Alternative Investments Will Continue to Have a Home With Institutional Investors

September 17, 2020

Source: Preqin Source: Preqin

The amount of capital being deployed into private markets (or alternative investments) has grown considerably over the past 20 years as institutions (public and corporate pension plans, insurance companies, foundations, endowments, etc.) find it challenging to generate their required rates of return from traditional assets (stocks, bonds and cash) alone. For example, according to BlackRock, alternative investments represented just 5% of global pension portfolios in 1996. By 2019, they accounted for more than 25%.

The chart above illustrates the growth of private assets under management (AUM) over roughly that same period. For the purpose of this post, private assets or investments refer to: buyout, venture capital and growth equity, as well as private real asset, infrastructure, natural resources and debt strategies. Between December 2000 and December 2019, private market assets grew at a compound annual rate of 11.4%. Over the last five years, the AUM of these assets increased by a staggering 17.2% per annum. There are a number of reasons for this incredible growth — the most obvious being that private assets are better suited than traditional assets to both diversify income streams and generate attractive returns. These are illiquid investments and generally “lock-up” investor capital for a long period of time — often 10 years or more. Because of this longer lock-up period, fund managers have much more flexibility in the types of assets they buy and how they manage them, compared to traditional asset managers.

The management of private assets tends to be much more hands-on. In venture capital (VC), for example, fund managers have the flexibility to invest very early in a company’s life cycle — anywhere from the concept stage (or earlier if the fund manager has strong conviction in the entrepreneur and his/her ability to start a great company) to the development of cutting-edge products and services; through the sale or public offering of that company. While not typical, venture capital managers can also invest in publicly-traded companies.

Both VC and buyout managers tend to be active investors in their portfolio companies, often assisting them with such things as product/market focus, recruiting, customer growth, operational improvements and capital introduction. Private capital gives the fund managers the freedom to allow their portfolio companies to stick to their longer-term growth plans. This is in stark contrast to their publicly traded counterparts, which are frequently distracted by quarterly earnings pressure that often runs counter to their longer-term goals.

Investors should be compensated for the illiquidity and hands-on active management necessary to make these assets successful performers. On the credit side, investors are able to benefit from income streams that fall outside of the traditional credit markets (e.g., litigation finance, life settlements and health care royalties) that cannot be meaningfully accessed through mutual funds and have vastly different return profiles than bonds or credit-focused mutual funds. Public investment managers, in most cases, manage their portfolios tightly to an investable benchmark, resulting in small performance deviations between these managers and their benchmarks. No such benchmark exists for private assets, however, due to their size and illiquidity. Accordingly, portfolios are constructed without an eye toward a benchmark, which results in no two funds looking the same and manager selection often being the deciding factor between good and bad performance.

The numbers bear this out. According to Cambridge Associates data, over the 1995 to 2018 vintage year period, the average spread between the top- and bottom-quartile private equity managers was an incredible 15%. That said, according to an annual survey conducted by Preqin each year between 2012 and 2019, 91% of respondents, on average, reported that their private equity investments met or exceeded their return expectations.

Further, 86% of respondents to the 2019 survey expected to maintain or increase their capital commitments to private equity over the next 12 months compared with the previous 12 months. Respondents answered similarly for private debt, real estate, infrastructure and natural resources. Alternative investments seem to have found a permanent home in institutional investment portfolios.

Key Takeaway

The need for institutions to continue meeting their mandates has become increasingly challenging in a yield-starved world. More and more, these entities have been turning to alternatives over the past 20 years to address their investment performance challenges. With continued prudent manager selection, it is likely their commitment to the space will only strengthen in the future.

Tags: Institutional investors | Venture capital | Private equity

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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