The ever-evolving cycle of alternative investments

Written By: Venilia Batista Amorim LAPF Investments

Venilia Batista Amorim examines how alternative investments have developed to become a key component of asset allocation

Although the rules of the Local Government Pension Scheme (LGPS) are set nationally, it is administered at local level by administering authorities, whose responsibilities include managing fund investments within a statutory framework. As with the trustees of pension funds in the private sector, the primary responsibilities of administering local authorities are to deliver the returns needed to pay scheme members’ pensions, and to protect local taxpayers and employers from high pension costs.

In recent years, the Ministry for Communities and Local Government (MCLG) has been looking at several different ways to achieve economies of scale in LGPS funds, with the primary aim of improving returns and reducing deficits but also to enable greater capacity for investment in infrastructure. However, the UK pension system is under severe strain, as the population ages and fewer workers support more retirees. Furthermore, there are reasons to believe that pension funds may soon be faced with lower returns from the traditional assets in which they invest.

There is, therefore a real worry that the UK will in the future be left with the choice of smaller pensions, later pensions or higher pension contributions. There is a way to at least partially mitigate this challenge: encouraging pension schemes to move towards alternative assets and strategies to better diversify their investments and improve returns. Alternative investments may also offer an important means by which UK pension schemes can protect the savings of their beneficiaries from the risks of today’s world. By offering a chance to diversify away from equities and bonds, alternative investments offer the possibility of accessing different types of cash flows, profiting from their typically long investment horizons, and generating investment returns for pension beneficiaries that are less vulnerable to market volatility.

Alternative assets usually encompass the asset classes private equity, hedge funds and real estate. They also frequently include investments in real assets, infrastructure and private debt. “The key feature that these investments share is a risk-return profile that differs from classic investment forms, such as equities and bonds,” said Sofia Harrschar, head of product solutions at Universal-Investment. “The reasons for this include, for example, lower liquidity, market entry barriers such as low market transparency, the relatively low correlation between asset prices and equity markets, and complex performance and risk measurements,” she added.

“Not long ago, alternative assets played only a minor role in capital investments. The consequence of the interest rate policy of central banks, above all that of the Federal Reserve and European Central Bank, is that the equity and bond investments of many investors fail to generate adequate returns,” Harrschar noted. This has prompted investors, particularly those that have to meet return targets in order to fulfil pension obligations, to rely increasingly on alternative assets. “Growth in investor demand, on the one hand, balances demand for suitable investment vehicles, on the other, with the structures having equally to fulfil customer requirements as well as the demands for greater specialisation within the alternative assets.”

Today, alternative assets account for a sizeable share of institutional investors’ portfolios. Besides investments in real estate, which date back a long time, investments in private equity, infrastructure and private debt are also assuming importance in strategic asset allocation planning. Private equity investments experienced their first boom around the turn of the millennium. Driven by technological transformation, venture capital became a source of intensive dialogue and analysis, and become a focus of investment. Private equity departments of major financial institutions, which had occupied a niche role before this, now evolved into the serious finance management departments of major private equity companies. Hedge funds also attracted greater attention, with investor demand fuelled by frequent high returns from this investment vehicle.

But the financial crisis of 2008 brought this development to an abrupt end. Demand among investors nosedived, and all at once the issue of returns made way for other considerations such as structure, regulation and investment security that still influence investor decisions even today.

Although investment volumes recovered very quickly, low interest rates, which are a consequence of the financial crisis, are exerting unprecedented pressure on the investment decisions of insurance companies, pension institutions, pension funds and other forms of pension provision. “Demand for investments that, after risk adjustment, offer maximum returns is enormous, with few alternative choices in most cases,” Harrschar stated.

According to recent research by Preqin, as of the end of 2018, UK institutional investors invested a total of €355 billion in hedge funds, while €224 billion was invested in private equity. Real estate and infrastructure came to a jointly third, with €64 billion invested in each. There is also private debt, with UK schemes investing €57 billion, and natural resources with €39 billion.

The popularity of these investments among asset owners is well understood: the unconventional monetary policies developed in response to the global financial crisis had a significant impact on all asset classes. Long-term low bond yields and expensive yet volatile equities made investors look to other assets for better sources of return.

According to Pedro Arias, head of alternative and real assets at Amundi, real assets are appealing to long-term investors for three reasons: they allow such investors to capture an illiquidity premium, enhance income through a source of predictable returns and create diversification, as they have low correlation to traditional asset classes. Stricter regulation of banks is also driving the demand for alternative sources of finance for the real economy. “This disintermediation of banking is a rapidly growing trend.” It is estimated that the move away from bank financing represents between 75-80% of funding volumes in the US market and about 20-25% of all funding in Europe, where growth is faster.

To cater for this growing demand for alternative or real assets, a new breed of alternative manager is needed. Alternative asset managers have tended to pursue one of two business models. There are boutique firms with deep expertise in a specific market but who lack financial clout. There is a danger that these smaller players do not have sufficient financial strength to ensure they will survive the full length of an investment project of one to two decades. Or there are large global players with strong resources, which ensure they will still be around in a decade when the profit on the investment is realised. These organisations can also generate economies of scale by centralising risk controls. There can also be useful pooling of knowledge across different specialisations such as real estate debt and property management, which creates insights a specialist player cannot access.

Arias believes successful real and private asset managers have to combine the best of both worlds: “They need to be strong global players who can access the right deal flow, and understand the specific complexities of an individual asset class and of a local market.” He said that the European market remains highly fragmented where local knowledge and contacts are vital. “Long-term business and banking connections are needed to gain access to assets. Boutique specialist managers often lack these connections and struggle to find these potential deals. Infrastructure illustrates the intricacies of an individual asset class. This is a highly complex and technical asset class. The due diligence required to assess the operational and investment risk takes both time and considerable resources,” he explained.

Additionally, alternative investment managers have been criticised over a lack of transparency. This is partially driven by many such managers using highly complex strategies to generate returns; it is also a function of their desire to keep their investment strategies confidential. This confidentiality can lead to investors not being aware of the exact investments into which their managers have allocated their funds. For instance, an investor that has not conducted proper due diligence could find themselves in the position of having their capital invested in volatile derivatives. This is, however, less of a concern today, as regulatory developments and investor demand have led to increased transparency.

While it is likely that the UK asset management industry will be affected as a result of Brexit, there is a significant and growing global investor market, an additional proportion of which UK-based managers could acquire if given the best tools to do so, according to Chris Evans, chair for the All-Party Parliamentary Groups (APPG) on alternative investment management. “An economically and operationally attractive UK funds regime would put UK professional fund managers in an optimal position to secure a greater proportion of global capital allocated to alternative asset classes, including the current $3.2 trillion global hedge fund and $650 billion private credit markets and their future growth,” he added.

In recent years, alternative assets have evolved into a key component of asset allocations. This also applies to the choice of structure for an investment in alternative assets. Investors today seek structures that are standardised and that at the same time offer maximum flexibility. Thanks to standardisation, existing investments can be integrated without problem, and flexibility gives the investor the possibility of reacting to performance and market developments.