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Are private markets net good for asset managers & investors?

12 March 2021 Gareth Stokes

The global asset management industry appears to have shifted focus from the active versus passive debate to an all-consuming concern with achieving environmental, social and governance (ESG), impact and sustainable investing outcomes. It is not a hard sell to get investors on board the ESG train; but one has to wonder whether the win-win is stacked in the asset managers’ or investors’ favour.

South African retirement savers will remember a previous step-change in the savings industry in a negative light. The move from a defined benefits (DB) to defined contribution (DC) pension savings environment, driven by asset managers, retirement fund administrators and their corporate clients, left many individual savers worse off. Financial institutions made truck loads in fees while employer firms celebrated the hand-off of most of their pension fund liabilities. 

Fee transparency in the unlisted investment world

The emergence of ESG as an investment theme coincides with the apparent victory of passive over active investing. Asset managers watched for years as more and more of investors’ capital found its way to cost-efficient passive structures. They have since taken two steps to address the inevitable decline in fee revenue that these structures introduce. First, asset managers have entered the world of so-called active passive investing, creating complex layered financial instruments to overcome the simplicity and transparency inherent in traditional index trackers. Second, asset managers started scanning the market for opportunities to create additional revenue streams from managing investors’ capital. They are now leveraging the ESG theme to channel investors’ capital into unlisted investments that potentially offer less transparency around fees. 

A quick Google search reveals that most fee concerns raised about ESG investments centres on the premium charged by asset managers to ‘find’ suitable ESG investments. “Although the myth that investing sustainably sacrifices performance is beginning to melt away amongst retail investors, many might start to wonder whether investing sustainably costs more in terms of fees or management fees,” writes Ian Tam of Morningstar, in an article published November 2020. His assessment of sustainable versus traditional funds in the Canadian market showed an 11 basis point premium for sustainable asset allocation and fixed income funds and a lower median net expense ratio for sustainable equity funds. This is good news for investors who have shown a growing unwillingness to pay extra fees for ESG fund management. A 2020 Product Trends survey by Alpha FMC showed that 70% of managers feel that ESG and responsible investing products should not command higher fees. 

Asset managers forecast revenue surge

Our fee concern is not with ESG funds made up of a basket of shares that meet an asset manager’s ESG selection criteria; but rather with the entrance by asset managers into private markets to find ESG opportunities. In such cases, investors’ capital is diverted from a regulated equity exchange into complex unlisted projects using a range of structures such as alternative investments, hedge funds, private equity and venture capital. These structures offer plenty of additional fee extraction opportunities through fees on structured financing, management input and others. Need proof? A recent media release by Alexander Forbes states: “Research suggests that global revenue projections of asset managers will rise significantly in the next five years, with specialties and alternatives exceeding 50% of the market”. 

Alexander Forbes has been vocal that impact investment outcomes are best achieved in private market structures.  Premal Ranchod, Head of ESG at Alexander Forbes Investments, observed during a Hot Topics 2021 webinar, held 10 March 2021, that “private equity is well positioned to capture secular or non-economically sensitive trends before they are accessible through listed stock markets”. Private equity is therefore seen as a perfect access point for asset managers to achieve ESG and impact-related objectives in addition to their financial objectives. The diversified financial services provider also upped the ante for fiduciaries in the local retirement fund industry, saying that a failure to consider ESG amounts to a failure of fiduciary duties. Ranchod said that fiduciaries would have to balance value, as informed by traditional risk and return metrics, against purpose, by determining whether pension funds will cater for the world their members retire into. 

Ignoring tough questions for the better good

The media, often informed by asset manager conferences and presentations, has bought the impact investment theme hook, line and sinker. We broadcast asset managers’ promises that investors need not sacrifice return to enter the impact investing world. We also publish the figures shared by global asset manager associations re the swelling demand for ESG funds in support of the trend. Our mistake is to allow the net good to society from impact and sustainable investing to prevent us from asking the hard questions about asset management fees. Imagine, for example, if we bothered to question the transaction fees charged in the world of structured financing? 

The fleecing of investors or other stakeholders often emerges long after the deal is complete. Take the recent headline from Businessinsider.co.za which reads ‘Nedbank took R191 million to be a ‘cardboard cut-out’ and paid eye-watering commissions’. Granted, this deal occurred in the banking rather than asset management world, but it illustrates how quickly things can go wrong when billions of rand are involved. In this example excessive fees were charged on setting up fairly standard interest rate swaps. (An interest rate swap allows a company to exchange a floating interest rate on a loan for a fixed cost, which is more expensive, but provides protection against an increase in interest rates). Nedbank has found no indication of wrongdoing: “Our board and management commissioned detailed internal and independent external reviews of the transactions and these reviews found no evidence of any collusion or corruption by Nedbank”. 

The critical question should be whether any institution should be paying such huge amounts to structure these type of deals. There is no logic in paying hundreds of millions of rand just because the financial instrument is valued in the billions. We should also be asking whether a fixed fee on assets under management is fair, when a 0.5% fee would yield R5 million or R50 million with the only difference being the value of the underlying. But that is a topic for another day. 

A way for government to hand-off infrastructure liability

Regulators are already queuing up to get involved in the emerging ESG investing world. “National Treasury’s draft technical paper on sustainable finance taxonomy was released in 2020, with an update to include social outcomes to arrive in the middle of 2021,” says Ranchod. And the Code for Responsible Investment Practices in South Africa (CRISA) has already begun a review process to ensure relevance against the current theme. It will take years before we can weigh up the pros and cons of the move to impact and sustainable investing. Guaranteed, it will be net good for broader society. Less clear is whether individual investors drawn into the theme will benefit. A future assessment might reveal that many individual investors are worse off. Financial institutions will have made truck loads in fees and government will be celebrating the hand-off of much of its infrastructure liability to the man in the street.

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