  to maintain  assets that  have appreciated  and may  "go up                                                               
more."   He clarified  that he  is trying to  figure out  "the 15                                                               
percent."   He asked, "Does that  mean that the funds  could then                                                               
take international equities  to 31 percent, with  the 15 percent,                                                               
less  the  16  percent,  currently,   if  the  fund  thought  ...                                                               
international assets  are going up and  ... we've had a  good run                                                               
in our  investments here and we  want them to continue,  so we'll                                                               
use  our  authority  to  increase   ...  that  allocation  to  30                                                               
percent?"                                                                                                                       
                                                                                                                                
MR.  STORER responded  that that  technically -  emphasis on  the                                                               
word "technically" -  could be correct.  However,  he stated that                                                               
it would  also be unlikely,  keeping in mind  that the goal  is a                                                               
fully  diversified portfolio.   He  revealed that  next week  the                                                               
[APDC]  will   recommend  increasing  the   international  equity                                                               
allocation from  16 to 18 percent.   He added, "In  fact, I think                                                               
we're more like 17 [percent] as  it now stands.  We're also using                                                               
parts of the basket clause."  He continued as follows:                                                                          
                                                                                                                                
      So, the fundamental question would be, "If one used                                                                       
      the entire basket clause to increase a single asset                                                                       
     class,   would    it   still   meet   the    rules   of                                                                    
     diversification  and  [the  modern]  prudent  [investor                                                                    
     rule]?"   I  am well  aware of  many public  funds that                                                                    
     have  been invested  in  excess of  25  percent in  the                                                                    
     international  equity  markets,   but  as  a  practical                                                                    
     matter, that would  be unlikely that we  would use what                                                                    
     I call the  privilege of an increased  basket clause in                                                                    
     any single thing.  ...   As [of] now we aren't going to                                                                    
     use  it  in  a  number  of  options  that  will  behave                                                                    
     differently in different market environments.                                                                              
                                                                                                                                
Number 1234                                                                                                                     
                                                                                                                                
REPRESENTATIVE SEATON asked for examples of "what these other                                                                   
new investments" are.                                                                                                           
                                                                                                                                
Number 1168                                                                                                                     
                                                                                                                                
MR. STORER responded as follows:                                                                                                
                                                                                                                                
     As noted,  we do  have a 55  percent limitation  in the                                                                    
     stock   market;  that   is  unique   in  public   funds                                                                    
     throughout  the country  where you  follow the  prudent                                                                    
     investor rule.   There  are no  limitations whatsoever.                                                                    
     So, I would like to  preface my response by saying that                                                                    
     even with the increased  basket clause, our constraints                                                                    
     would  still constrain  us  to being  one  of the  more                                                                    
     conservative public funds in the  country.  So, even if                                                                    
     we  increase it,  we're  still not  going  to have  the                                                                    
     ability  to take  as much  risk as  other public  funds                                                                    
     may.     And  of   course,  risk  is   not  necessarily                                                                    
     pejorative;   you   should   be  rewarded   for   being                                                                    
     compensated for that risk.                                                                                                 
                                                                                                                                
     As  an immediate  objective we  will  probably use  the                                                                    
     basket clause  to not be  forced to sell stocks  in the                                                                    
     ... equities if we  exceed the statutory limit, because                                                                    
     we  would   apply  ...  that   basket  clause   to  the                                                                    
     additional equities.   ...   We  don't believe  that is                                                                    
     bad at all.  What we're  doing is we're letting ... the                                                                    
     markets  define when  to rebalance,  we're not  letting                                                                    
     ... arbitrary constraints  tell us when to  apply.  So,                                                                    
     one immediate use  would be simply to  benefit from the                                                                    
     appreciation of the  markets and not be  forced to sell                                                                    
     for arbitrary reasons.                                                                                                     
                                                                                                                                
     [Regarding]  the balance  of it,  we would  ... educate                                                                    
     ourselves  on any  number of  things.   I mentioned  an                                                                    
     example - potentially  high yield.  We've  looked at it                                                                    
     modestly.  We  have looked at private  equity and we're                                                                    
     starting a modest program in  private equity, which, by                                                                    
     definition,  that's  "nonpublicly" traded  investments.                                                                    
     ...  It's a diversified  portfolio that could have some                                                                    
     venture  capital, some  buyouts in  it.   Typically you                                                                    
     expect to earn about 5  percent return in excess of the                                                                    
     publicly traded  markets [when]  you do  something like                                                                    
     that.                                                                                                                      
                                                                                                                                
