Written By: Michael Walsh
Michael Walsh of T. Rowe Price ponders the question of whether allocations to private assets are subject to adequate levels of sound governance, and sets out the benefits of a pre-planned approach to the management of committed capital
Private assets investing is an increasing feature of institutional investor portfolios. It is no longer the preserve of “multi-generational” investors such as endowments, foundations and sovereign wealth funds. The reasons for the increased allocation are varied, but the primary motivation is the prospect of enhanced total return. More democratic access as smaller investors began to gain access via multi-fund providers has resulted in wider investor interest and an increase in demand. Defined benefit pension schemes are participating in this trend with vigour.
UK pension funds have made much progress over the last couple of decades on the governance of all aspects of managing their asset pool; does anyone remember the Myners Principles set out back in 2001? This includes steps taken to ensure the sound management of portfolio switches within or between listed asset classes – for example equities to equities or equities to fixed income. The increased scrutiny in this area has resulted in more efficient management of asset and manager transitions to ensure that transaction and market impact costs are minimised and risks, particularly out of market risk, are properly managed.
This article asks if the allocations to private assets are enjoying the same level of sound governance and whether there is adequate attention being paid to the many frictional costs and risks of switching from generally listed legacy assets to the ultimate destination in private markets. Given that the capital commitments to private assets are contractual but are likely to being drawn down and invested over a period of years, we posit that this issue is of increasing relevance. Further we understand that the increased demand for private market assets is resulting in delays to the expected commitment timetables; this amplifies the challenge of the management of the “dry powder” of committed but yet to be deployed capital.
So, what are the issues that require attention?
In our view, the governance and operating challenges are:
- In liquid markets a manager switch or asset class change by a pension fund takes place at the effective date decided by the trustees or board, with the performance measurement clock starting from the effective date. This approach is not possible in private markets as it takes a number of years to fully deploy the committed capital. So where should the “money waiting” be invested whilst waiting deployment? Should it remain invested in the legacy asset, be invested in cash or something else, such as a viable proxy for the destination asset?
- What are appropriate expectations for the return and the tolerance to risk of the “money waiting”? The modelling that will have resulted in the increased allocation to private markets will have assumed an “immediate” switch from the legacy to the destination private markets asset. The longer it takes to deploy the capital the further away the outcomes will be from the modelling results that drove the allocation decision. Ideally the money waiting should be generating a good return. But the commitment is an absolute amount and the notice period can be a matter of a week, so what are appropriate volatility and liquidity budgets?
- The success of a private markets programme is currently judged largely on the money-weighted returns delivered by private assets managers in the form of internal rate of return (IRR). However, this calculation focuses only on the returns generated on capital once it has been deployed – it does not take into account the return on the capital whilst waiting to be invested. This leaves the return generated and risks incurred by this “money waiting” to be accounted for elsewhere within the investor’s portfolio as an unintended consequence. This raises a fundamental governance question – should the returns, risks and real opportunity costs of the “money waiting” be included in measuring the success of the fund, or indeed the overall programme? The key governance question is “what is the correct measure of success for the private assets programme?” We believe that the outcomes of the complete investment journey across both money waiting and money invested should be considered alongside those of money actually invested in private assets.
- Once the programme is mature, distributions from the programme are likely to occur at the same time as commitments to new programmes take place. Are cash flow management processes adequate to capture the additional complexity of managing this process? Should the cash-flow process include cash flows across the entirety of a fund such as net contributions, dividends and coupons?
These challenges are not new. A number of different approaches are adopted. Some are ad-hoc and pragmatic, some more structured. These include remaining invested in the legacy asset whilst waiting for the capital calls, while for those with liability or solvency considerations “over-hedging” may be of appeal as the capital is thus providing some portfolio utility in that it reduces overall risk relative to liabilities. Still others will invest in some “mid-risk” asset such as a multi-asset portfolio.
What is becoming obvious is that there is no “best practice”; research has indicated that this is especially true of defined benefit pension funds. This is not surprising nor a criticism; some are just starting their journey and are focused on front-office issues such as identifying and allocating to private assets funds.
We believe that this issue is ripe for discussion and that a clearly set out and pre-planned approach to managing committed capital is appropriate. This is an increasing relevance as private assets now play a greater role in portfolios and the resulting cash flows become more complex as a result. Such an approach will strengthen the governance, reduce operational risks and costs and optimise cash flow management.
Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
Issued and approved by T. Rowe Price International Ltd, 60 Queen Victoria Street, London, EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority.
© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectivelyand/ or apart, trademarks of T. Rowe Price Group, Inc.