CS FOR HOUSE BILL NO. 156(FIN) "An Act relating to investments by the Alaska Permanent Fund Corporation; and providing for an effective date." This was the second hearing for this bill in the Senate Finance Committee. Co-Chair John Torgerson noted that there was some disagreement he had with the Alaska Permanent Fund Corporation dealing with the amount of money the corporation may borrow for real estate purposes. Under the current language, he explained, there is no limit. He told the Committee he had asked the corporation to propose an amount appropriate as a limit. Another concern of Co-Chair John Torgerson's related to Section 1 of the committee substitute ".the corporation may, either directly or through an entity in which the investment is made, borrow money." He proposed an amendment (Amendment #1) that deletes "either directly or" and said the corporation agreed to that change. Co-Chair John Torgerson referred to discussions about the management of real estate owned by the corporation. His proposed amendment adds a new subsection (C) that requires properties to be professionally managed. Co-Chair John Torgerson said he had also raised the issue of allowing the Legislative Budget and Audit Committee to review and approve real estate transactions rather than simply review and comment. However, he was assured during previous testimony that to make this change would give the legislature too large of a role in the investments of the fund. The final concern Co-Chair John Torgerson had with the bill related to the "five-percent float" and whether or not it should only exclude equities. Amendment #1: This amendment deletes, "either directly or" following "may" on page 1 line 7 of the committee substitute. The language then reads, "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." The amendment also adds a new subsection to Section 2 of the committee substitute that requires real estate management firms to be "professionally managed." Senator Sean Parnell moved for adoption. Senator Al Adams objected to hear the corporation's position on the amendment. JIM KELLY, Director of Communications, Alaska Permanent Fund Corporation, Department of Revenue testified that the amendment is acceptable to the corporation. He added that the first part of the amendment also addresses Co-Chair John Torgerson's concern with the borrowing limits. He offered Peter Naoroz to explain "non-recourse" and how the comfort level of the legislature can be maintained. Senator Al Adams withdrew his objection and without objection, Amendment #1 was ADOPTED. PETER NAOROZ, Manager of Real Estate Investments, Alaska Permanent Fund Corporation, Department of Revenue testified. He related how, two years ago, Mr. Kelly asked his office to review the existing statutes governing the corporation's flexibility, and come up with ways to increase the fund's return and to reduce risk. The resulting review, he told the Committee, showed opportunities to reduce operating and administrative costs. Peter Naoroz used as an example a real estate investment in Washington D.C. called Tyson's Corner; a mall that also includes an office building and surrounding land. He relayed that when the corporation went to refinance this property, the lender requested the corporation to address the statute that prohibits the corporation from borrowing money or to guarantee from the principal of the fund, the obligations of others. He said that it was thought that because the corporation held this investment in partnership with other investors, the state was in effect guaranteeing the other investors' obligations. As a result, he said, the corporation had to undergo a long process of forming a legal opinion on the interpretation of the statute and then convince the lender that the loan could be extended. He identified this situation as an area where changing the statute could show a cost saving to the State because of the delay in procuring the loan and the extra cost to obtain the legal opinion. He viewed this as a housekeeping matter. Peter Naoroz then explained how the fund is currently governed by the "Prudent Investor Standard", and because of this, the corporation looks at borrowing caps, loan-to- values, its obligations to those it borrows from as well as entities the corporation invests in. He said the corporation then compares these factors to the existing "rent roll" i.e. the existing assets of the entity, and tries to match them. The corporation also looks at several factors, he continued, for sources to address risk mitigation. In this manner the corporation is able to secure financing on portfolios of assets, according to Peter Naoroz. Peter Naoroz felt the request for a cap on a particular investment is appropriate and should be considered, However, he thought that when the corporation is attempting to secure financing on a pool of assets, the amount could potentially be much larger, he cautioned. He noted a number of office investments in Atlanta, Washington D.C., New Jersey and San Diego that are unleveraged, where the portfolio is approximately $400 million. He stressed that in today's marketplace, the finance on this pool is very attractive compared to any single asset financing opportunity. Therefore, he said, pooling of assets gives the corporation more flexibility and additional buying power, as well as reducing the costs and enhancing returns. Peter Naoroz stated that the corporation is currently addressing the loan cap internally on a case-by-case basis. He wanted the Committee to consider allowing this practice to continue. Jim Kelly asked Peter Naoroz to give an example of the Permanent Fund's risk to borrowing on a $400 million portfolio. Peter Naoroz replied that in this situation, the corporation would approach the marketplace and request the best terms to borrow approximately $200 million. He noted that the corporation's current portfolio