May 2013

ASSOCIATION COLUMN: Financing illiquid assets

Andrea-LoweA comprehensive rethink of global financial regulation is not something any sane person would want to rush. Unfortunately, against the backdrop of a global financial crisis with political pressures to act, this has been the unenviable task facing many a regulator of late. Something had to give: impact studies commissioned ex-post; industry consultations confined to Christmas holidays. This is regulation at its most unpredictable – regulation on the fly. Increasingly, policymakers are having to double back or construct work-arounds on the move when politically unacceptable consequences start to emerge from their hive of activity. Take the European Commission’s recent Green Paper on Long-Term Financing on the European Economy, prompted by a fear that the impact (read unintended consequences) of all the new proposed prudential regulation combined could be greater than the sum of its parts. Solvency II, for instance, was a sensible attempt to ensure insurance companies understand their investment risks, or else deter them from risky asset classes. Unfortunately, the measure of risk used (value at risk calibrated to a 99.5% confidence level over a one-year period) introduces an artificial volatility for illiquid assets. Nobody knows if the approach will prompt insurers to invest more in sovereign bonds, less into vanilla equity and much less into infrastructure or private equity, but you can certainly argue the case. In fact, the alternatives industry has argued the case pretty hard lately, but to not much avail, based on the European Insurance and Occupational Pensions Authority’s comments this April. Still, behind closed doors the European Commission is presumably not so sanguine. Why else publish a consultation in March on long-term investment funds in an attempt to test sentiment around raiding dormant sources of long-term capital to finance such projects? It is not just Solvency II, of course, but the whole raft of prudential regulation in the pipeline – the Institutions for Occupational Retirement Provision Directive, banking regulation, and so on – that could leave politically imperative corners of the European economy such as small and medium enterprises, and infrastructure, without their traditional backers. How have the market’s attitudes changed to alternative investments? Volatility across equity and bond markets has mushroomed in the past 10 years or so (since before the crisis) and diversification is a beneficiary. For a student of risk it has been a fascinating few years and it has been interesting to see how different alternatives faired. Against this backdrop of unintended regulatory prejudice towards investment into illiquid assets, a political will to safeguard finance for such assets and a growing market appetite for some related alternative investments, it will be the pragmatic operator that thrives. Certain listed investment companies, such as listed private equity and infrastructure companies, have been providing access to illiquid, long-term asset classes for well over a century. These are listed securities, so naturally they behave like equities to a large extent. But they trade with reference to pools of unlisted assets. As investment vehicles go, few have proved more robust – it has survived wars, crisis and recession for longer than living memory. Meanwhile, the sources of alpha in such companies also tend to be quite old fashioned. Rather than complex algorithms, its performance story is underpinned by its approach to people and hard work. That is to say, it uses its experience and people network in opaque private markets to exploit information asymmetries, and it introduces powerful incentive structures that align interests, right through the company and investee businesses. Despite an enviable long-term record, such investment companies have never been good at marketing themselves, and so have never quite made the mainstream. In a newly calibrated financial world, their many attractions may become too great for a range of investors to ignore. Andrea Lowe is the chief executive officer at Listed Private Equity (LPEQ) ©2013 funds europe

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