Number 0997                                                                                                                     
                                                                                                                                
MR. STORER mentioned absolute return strategy and hedge fund.                                                                   
He said that he is about to recommend something that's kind of                                                                  
unique.  He continued as follows:                                                                                               
                                                                                                                                
     I'm introducing, for  the first time ever,  ... a pilot                                                                    
     program.    These  are  very  sophisticated  investment                                                                    
     approaches;  we've studied  it  for well  over a  year.                                                                    
     And there's a lot more to  be learned, but the only way                                                                    
     I think we can learn beyond  here is live.  And so, I'm                                                                    
     recommending that we invest a  modest amount in a pilot                                                                    
     absolute return strategy.  We're  going to define it as                                                                    
     very low risk.   Our objective is to  have ... targeted                                                                    
     risk that  is equal  to or less  than the  bond market.                                                                    
     That'll  be  part  of  the  criteria.   ...    I  think                                                                    
     everyone in this room will  agree that sometimes things                                                                    
     exist in  government perpetually, and to  make it truly                                                                    
     a pilot  program, I'm recommending a  sunset clause ...                                                                    
     so that  the program will  expire within 30  months, so                                                                    
     that not only by policy  it will die, but our contracts                                                                    
     with the  experts will  expire in  36 months,  as well.                                                                    
     So, the  only way we  can continue forward on  that one                                                                    
     is to take the knowledge  we've learned and vote it up,                                                                    
     rather than it just [becoming]  perpetual.  So, that is                                                                    
     another   use,  and   I'd  like   to  think   that's  a                                                                    
     conservative   approach   to   a   very   sophisticated                                                                    
     investment  strategy.   So, those  are sort  of on  the                                                                    
     immediate table.                                                                                                           
                                                                                                                                
     I  spoke  last  week  in front  of  [the  Senate  State                                                                    
     Affairs Standing  Committee], and I did  the cornucopia                                                                    
     of  opportunities, most  of  which  I don't  personally                                                                    
     agree make  any sense.   When people invest  in timber,                                                                    
     it usually means timber in  Indonesia or overseas.  And                                                                    
     can you imagine investing in  timber in a small way and                                                                    
     then [ending]  up with an environmental  nightmare in a                                                                    
     country where you have no  control.  So, I'm giving you                                                                    
     a bad  example, in  my opinion.   So,  we have  to work                                                                    
     through all these things.                                                                                                  
                                                                                                                                
Number 0760                                                                                                                     
                                                                                                                                
REPRESENTATIVE BERKOWITZ said he  would quarrel with Mr. Storer's                                                               
assertion   that  the   list  forces   conservative  investments.                                                               
Conversely,  he  said   it  seems  to  him   to  force  imprudent                                                               
investments.   He  said sometimes  there  might emerge  conflicts                                                               
between  the list  in  Title 37  and the  explanation  of what  a                                                               
prudent investor  should do in Title  13.  He said,  "When you're                                                               
forced to sell  assets because you're going up  against the upper                                                               
limits, that's not conservative ...."                                                                                           
                                                                                                                                
Number 0740                                                                                                                     
                                                                                                                                
MR. STORER  concurred with Representative  Berkowitz's statement.                                                               
He said that he has been "at  or near" the permanent fund and has                                                               
long thought that the statutory  list could become so restrictive                                                               
that "it belongs in the  Smithsonian rather than as an investment                                                               
tool."   He stated, "We have  not suffered, to date,  but I think                                                               
...  that we  need to  create a  flexibility to  manage the  fund                                                               
successfully in the future."                                                                                                    
                                                                                                                                
Number 0682                                                                                                                     
                                                                                                                                
REPRESENTATIVE  GRUENBERG indicated  that he  may be  offering an                                                               
amendment that  would eliminate the  [limitations] and  allow the                                                               
board to  just invest under  the prudent  person rule.   He asked                                                               
Chair Weyhrauch if  the bill would not be moved  out of committee                                                               
today,  because he  indicated that  he  has questions  to ask  to                                                               
which he would like answers at the next meeting.                                                                                
                                                                                                                                
