Investors display a greater command over private markets, which reflects how the asset class has evolved. But trends within the industry - including ESG and regulations that allow wider access to private assets – are forcing the firms themselves to evolve new offerings and operational processes.
- Julie Nedellec, head of UK private capital solutions and global private capital solutions manager at securities services, BNP Paribas
- Emily Pollock, client director, private assets, Schroders Capital
- Howard Sharp, chairman and co-head of private credit, Alcentra
- Alistair Yates, managing director at Macquarie Asset Management
Speaking to a “young person” recently, private credit specialist Howard Sharp was asked: “When do you think interest rates will go back to normal, at 0%?”
Sharp, who is chairman and co-head of private credit at fund manager Alcentra, explained that interest rates would be more normal at 4% - as they were before the 2008 financial crisis. He explained that it was only after the 2008 meltdown that emergency economic policies ushered in a long era of exceptionally low-interest rates. This was not “normal” but was deemed necessary to stabilise financial systems and foster growth.
What this period also did was make traditional fixed income, such as high-yield bonds, a “very significant” asset class, as net returns to investors – against a backdrop of very low to zero base rates – were very compelling. But central bank policy rates have risen again over the past two years, increasing bond yields and pushing down prices, and Sharp says this makes bonds once more “very uninteresting versus floating rate securities”.
But that’s fine for a credit specialist like Sharp. Since around 2012, investors have had other viable fixed-income alternatives to invest in. There has been a marked growth in less liquid forms of debt, namely direct lending and other private credit, mostly infrastructure and real estate investments. Thanks to the “democratising” trend of private markets investments, the young person in question may well find him or herself soon investing in these assets alongside wealthy individuals and institutions whose deepening interest in private markets is indicated by many surveys.
Sharp was taking part in a Funds Europe roundtable along with peers from Schroders, Macquarie Asset Management, and BNP Paribas Securities Services to discuss how changing market dynamics will affect private capital managers and allocators.
According to Sharp, many institutional investors feel themselves to be under-allocated to private debt.
Although investors are concerned about the likelihood of defaults due to higher interest rates putting pressure on firms to pay back private loans, he said that a consensus that eurozone interest rates will likely remain between 2-3% until 2030, makes it possible for private asset investment managers to confidently create products with stable returns and appropriate fees.
“I think people are generally very interested in the sector, and they want more exposure to the space,” says Sharp.
But there is a difficulty: the “denominator effect”.
“The problem in 2023 has been the ‘denominator’ effect, especially in Europe. People holding bonds have seen values go down as rates go up. This means they’d register a loss if they switched out part of their fixed-income portfolio into alternatives like private debt. This is something that we're hoping will change in 2024.”
"People holding bonds have seen values go down as rates go up. This means they’d register a loss if they switched out part of their fixed-income portfolio into alternatives like private debt. This is something that we're hoping will change in 2024."
Times of dislocation
Emily Pollock, client director, private assets at Schroders Capital, is convinced that investors are increasingly attracted to real assets – a segment of the private markets universe that incorporates real estate and infrastructure and other asset-backed securities. Investors are well aware of the inflation linkage, which Pollock says is particularly the case in infrastructure and renewable infrastructure.
“I think that as private markets have grown more and more, it is not a challenge now for investment managers to find investors. However, what is a challenge is finding good investments and making sure that you're investing with disciplined managers, particularly at times like these.”
Alastair Yates, a managing director at Macquarie Asset Management, says acceptance of infrastructure as an asset class is indicated by the fact that fundraising in recent volatile periods did not fall by as much as it did following the 2008 crisis when the sector was nascent. There is much more sustainability of flows within the investor base now, he says, as the sector matures. However, with this maturity, the well-known thesis that infrastructure is a hedge against inflation is coming under scrutiny.
“There's a lot of work at the moment within infrastructure investing because it is more widely appreciated that not all infrastructure assets are the same. There's now more sophistication around the understanding of what an investor is actually getting from the macro picture of infrastructure.”
Principally, he means that there is an appreciation that the inflation linkage is weaker for some assets.