of this amount has between 8 1/2 and 9-percent current return and has appreciated in value since its purchase. Using this data, he predicted that the returns on the investment would be deposited into the principal of the fund and could be borrowed against. He stated that the assets in the portfolio would be the only collateral, i.e. there would be no obligation on the part of the permanent fund and the $200 million that was borrowed would be a return of principal. This is a good thing he stressed, because the corporation can then redeploy its cash or principal. He told the Committee that when he is asked to rebalance the total portfolio, the ability to aggregate the assets and place financing on them is a good tool. Co-chair Torgerson asked for the definition of "real property" versus real estate. Jim Kelly answered "real property" is defined in statute as real estate that is improved by completed and substantially rented buildings. Co-chair Torgerson wanted a comparison to "raw land." Jim Kelly responded that raw land is not allowable for permanent fund investment purposes. However, he noted proposed language that will allow raw land in some cases, such as the property adjacent to Tyson's Corner. The committee substitute will allow the corporation to invest in vacant property that is adjacent to property in which the corporation already has a vested interest in, thus adding to the portfolio. He noted this is the only instance where investment in raw land is allowed. Peter Naoroz added to the definition of real property saying it is the corporation's direct investments, whether in entities or not. The other assets considered real estate, he continued, are mortgages-both whole loans and securities mortgages for commercial mortgage backed securities, and investments in the stock of real estate operating companies and real estate investment trusts. Co-Chair John Torgerson asked if the Prudent Investment Standards are in statute or simply practiced internally. Jim Kelly responded that the standards are contained in statue under AS 37.13.120. Co-Chair John Torgerson referred to page seven of the committee substitute discussing the "five-percent float." He said he would leave it up to the Committee to decide whether or not they wanted to limit the investments allowed using five-percent of the total assets of the fund. Jim Kelly recounted when the Permanent Fund was first established and that it was given a conservative "legal list" that did not include real estate or stocks. Over time, he said, the legislature has given the corporation authority to make those investments. He stated that it has become more apparent in the investment world that risk is not a matter of one individual asset, but rather how the total portfolio is constructed. In the rules set for pension funds, he noted, it was determined that risk should be determined on a total portfolio basis. Therefore he emphasized, very risky assets, such as international investments can be held if they are included in a portfolio that also contains domestic stock to result in a portfolio with less risk. This applies to alternative investments as well, and the corporation can purchase them under the basket clause, he said. Jim Kelly advised that to construct a portfolio that has good risk management, the mix of investments should have good correlation with each other. He pointed out that the basket clause would increase the flexibility of the corporation by allowing it to either increase the allocation at an asset allocation level or at a security level. He referred to a statement made by Michael O'Leary describing how fixed income investments have evolved over time. Jim Kelly spoke of investment opportunities that have arisen that were not on the "five percent float" list, such as asset-backed securities that are considered not risky. He speculated that similar opportunities would come up in the next several years and said that the fund's trustees want an opportunity to invest in both fixed-income and equities, knowing that equities return more money. This bill, he said, has a provision to allow those investments. Jim Kelly stated that with the asset allocation currently in statute, the fund's rate of return on investment would be 7.75 percent. If the asset allocation increases five- percent in equity, he predicted the fund would earn an expected medium return of 7.94 percent. If the corporation is allowed an asset allocation of fifty-eight percent in equities, which would be two percent below the maximum, he predicted a return of 8.13 percent rate of return. Changes to the asset allocation, he qualified, would reduce the amount of return. Co-Chair John Torgerson calculated a rate of return increase of 19 points for each five percent allocation to equities. Senator Gary Wilken understood that there were two separate issues addressed in the bill. The first, he surmised, was the original intent of the bill to expand the corporation's portfolio into different markets, such as real estate. The second issue dealt with the fifty-five percent provision, he noted. Therefore, he concluded that there were really two questions the Committee must decide on, either independently or together. He expressed he was comfortable supporting both items. He commented that he did not think the corporation request of five percent of the total assets to use in other investments was unreasonable. He believed that the fund managers would remain conservative in the investment strategy of the overall fund. Senator Loren Leman echoed Senator Gary Wilken's comments in support of the bill. Senator Gary Wilken offered a motion to report from Committee, SCS CS HB 156(FIN). Without objection, it was REPORTED from Committee with individual recommendations and the House fiscal note for the Department of Revenue, Revenue Operations in the amount of $3,154.6. The committee took a brief at ease.