CHAIR WEYHRAUCH stated  that it is not his intention  to move the                                                               
bill today.                                                                                                                     
                                                                                                                                
Number 0487                                                                                                                     
                                                                                                                                
RONALD  W.  LORENSEN,  Attorney  at  Law,  Simpson,  Tillinghast,                                                               
Sorensen & Longenbaugh,  P.C., told the committee  that that firm                                                               
is outside  counsel to the  APFC.  He  stated that he  has worked                                                               
with Mr. Storer and the  board on the proposed legislation before                                                               
the committee.   He announced  that he would limit  his testimony                                                               
to addressing the changes sought in  the bill.  Both sections, he                                                               
noted, would make amendments to AS  37.13.120.  He stated that AS                                                               
37.13 is  the chapter that deals  with the APFC and  is described                                                               
as the  legal or  statutory list.   Section 120  is approximately                                                               
four pages  long, he noted,  with subsection (g) setting  out the                                                               
legal list of those investments  that the [APFC] is authorized to                                                               
invest in.   Other subsections within Section  120 provide either                                                               
limitations or  guidance with respect  to the investments  of the                                                               
fund.   For  example, he  said, subsection  (a) is  the provision                                                               
that deals  with the prudent investor  rule as it applies  to the                                                               
fund, while  subsection (k)  is the  subsection that  created the                                                               
basket clause  in 1999.  Subsection  (k) would be amended  by the                                                               
bill  to  add references  to  two  additional subsections  within                                                               
Section  120,  as  exceptions  to the  operation  of  the  basket                                                               
clause.  Those additions are subsections (h) and (j).                                                                           
                                                                                                                                
MR.  LORENSEN  stated  that subsection  (h)  would  prohibit  the                                                               
corporation  from  investing  in  futures  contracts,  except  in                                                               
specific circumstances.  He continued as follows:                                                                               
                                                                                                                                
     That limitation, although it  makes sense in the scheme                                                                    
     of   the   existing   statutory  list,   creates   some                                                                    
     difficulties in  terms of flexibility, with  respect to                                                                    
     the basket  clause.  ...   The  example I have  most in                                                                    
     mind is in  the area of hedge funds,  where hedge funds                                                                    
     may invest, as part of  their strategy, some portion of                                                                    
     the funds under management  in various forms of futures                                                                    
     contracts.   This  limitation page  would prohibit  the                                                                    
     basket clause from being used  for those kinds of hedge                                                                    
     fund investments.   It certainly was  not the intention                                                                    
     at the time that the  basket clause was proposed to the                                                                    
     legislature that that limitation  exist to apply to the                                                                    
     basket clause;  it was just, basically,  something that                                                                    
     hadn't been  anticipated or perceived  as a  problem at                                                                    
     the time.                                                                                                                  
                                                                                                                                
MR.  LORENSEN  stated  that  subsection (j)  is  a  provision  in                                                               
Section 120 that states that the  [APFC] may not invest in bonds,                                                               
basically,  where  the  interest  payment  on  a  bond  has  been                                                               
defaulted in  the last five years.   And again, that's  a prudent                                                               
rule, with respect to fixed income  as a class of investment, but                                                               
it  creates difficulties  when you're  talking about  alternative                                                               
forms of  investment, such as  high yield investments,  which Mr.                                                               
Storer's also described  as what some people  call, "junk bonds,"                                                               
where you're looking for a higher  return.  And the reason you're                                                               
looking for  a higher return  is because  you are investing  in a                                                               
class of bonds which is more  risky, and frequently ... that risk                                                               
is demonstrated by the fact  that interest payments have not been                                                               
made within the last five years.                                                                                                
                                                                                                                                
[The committee took a brief at-ease.]                                                                                           
                                                                                                                                
TAPE 04-26, SIDE A                                                                                                            
Number 0001                                                                                                                     
                                                                                                                                
MR. LORENSEN continued as follows:                                                                                              
                                                                                                                                
