The rise of private markets, how and why asset management is changing

Rudigor Kleyn, managing director, Corporate and Institutional at Ashburton Investments.

It is incredible how the vocabulary of the asset management industry has changed in the last few years. “Alternatives” has become an almost overused word for an asset class that is an increasingly prominent and often critical component of the portfolios of many sophisticated investors. There is also no agreement on what it fully includes. Everything from some structured products, hedge funds to leveraged private equity buyouts has found space within this word. Similarly, private equity is no longer always private nor necessarily equity. And then there are ambiguous terms, such as “real assets”, which now encompass everything from affordable housing, toll roads, renewable energy projects to commercial real estate.

For us “Private Markets” is an umbrella term encapsulating a variety of illiquid (or semi illiquid) investments that cannot (not necessarily) be sold at short notice and require longer investment horizons and patient capital. It includes, for example, private equity buyouts, private equity secondary investments, direct investments in infrastructure and real estate, unlisted corporate loans and mezzanine financing.

Although the narrative in financial markets is overwhelmingly dominated by events taking place on public markets, a large part of the global economy is funded and controlled privately. With asset yields low or negative in the years following the global financial crisis, the private sphere has become increasingly important for investors searching for diversification benefits, higher investment returns and the potential security that comes with recourse to the underlying assets. Long-term investors are challenged when it comes to their return requirements through traditional investment strategies and are now opting more and more to allocate a portion of their portfolio to private markets.

As seen in the chart below, global institutional investors have been raising allocations to private markets and there is an increasing level of dry powder for private market assets. We are also seeing South African institutional investors increasing their allocation to these asset classes but there is still a long way to go before they catch up with their international peers. In our opinion, private market assets have plenty to offer patient investors who are willing and able to find and unlock returns in less exploited areas. Adding private market assets to a portfolio can also help broaden the opportunity set, increase return potential and enhance portfolio diversification, while in some cases adding a dose of inflation protection (for example renewable energy debt that is linked to the consumer price index).

Source: Preqin, October 2017

We also believe that the return and diversification benefits of investing in private markets are best captured through a “buy and hold” approach. Investors should therefore be willing to deal with illiquidity but also some complexity. That being said, one can compile a portfolio of private market assets that has a much improved liquidity profile trumping the traditional notion that an investor commits to a fund and sees a return on their capital in 8-10 years’ time. An investor’s return therefore does not have to be Internal rate of return (IRR) based, which is made up of realised and unrealised returns, but can also consist of regular cash flows such as interest payments.

Do private market assets provide superior returns?

Some say that private market assets provide superior returns. We, however, feel that it is better viewed as offering good risk-adjusted returns. The reason for this is that the definition of superior returns is changing. It is no longer a target IRR of 20-25% for private equity. Rather, it is:

• differentiation of investment strategy;
• the consistency with what was promised to investors;
• absence (or lowering) of volatility in returns;
• repeatability of core investment selection, execution, and value creation processes; and
• a high-quality, seasoned team with a culture of openness, debate, and dynamism

Catering for various investor return/risk objectives

In the past, many companies had to go public or tap public debt markets to access financing after raising initial seed capital. But private investment funds now serve as a meaningful source of capital. As a result, many companies are choosing to stay private for longer. Some are leaders in their industry, with strong cash flows and limited capex requirements. And a secondary market is growing, whereby eligible private investors can sell their ownership stakes to others. South Africa has a small but vibrantly growing secondary market, which will look very different in years to come.

In our opinion, private market assets are suitable for a range of investors needs which is evident from the diagram below. It could be that an investor is looking for a low risk, income producing solution. For example, investment-grade loan assets could be suitable for investors seeking predictable cash flows, perhaps as part of a cash flow driven investment approach. The inflation-linked income streams offered by infrastructure assets such as renewable energy CPI-linked debt is also a sound example.

