Alternative investments: A core asset class

Read the article and learn about:

• Alternative assets’ growing importance in diversified portfolios
• Expectations for the future direction of alternative assets in 2018 and beyond
• Alternative assets industry trends – the potential impact on investors, allocators, and the operating platform

 

Amy Bensted
Head of Hedge Fund Products, Preqin

About the author

Amy Bensted joined Preqin in 2006. Today, she manages Preqin’s hedge fund services. Amy is a regular contributor of articles in the financial press, and her research has featured in the Financial Times and the Wall Street Journal as well as in specialist hedge fund media. As well as leading Preqin’s hedge fund suite of products, Amy sits on Preqin’s 11-person management team, helping it to form and meet strategic commercial goals. Amy graduated from Imperial College London in 2003 after gaining a BSc. in Biology and a MSc. in Applied Biological Sciences.

The term ‘alternative investments’ is increasingly something of a misnomer. Four out of five institutional investors globally have some exposure to private capital or hedge funds, and more than half invest in three or more different alternative asset classes. This is a stark shift from 20 years ago, when a considered approach to alternative assets was part of what set investors like the Yale University Endowment apart. Twenty years may be a long time in some asset classes, but it represents just two life-cycles for the typical private equity vehicle – a sign of how quickly this sea-change has occurred. In this article, we take a closer look at the future challenges and opportunities facing investment managers with the growing importance of alternatives assets.

The attraction and complexity of alternative assets

The appeal of alternative assets is slightly different for each investor, but centers around three core advantages of these asset classes. First, they offer portfolio diversification at a time when most traditional asset classes are seeing their long-term trends increasingly converge. Second, many alternative assets investments offer a significant hedge against inflation, particularly among real assets funds. Third, alternative assets offer a strong profile of risk-adjusted returns, even as they are still considered relatively high-risk assets.

It is perhaps this third advantage which has mostly driven investors to engage with the asset class over the past decade. In the wake of the 2008 Global Financial Crisis (GFC) and the ensuing prolonged period of depressed interest rates, institutional investors found that some asset classes such as fixed income investments were not offering them the returns they had done previously. At the same time, increasing liabilities – particularly for pension funds and insurance companies – meant that the gap between required and actual rates of return rose. Alternative assets, meanwhile, were not as severely affected by the GFC as some other asset classes, in part because their illiquid and long-term nature insulated them from sharp shifts in investor sentiment. As such, the relative rate of return offered by alternative investments compared to other asset classes has been attractive to many investors, and allocations to the alternatives industry have surged in the proceeding period.

Beyond pure engagement, we have also seen the extent and complexity of investor allocations to alternative assets increase in recent years. At the start of 2018, 52% of investors are allocating to three or more alternative asset classes. Among these, real estate, private equity, and hedge funds are most commonly sought after, with 59%, 58%, and 50% of institutions respectively committing to these sectors. Even the least sought-after asset class, infrastructure, has more than a third (36%) of institutions globally allocating to it.

Allocations can be significant too: around half of investors active in private equity, hedge funds, or real estate allocate 10% or more of their total assets to these sectors, while a similar proportion allocate at least 5% of assets to private debt, infrastructure, or natural resources. And increasingly, we are seeing investors create specific allocations for each asset class in which they are active, rather than using a general alternatives allocation. This shows the extent to which alternative assets have become a mainstay of investors’ portfolios.

Operational challenges and support

This provides investors with more options to fulfil their long-term investment goals, but brings with it increasing challenges of portfolio monitoring and appraisal. Alternative assets’ illiquid and long-term nature makes it difficult to directly compare the risks and performance of these investments with traditional asset classes. Today, many investors must use hybrid monitoring platforms which rely on a large degree of manual labor and which cannot provide timely analysis. Increasingly, sophisticated multi-asset class solutions for investors are coming onto the market, but most require investors to convince fund managers of the necessity of adopting them – not always a straightforward task. However, with competition increasing, investment managers must strongly consider if they can afford not to transform their operating models and adopt multi-asset class solutions that can handle alternative investments on the same platform as traditional assets.

The future of alternatives

Given the broad and specialized nature of today’s alternatives industry, it is difficult to draw many overarching conclusions as to the direction the industry may take in the next few years. However, there are some trends apparent, which are likely to become important themes in the sector going forward.