“If you look at, say, 200 assets, you’d find the inflation linkage in the portfolio. But with some investments, regulations would allow us to pass through increases in tariffs and inflation – for example, through an inflation-linked contract. Or the inflation-related increase might be through market power over pricing.
“But what’s then to be considered is if you can actually pass through price increases in practice, whether that's due to the cost-of-living pressure or political or regulatory intervention. Sometimes policymakers won’t allow it.”
He said Macquarie had made the decision to not pass through price rises, at least not in all cases. Rather, it’s a case of phasing them in.
Leverage is central to private markets investing. As institutions have increased allocations to private assets in the past 20 years, the fact that their third-party fund managers will borrow money to increase investment sizes is a practice that institutions have had to accustom themselves to, particularly those with conservative investment values or difficult liabilities to manage.
Julie Nedellec, head of UK private capital solutions and global private capital solutions manager at BNP Paribas’ securities services business, said from the point of view of an administration firm that also supports private-markets financing, it was clear that a rebalancing in investor portfolios was taking place now that interest rates have shifted upwards. She cited a tilt within leveraged finance - “that's seen as being impacted by increased interest rates” - towards smaller deals.
“The economics in private equity are impacted by higher interest rates that affect the level of leverage in portfolios, while on the direct lending side, we see more use of floating rates and issuance of floating-rate financing. This is a dynamic that will continue as long as the underlying portfolio remains strong. We are finding that investors are not very levered and are leaning now towards sectors that are less exposed to inflation, such as services rather than consumer goods.”
"I think that as private markets have grown more and more, it is not a challenge now for investment managers to find investors. However, what is a challenge is finding good investments and making sure that you're investing with disciplined managers."
Overall, the picture from the Funds Europe panel seems to be that inflation and its associated higher interest rates did cause investors to pause over-allocation to private markets. But this changing market dynamic comes at a time when institutions – thanks to the maturity of the asset class - possess the capability to prolong their allocations or re-balance them in a more discerning manner.
Democratisation of private equity
If private markets do manage to hold institutional and other professional investors’ interest (and nerve), the private equity and private debt industry is now on the verge of a significant extension of its distribution footprint, namely into the smaller institutional market (such as defined contribution pension schemes) and even to individuals of modest wealth.
Pollock, of Schroders, highlighted the recent creation of fund structures that are aimed at smaller investors – namely the Long-term Asset Fund (LTAF) in the UK and the European Long-Term Investment Fund (Elitf) in the EU.
A number of firms, including Schroders, have launched LTAFs in recent months and the list of registered Eltifs in Luxembourg – a major centre for private-markets fund domiciliation and administration – is widely acknowledged to have grown since the EU upgraded the rules around Eltif management.
Pollock says these funds have a better chance of succeeding among the nascent client base of smaller investors if wealth managers think on a jurisdiction-by-jurisdiction basis and consider the actual size of client assets.
“High-net-worth investors and retail investors generally want to put more of their capital locally, and so local funds will become much more important.”
"There's a lot of work at the moment within infrastructure investing because it is more widely appreciated that not all infrastructure assets are the same. There's now more sophistication around the understanding of what an investor is actually getting from the macro picture."
She said that of the newer fund structures, such as the LTAF, each one has nuances that allow for different investor demands. Central to this demand among newer investors who are less familiar with private markets is the issue of liquidity.
Liquidity mainly relates to the target assets of private capital funds, which are less liquid than traditional assets. But it’s because of the illiquid nature of these assets, such as real estate or private loans, that investors have the right to expect higher returns. This is the so-called ‘illiquidity premium’.
However, the illiquidity of investment creates illiquidity for investors’ cash. Investors must expect their funds to be tied up for longer periods of time, albeit that in the newer fund structures – referred to sometimes as “semi-liquids” – regulations permit for regular redemption periods.
“What you really should always remember is that the type of fund structure should then match the underlying asset,” said Pollock.
It would be “impossible” for these funds to not have some form of liquidity in the structure, said Pollock, even if only for the sake of prudence.