Private equity is an asset class that also has the potential to offer higher, growth asset type returns. The problem is, however, that one needs a well-diversified pool of private equity assets as to avoid concentration risk in one’s portfolio. Diversification should not only be thought of as having more assets in a portfolio, but also increasing sector and vintage diversification. Diversification is critical as it ensures that the true non-correlation benefits of private market assets come to the fore.

Source: Ashburton Investments

How difficult is it to access assets in the private market space?

It is important to have access to a good origination platform that provides sustainable origination of quality assets in a timely manner as private market assets are not listed and hence not necessarily readily available. The quality of one’s origination platform is therefore incredibly important as you will otherwise struggle to deliver consistent returns if you are forced to remain in cash while looking for deployment opportunities.

In credit markets, post-crisis bank regulation has caused a shift in the investor profile. New capital rules are forcing global banks to deleverage, making it costlier to hold illiquid or longer dated paper or to advance “middle market” type loans. This is also true for SA, and it is for this reason that unlisted loans, be it sub-investment grade or mezzanine loans, are now more accessible to a broader investment audience than before. These assets offer a yield-pick up from investment grade loans, and if well-structured, as part of a diversified portfolio, could offer an enhanced income stream to investors. One cannot overstate the importance of a well-diversified pool of high yielding loans as credit is an asymmetric asset class with limited upside but with a lot of downside. This also speaks to the earlier point of having access to sustainable origination sources as this helps one overcome portfolio concentration over the long run.

How illiquid are private market assets really?

The perception, especially in SA, is that all private markets are totally illiquid. Maybe put differently there is a perception, especially in SA, that listed instruments are all highly liquid. This is not always the case especially say in the corporate bond space if you want to sell a big block of bonds as it might take a while to sell your entire position. The reality is that private market assets are less liquid than listed assets but liquidity does depend on what underlying asset class one refers to, and how the portfolio is structured. If one uses an example of a portfolio of unlisted corporate loans which are well diversified and where maturities are staggered, then an investor could receive regular coupon payments, even monthly payments. As the portfolio of loans amortises or matures, these cash flows could either be returned to the investor or be reinvested, by following the investor’s instruction. A solution can therefore be crafted to meet the client’s known liability profile and which will suit their needs.

Private equity is also an example where the perception is that one needs to wait 10 years to see a return on investment. Even in a traditional private equity fund this is not entirely true as it all depends on how quickly investments are made, how these companies grow in value and develop and how quickly the manager can list or sell the underlying company to say a trade buyer. With solutionist thinking, one can compile a portfolio of private equity investments that spans over a number of industries and investment vintages. The latter has the added benefit of providing exits that are staggered even across the early years of the private equity fund which results in realisations not all being back ended. The investor would therefore benefit from receiving realised gains sooner.

How complex are private market investments?

Occasionally, we also get confronted with the notion that all private market fund investments are extremely complex. This is probably an accurate statement if one’s portfolio to-date has consisted of listed equities, cash and bonds. Private market funds are normally structured as en commandite partnerships or as notes (often these notes are listed), so they might be perceived as complex to the uninitiated. We would, however, say that the actual documentation for say a private equity or mezzanine fund has become very standardised over the last decade. Another positive is that all partners in such a partnership benefit from the legal vetting that they collectively provide to the manager. This is especially advantageous if one is a smaller or later stage investor, as you will benefit from the work that other investors have already performed on the fund’s legal documentation.

Conclusion

Private markets offer diverse opportunities for return seekers, where the trade-off for greater complexity and illiquidity can be reflected in the bottom line. Basel regulation has been a game-changer, and thus a range of investment opportunities is now available as banks continue to reshape their balance sheets and rein in the scope of their activities.

In our opinion, private market assets have an incredibly important role to play in an institutional or high net worth investor’s portfolio as they offer access to different sources of return, they are highly uncorrelated to public markets and offer a range of risk adjusted returns that caters for both growth and income type investors. A number of the underlying asset classes provide security and regular cash flows as not all investors have the luxury of waiting for capital gains to accrete. Inflation linked assets also have tremendous benefits for any portfolio that has long term liabilities to meet.