     So, adding [subsection]  (j) in Section 2  of the bill,                                                                    
     to  the  exceptions for  the  operation  of the  basket                                                                    
     clause, would  permit a  portion of  the assets  of the                                                                    
     permanent fund  to be  invested in  certain alternative                                                                    
     investments, which use - as  a part of their investment                                                                    
     strategy  - investing  in bonds,  which  have a  higher                                                                    
     risk  of   default,  but   also  the   counter  veiling                                                                    
     consideration is that they have  a higher potential for                                                                    
     an increased return.                                                                                                       
                                                                                                                                
MR. LORENSEN turned to the other  change proposed in Section 2 of                                                               
the  bill, which  is to  increase the  limit on  the size  of the                                                               
basket clause from 5 percent to  15 percent.  He noted that there                                                               
had  already  been  discussion  on  the issue.    Section  1,  he                                                               
specified,   addresses   the   potential  restrictions   on   the                                                               
investment  ability   of  the   permanent  fund   in  alternative                                                               
investments.   Mr. Lorensen  paraphrased Section  1 of  the bill,                                                               
which read as follows:                                                                                                          
                                                                                                                                
     *Section 1. AS 37.13.120(e) is amended to read:                                                                          
          (e) The corporation may not borrow money or                                                                           
     guarantee from  principal of  the fund  the obligations                                                                    
     of others except as provided  in this subsection.  With                                                                    
     respect  to [REAL  PROPERTY] investments  of the  fund,                                                                    
     the  corporation may,  through an  entity in  which the                                                                    
     investment is  made, borrow money  if the  borrowing is                                                                    
     without recourse to the corporation and the fund.                                                                          
                                                                                                                                
MR.  LORENSEN explained  that the  idea is  as long  as the  fund                                                               
itself  is protected  by  some intervening  legal  entity, it  is                                                               
currently permissible "for real  estate only" to make investments                                                               
that  might involve  borrowing money  as part  of the  investment                                                               
strategy.  He  added, "And, of course, there  we're talking about                                                               
leverage, basically."  He continued as follows:                                                                                 
                                                                                                                                
     Now  that  we  look   at  various  available  forms  of                                                                    
     alternative investments,  we see that certain  kinds of                                                                    
     hedge  funds, and  potentially  also  certain kinds  of                                                                    
     private  equity  funds,  do  -   as  a  part  of  their                                                                    
     investment  strategy  -   invest  ...  through  limited                                                                    
     partnerships.  It's never the  [APFC] itself that would                                                                    
     be  the  investor, but  the  [APFC]  would purchase  an                                                                    
     interest in  a limited partnership, for  instance.  And                                                                    
     the  limited   partnerships,  again,  may   enter  into                                                                    
     borrowing  for  leverage purposes,  as  a  part of  the                                                                    
     investment strategy.   And so, here  the recommendation                                                                    
     is  simply  to  delete   the  ...  limitation  on  real                                                                    
     property  and  make  it  available   for  any  kind  of                                                                    
     investment of the  fund, so long as it  is done through                                                                    
     a  separate legal  entity and  so long  as there  is no                                                                    
     recourse back against the fund.                                                                                            
                                                                                                                                
Number 0356                                                                                                                     
                                                                                                                                
REPRESENTATIVE LYNN asked how 15  percent was chosen in Section 2                                                               
of the bill.                                                                                                                    
                                                                                                                                
MR. LORENSEN deferred to Mr. Storer.                                                                                            
                                                                                                                                
Number 0419                                                                                                                     
                                                                                                                                
MR. STORER replied that "we"  want as much investment flexibility                                                               
as  possible   and  the  constitution  [allows]   investments  as                                                               
designated  by law,  which would  be 15  percent.   He added,  "I                                                               
would note that if you looked  at other public funds, it's silent                                                               
by virtue of their rules.   Their rules would be 100 percent, not                                                               
15 percent.   So, 15 percent  still [is a] far  more conservative                                                               
constraint than others."                                                                                                        
                                                                                                                                
REPRESENTATIVE  LYNN asked  if the  15 percent  was "pushing  the                                                               
envelope" or whether it was "still plenty of room."                                                                             
                                                                                                                                