More fragmentation

Chief among them is the trend towards specialization. This reflects not just the proliferation of new fund and deal structures available to investors, but that funds nominally operating within the same industry or asset class may in fact have very different profiles. For instance, much has been said of the SoftBank Vision Fund and its impact on the venture capital industry. But the average venture capital fund closed in 2017 raised just $128mn, 0.1% of the Vision Fund’s most recent reported size. Comparisons cannot meaningfully be drawn between the largest and smallest funds within a sector, even when their structure, region, and industry focus are the same.

Increasingly, we are seeing the largest private capital and hedge funds compete against large corporate and sovereign investors to acquire sizeable companies, often as take-private deals. At this end of the market, we are seeing the biggest buyout funds balloon in size and adopt longer lifespans in order to align and compete with retail investors with deep pockets and long investment horizons. At the other end of the scale, we are seeing smaller managers compete in an ever-more-crowded marketplace to attract investor capital. As a result, fund managers are increasingly looking to stand out by specializing in specific industries or instruments, or by making their fees and terms more accommodating for potential investors.

This only increases the challenges of effectively monitoring and managing a complex investment portfolio. However, it also offers a fillip to those seeking solutions – fund managers seeking to accommodate investors are more likely to be open to instituting consolidated multi-asset class operating models and reporting platforms that suit investors’ needs.

Investors dictate terms

As they compete for investor capital, smaller firms, in particular, have been adjusting their fees and terms to cater to investor demands. In simplest terms, this is apparent in changing fee rates and structures. On the hedge fund side, the average management and performance fees for funds incepted in 2017 were 1.52% and 19.37% respectively, a far cry from the traditional ‘2 & 20’ model. However, although the majority of investors said they thought terms had moved more in their own favor through 2017, 41% said they were seeking changes in the fees they pay to funds in their portfolios, and 57% said they would like to see both management and performance fees fall further in 2018. This indicates their intention to keep pushing fund managers on this issue, and we could see the downward trend in average fees continue.

On the private capital side, more focus is being put on alternative fund structures and rights open to investors. Sixty-four percent of fund managers now offer co-investment rights to their investors, and more than a third will look to increase this provision over the next 12 months. At the same time, separate accounts and joint ventures are becoming more prevalent, with fund managers keen to offer investors more ways to access deal making opportunities. This reflects the increased demand from investors for customization as they become more involved in alternative assets. With much lower liquidity than traditional asset classes, investors are seeking to find opportunities that suit them for 10 years or more at a time.

Impact of valuations

One thing that was striking from Preqin’s latest year-end surveys of fund managers and investors was that significant proportions of both groups in each asset class cited asset valuations as a key concern in the months ahead. This has been a notable concern in the private equity industry for some time, but its prevalence in asset classes as diverse as private debt and infrastructure indicate that it is a nigh-on universal problem. With competition so fierce, valuations for portfolio companies are rising quickly and show no signs of abating. This is evident in the accelerating number of venture capital-backed companies gaining ‘unicorn’ status in recent years, as well as in the number of public-to-private buyout deals and sales from one alternatives fund to another. In debt markets, 45% of investors think assets are overvalued and that a correction is likely, while in infrastructure we are seeing funds move up the risk/return scale in search of returns.

The impact for investors

Regardless of current concerns, alternative assets have gained a place in investors’ portfolios over the past decade that they are unlikely to give up. The GFC drove many investors to look more closely at the industry, and long-term returns in most asset classes have been a powerful enticement. Beyond that, alternative assets offer almost unrivalled advantages for portfolio diversification and inflation hedging, both of which are valuable to investors concerned about futureproofing their portfolios against market movements.

But for investors, the process of choosing the right investments has never been so daunting: there are more funds than ever before seeking their attention, and the average investor receives a dozen or more pitches from fund managers every month. At the same time, the fragmentation of the alternatives market is a double-edged sword – it offers a greater chance for investors to find opportunities which fit their needs exactly, but it requires more effort to establish investment criteria and find funds meeting them.

Demands on the future operating model

On this front, transparency and equivalency are powerful tools for investors. Despite holding almost $8tn in assets as of the middle of 2017, the alternative assets market remains far more opaque than more traditional asset classes. For investment managers, making accurate, reliable, and convertible information available to investors is paramount to the continued success of the industry, and requires a degree of transparency that the industry has traditionally not met.

However, with competition so fierce, and with the balance of power shifting towards investors for the time being, we may yet see the industry take greater strides in this direction in order to meet investors’ needs. Going forward, ensuring sufficient support for alternative investments and having the right operating model setup will be crucial for investment managers to succeed with this increasingly popular asset class.