Investor education will be essential, said Pollock, so that clients fully appreciate that they would not get even a daily price, let alone regular redemption rights.
She said Schroders built out its back office significantly in order to be able to price on a monthly basis and aggregate many capital calls, and also to have investments “ready to roll into once the capital arrives each month”. Funds are structured differently depending on the minimum investment sizes and depending on whether the fund is for DC clients or wealthy individual clients.
“All funds will need to be built specifically for their end investor,” she said.
“Not all private”
BNP Paribas’ Nedellec echoed this, saying nuances between funds had implications for returns, which investors needed to understand, particularly at the more liquid end of the private assets spectrum.
“Although in order to make these funds more accessible to retail investors, they will need to integrate more liquid elements into their structures, at the same time, investors will need to understand that this greater liquidity – comparative to public markets - could reduce the return from the fund. They will need to appreciate that the private markets fund they invest in could perhaps be a hybrid fund and not necessarily completely private.
“And so there is the issue of education, particularly to retail investors where education can become diluted if there is an intermediary, such as a bank, in between the investor and the asset manager.”
Sharp – who said some private-assets managers considered the retail market to be a huge opportunity - said the sector’s traditional clients were insurers and pension funds who were “about as far removed from a retail investor as you could possibly imagine”.
He said if private markets began “touching retail too much” – for example, wealthy individuals but whose understanding and whose portfolios were more traditional - then legal cases could fly due to a misunderstanding with the terms of these newer asset classes.
“When investors call to get their money back, telling them they may only get 20% of it back once a year could be a difficult conversation,” he said, with reference to the redemption terms that are capped in some semi-liquid fund structures.
Yates, of Macquarie, said the challenge of matching liquidity management with client expectations whilst still retaining higher return potential from a private-markets portfolio, would come down to investing in appropriate assets.
“It will be a big challenge, but I think there will be all sorts of solutions across the market that will come about because the demand isn't going to go away.”
He added: “Firms will consider which assets are the ones that a fund can confidently liquidate in an appropriate time frame. In the case of infrastructure, infrastructure assets are very different across the world. Some are not that difficult to liquidate, such as smaller renewable infrastructure assets. But if you take a national regulated utility which needs government approval, or an asset that has complex foreign ownership structures, that is more difficult.”
A secondary market
Both Sharp and Pollock said the secondaries market – where existing private investments can be sold before lock-up periods expire – offered a route to greater liquidity.
Pollock said: “Funds could use primaries, secondaries and co-investments within one fund, which could mean that there will be a quicker return of capital than in a traditional primary or traditional co-investment.”
With the growth of the secondary market, and the rise of GP-led and continuation vehicles, there is more liquidity in the system, which allows underlying investors to get access to a wider range of risk-return profiles on the investment side, while on the flipside there is the ability to more actively manage historically illiquid positions.
Sharp said that as investors increased their allocations to alternatives and become more sophisticated, he expects to see a trend towards multi-asset private markets investing - potentially even globally diversified, or at least cross-Atlantic.
“This could translate into a portfolio of mixed European and US direct lending. Money might initially go into liquid credit and be drawn down into a private fund using pre-agreed parameters.”
The panel was asked about how private equity firms and their underlying invested companies can pivot towards ESG and sustainable investing. Within the private equity firms themselves, our panellists highlighted some changes as ESG demand had grown.
Macquarie’s ESG team had grown five-fold in the last few years, partly with lawyers dedicated to ESG, said Yates.
“It's become very much a legal and regulatory part of the world, whereas a few years ago ESG was more ‘aims and purpose’ driven.
“If firms don't have the ability to navigate the additional ESG reporting required by regulations, it's going to be difficult for them.”
Sharp agreed. “I think that's exactly right because the ability to raise money as a non-Article 8 or Article 9 fund is going to be increasingly difficult,” he said, with reference to the EU fund classification regime under the Sustainable Finance Disclosure Regulation. “If you go to Paris or Germany, the first thing they want to talk about is ESG or sustainable investing.”
From an administrator’s point of view, BNP Paribas’ Nedellec spoke about the oft-used term in asset management of ‘ESG integration’.