MR.  STORER  responded  that he  personally  doesn't  think  it's                                                               
pushing  the envelope  at all.   Conversely,  he opined  it's the                                                               
maximum that  "we" can  use and still  fall within  the direction                                                               
that  the constitution  allows.   He observed  that where  he has                                                               
seen  public funds  that  have no  constraints,  those funds  are                                                               
still  managed  in  well-diversified  portfolios.    He  said  he                                                               
doesn't see undue risk in being allowed that extra flexibility.                                                                 
                                                                                                                                
Number 0610                                                                                                                     
                                                                                                                                
REPRESENTATIVE  GRUENBERG  asked,  "What  do  you  mean  by  'not                                                               
withstanding these other subsections'?"                                                                                         
                                                                                                                                
Number 0652                                                                                                                     
                                                                                                                                
MR. LORENSEN replied as follows:                                                                                                
                                                                                                                                
       "Notwithstanding", in this context means that even                                                                       
      though these limitations exist, they do not apply to                                                                      
     the basket clause.                                                                                                         
                                                                                                                                
Number 0670                                                                                                                     
                                                                                                                                
REPRESENTATIVE  SEATON, indicating  [the language  to be  deleted                                                               
regarding] real estate in Section 1  of the bill, asked, "Is that                                                               
because they're real estate mortgages?"                                                                                         
                                                                                                                                
MR. LORENSEN  answered that he  thinks real estate  mortgages are                                                               
probably  the best  example of  how real  estate investments  are                                                               
made by  the permanent fund.   He  noted that the  permanent fund                                                               
actually  has "a  fairly low  percentage  of its  assets in  real                                                               
estate that is actually leveraged or  is borrowed."  He said some                                                               
of the  real estate properties  that are purchased by  the [APFC]                                                               
do have  a borrowing,  leverage, or  mortgage component  to them,                                                               
and "this  was inserted in  1999 to make  it clear that  that was                                                               
permissible, so  long as  it was done  through a  separate title-                                                               
holding entity."                                                                                                                
                                                                                                                                
Number 0750                                                                                                                     
                                                                                                                                
MR.  STORER added  that  the [APFC]  leveraged  its "direct  real                                                               
estate portfolio  approximately 15  percent; it's  an incremental                                                               
return."  He  stated that that's still  conservative by virtually                                                               
all standards.   For example,  he proffered that  publicly traded                                                               
real estate  investment trusts "tend  to run about  40-60 percent                                                               
leverage."  He  offered his understanding that  most public funds                                                               
actually use more  leverage - particularly in the  last few years                                                               
with the lower interest rate.                                                                                                   
                                                                                                                                
REPRESENTATIVE  SEATON asked,  "Is that,  basically, the  futures                                                               
market  that we're  talking about,  whereas real  estate is  more                                                               
mortgaged?"                                                                                                                     
                                                                                                                                
MR. LORENSEN answered no.  He continued as follows:                                                                             
                                                                                                                                
     Maybe the  best example has  nothing to do  with either                                                                    
     mortgages  or  real  estate,  but is  in  the  area  of                                                                    
     private equity,  where ... there are  leveraged buyouts                                                                    
     and that  sort of  investment activity  as part  of the                                                                    
     strategy.  And so, there  will be a borrowing component                                                                    
     in these private equity transactions,  which is - again                                                                    
     -  nothing to  do with  real estate,  specifically, but                                                                    
     just is  a way to  finance the  underlying transaction.                                                                    
     And so, to the extent  that a particular private equity                                                                    
     investment involves  a leverage  aspect, we  would like                                                                    
     to see  this language  in place to  make it  clear that                                                                    
     that's permissible.  Private  equity is now permissible                                                                    
     to the extent of the cap created by the basket clause.                                                                     
                                                                                                                                
Number 0903                                                                                                                     
                                                                                                                                
MR.  STORER added  that  "we" view  "this" as  a  cleanup to  the                                                               
original  intent of  the basket  clause.   He said  he hopes  the                                                               
committee agrees.                                                                                                               
                                                                                                                                
MR. LORENSEN concurred.                                                                                                         
                                                                                                                                
Number 0948                                                                                                                     
                                                                                                                                
CHAIR WEYHRAUCH announced that HB 466 was heard and held.                                                                       
                                                                                                                                

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