Seeing the wood through the trees

Institutional investors are expected to commit almost $4 billion of equity to the timberland asset class in 2010. From rarely featuring in investment portfolios in years gone by, timberland is becoming an increasingly attractive sector as LPs seek to diversify and green their investments.

Reflecting on the history of timberland investment, it could be argued that the early years of the 21st century were when the asset class truly emerged as a mature and attractive asset class.

During this period, capital poured into timberland from around the world, as investors increasingly recognised its attractive return history and its unique diversification and inflation-hedging attributes. For years, no more than three to four million acres of US timberland changed hands each year, but by 2006 that figure had grown to almost eight million acres. The global market capitalisation for pure timberland investments grew from approximately $13 billion in 2003 to more than $40 billion in just five years, according to forest products data provider RISI.

However, the global financial turmoil, and the recession that followed, quickly changed the timberland investment game. By 2009, total purchases of US timberland fell to 1.55 million acres, an 80 percent drop from 2006. This dearth of activity was not limited to the US market; global timberland markets also experienced contracted capital flows. As a result, timberland investment managers (TIMOs) faced strong headwinds in their efforts to attract new clients and raise new funds domestically and internationally.

 Yet since 2009, there has been a significant change in investors’ outlook on this asset class as liquidity has returned to investors’ balance sheets and LPs increasingly position themselves to operate with a longer-term perspective. Perhaps most importantly though, the investment community has also gradually realised that a repricing of timberland assets has already largely taken place.

Timberland’s renewed attractiveness was confirmed by a new wave of capital commitments in early 2010. It was clear that the capital drought of 2009 was over when, in April 2010, the Massachusetts Pension Reserves Investment Management Board (MassPRIM) announced its intent to invest an additional $500 million in timberland. A long-time investor in the asset class, MassPRIM had liquidated a significant portion of its portfolio in 2007.

As the fundraising environment improved, timberland investment managers responded with new investment vehicles. By mid-2010, some accounts indicated there were more than 20 new TIMO fund offerings available in the US, with more targeted for European markets. Publicly announced or confirmed fund commitments totalled $2 billion over that same period and could reach $3 billion or more for the full year.

While this level of interest pales in comparison to the commitments seen during the height of the timberland cycle in the mid-2000s, when more than $7 billion of capital poured into the asset class annually, it represents a measured return by investors, which could be a prelude to healthier markets in the future.

Changing faces

But who, exactly, is investing in timberland? As a long-duration asset, timberland attracts those with patient capital: institutional investors, such as pension funds, endowments, foundations and insurance companies. According to a survey by the investment consulting firm Timberlink, in terms of market value, three-quarters of the private forest investments managed by TIMOs are owned by institutional investors.

Regardless of the type of investor, there is a growing bifurcation of investment style between experienced timberland investors and those who are new to the asset class. In the case of the former, they are more likely to have made investments in established markets, such as the US, Canada, New Zealand, Australia, Brazil and Uruguay. Having grown comfortable with the characteristics and performance of the asset class, they are at the vanguard of efforts to expand the reach of the asset class in places such as sub-Saharan Africa, China, Central Europe and Central America.

In contrast to experienced investors, new timberland investors are more likely to commit capital to core investment programmes that are geographically oriented to the “A-list” markets.

The global outlook for the capitalisation of timberland investment, therefore, is varied. In the US, the upper end of the institutional market has had access and exposure to the asset class through TIMO-sponsored investment programmes for nearly three decades. Consequently, future growth in terms of committed dollars is likely to be steady and measured rather than exponential, as was the case in the early- to mid-2000s.

Yet there may be some churn in investors and shifts in allocation levels. Among both prospective and committed North American timberland investors, Harvard Management Company, which runs the Harvard University endowment, is considered a thought leader. It has the scale and the in-house expertise to execute a deliberate and opportunistic timberland investment strategy.

However, since the financial collapse of 2008, it has kept a low profile within the asset class. Meanwhile, the spotlight has shifted to other large institutional investors that have initiated significant levels of participation, including the Alaska Retirement Management Board and MassPRIM.