Rather than have a ‘green’ fund accounting process, the firm had incorporated sustainability into its whole culture, said Nedellec.
The firm has also embedded sustainability into its financing offering with products designed for the green transition, namely sustainability finance and impact finance products, which she said are distinct offerings. For example, sustainability-linked financing calibrates the green transformation of a business – measured by KPIs - with the level of interest rate paid on its debt.
“Interest rates can reduce as sustainability objectives are met, which shows how sustainability financing is a concrete and impactful product within the private-markets sphere. Sustainability financing can be embedded into finance capital, bridge capital, working capital, and so on. These form a range of products that can accelerate the rate of transition.”
ESG has created much more pressure on investors and portfolio companies. Compliance is one chief pressure point. It entails greater sophistication by smaller portfolio companies, perhaps after a spin-out from a larger firm that had greater ESG resource.
Sharp, at Alcentra, said: “Some portfolio companies will not even know the answers to the ESG questions put to them, such as ‘What is your carbon footprint?’ But we can introduce these firms to others in our portfolio so that they can gain more knowledge. Gradually there's a sort of ramping up of ability and more and more companies over time will be able to produce better levels of ESG data. But what that increased data will mean for general partners like us is that some smaller firms will find it harder to keep Article 8 status and will perhaps fall back to Article 6.”
Pollock, at Schroders, said private capital managers will have to enhance the ESG processes within the portfolio companies they invest in for the sake of keeping their valuations higher over the longer term, or for meeting impact-investing goals. Impact investing, she said, was becoming a more prevalent investment strategy in private markets.
"We are finding that investors are not very levered and are leaning now towards sectors that are less exposed to inflation, such as services rather than consumer goods."
Fortunately, though, private ownership offers a boon to private markets firms grappling with the ESG capabilities (or lack of) among their portfolio companies. Private-assets investors are usually much closer to the company invested in than are their peers in public markets. This also brings them closer to the data than they would be in a traditional investment, Pollock said.
“Knowing what data you want and making sure that you are tracking the right KPIs, particularly as it relates to an impact investment, is one of the challenges. But I think that private markets works really well in the arena of impact investing because the fund owns and operates its portfolio companies more directly, which gives us better and more direct access to data and a greater ability to affect change over the longer term.”
BNP Paribas’ Nedellec said more private markets firms were turning to service providers for data processes, as well as for higher levels of automation. She argued that service providers are better placed in many cases to invest in the technology and more routine aspects of private-markets investing owing to economies of scale that come from servicing a large number of clients at the same time with similar needs.
“The first point about data is that you want to have data held in a golden source. We hear managers constantly telling us that really all they need is to have data on time, correct, reconciled, and clean from the start.”
Pollock said Schroders has five data scientists who consider a disparate number of data points, from broad market data to population data.
“We're also then building tools which will hopefully enable us to use our own data in different ways,” she added.
Pollock also pointed to the widely acknowledged shortcoming of data in the funds industry at present, which was sometimes due to basic issues with a lack of standardisation that leads to data presented in different formats or to a lack of skills that meant firms did not know how to get the most value from their data.
“The asset management industry needs to take a step forward, where other industrial sectors have done already. What we want is really clean data. Investors just want to make sure that they're not making a mistake, and data is what will ultimately make a firm an excellent firm over the longer term. In fact, it could even be the difference between success and obsolescence.
“Data has not been integrated into the industry as a whole, or at least not in a way that it can be used powerfully.”
Similarly, Yates at Macquarie pointed to the need for standardisation of investor reporting.
“Different investors tend to want something slightly different to each other for different reasons. AI could help here in creating unique reports for investors. But more standardised reporting could enable more comparisons to be made.”
Challenges with data and the difficulty of gaining efficiencies through increased adoption of technology, such as automation, have plagued the broad asset management industry for many years. Removing these frictions presents a road to El Dorado for private-markets firms, a sector in which these issues have less frequently been discussed. Our panel reflects on how firms are grasping these challenges and also emphasises that ESG investing is not just relevant at the level of large corporations.
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