The situation among Western European investors is quite different. Most European institutions have much shorter histories within the timberland investment space and the number of participants is limited. However, this has not dampened enthusiasm for the asset class. In fact, European investors, including plan sponsors, insurers and financial intermediaries, may currently be more enthused about timberland than their peers in North America.  

European investors have begun to emphasise the importance of diversification and, as a result, participation in alternative asset classes is rising considerably. In Western Europe, interest in the timberland asset class is partly correlated to the degree to which a particular country has active markets for timber and a long established history of private forest ownership and management. Investors based in Germany, Austria and Scandinavia, for instance, tend to be more receptive to participating in timberland investment opportunities than those based in countries such as Italy or Greece, where they may lack an informed perspective on the mechanics of the asset class. Investors from these countries generally employ due diligence processes that are longer and more involved than those of their peers based in areas where the forest products industry is a more significant part of the economy.

Outside North America and Western Europe, the universe of current and prospective timberland investors is small at present. While interest is growing in South America, Asia and the Middle East, investors in these regions tend to be several years behind the North Americans and Europeans in actively participating in timberland investment programmes. In the case of investors based in Oceania, two sovereign wealth funds, the Australian Future Fund and the New Zealand Superannuation Fund, have made both domestic and North American forestry investments. Aside from these, however, there has been little institutional capital flowing into the asset class from the region.

Wooden allocations

When reaching a decision to allocate capital to the timberland asset class, many investors target a total commitment of 1 percent to 5 percent of their total portfolio, with most investing between 2 percent and 4 percent. Most investors usually do not exceed those levels because they recognise that the timberland investment universe is measurably smaller in scale than other leading asset classes: compare global hedge fund assets, for example, which exceeded $1.6 trillion in the first quarter of 2010, according to Hedge Fund Research, with invested timberland assets, which had a total market capitalisation of just $40 billion to $60 billion.

 Diversification to manage risk is another important consideration for timberland investors. They can achieve this by investing in a mix of both natural forests and intensively managed plantations. Other variables can also improve diversification, including climate, soil type, species and end-use markets. Tree species, their ages and the types of log and forest products that will be harvested for income can all have an impact on the volatility of a timberland portfolio.

These diversification considerations mean that investors with smaller amounts of capital to commit to the asset class may wish to consider participating in TIMO-sponsored commingled funds or through a fund of funds investment structure. Both vehicles typically have lower levels of minimum commitment than straightforward direct funds and they offer investors the ability to pool their capital with others, allowing them to achieve much broader diversification than would otherwise be possible. For separately managed accounts, most TIMOs encourage minimum commitments in the $100 million to $200 million range. In short, a dedicated portfolio of this size provides the flexibility to execute an investment strategy that ensures broad diversification in accordance with an investor’s unique risk and return objectives.

In addition to working with TIMOs, which make and manage timberland investments strictly in a private equity context, investors also have the option to participate in the asset class through a small universe of publicly traded investment vehicles. These vehicles are particularly attractive to investors who favour high levels of liquidity, and they are typically structured as real estate investment trusts (REITs), unit investment trusts or exchange-traded funds (ETFs).

Future outlook

New capital commitments for timberland are expected to exceed $3 billion or $4 billion in 2010, with equal or higher levels anticipated in the coming years. While this is well below the peak of $7 billion seen during the last market cycle, it signals that the capital drought the market experienced in 2009 is over.

Institutional investors continue to be the major players in the global timberland investment markets. While much of the capital flowing into the asset class originates from seasoned investors based in North America, European investors are becoming increasingly active. Investors based in Latin America and Oceania are showing growing interest as well, but their capital is being placed primarily in their own regions.

As more capital enters the timberland investment space, investors have more choices for structuring their participation using both private equity and publicly traded investment vehicles. TIMOs and other managers of forest investments are responding by differentiating themselves from the growing universe of competitors. All these factors are producing benefits for investors by providing improved liquidity and a wider range of options for both investment products and managers. This is helping investors structure their involvement in the asset class in ways that meet their investment objectives, such as total return, risk tolerance, cash flow, investment horizon, social responsibility and correlation to other assets in their portfolio.

Extract taken from The Definitive Guide to Investing in Timberland, published by PEI Media in August 2010.