4 minute read
Finding relative value in private markets through active portfolio management
Traditionally, private markets investing has been characterized by a rigid asset allocation policy that fails to tap into new waves of opportunity as they emerge. In today’s constantly evolving world with investors navigating fresh challenges, why shouldn’t investment portfolios and return targets dynamically change too?
Relative value investing involves tactically adapting a portfolio so that it can capitalise on the most attractive market opportunities. In practice, this means moving overweight or underweight across different regions or asset classes relative to the initial strategic asset allocation. This agility can be very accretive to portfolio returns: our own analysis has shown that pivoting towards a relative value approach has historically added 100-150bps performance p.a. to multi-asset private market mandates over the last 5 years.
Unlocking relative value requires three pre-requisites:
1. Implementing relative value requires investors to take a view. Significant resources and expertise are required to map out a universe, before credibly deciphering between the various different areas.
2. Once a view is established, the investable universe must be determined, and this must be wide and varied enough for managers to be able to scan and assess new opportunities in order to execute their view.
3. Finally, a strong and consistent flow of new investment opportunities is critical for managers to implement their views. Without a surplus of quality ideas, managers may fall short on their ability to translate their views into tangible investments.
In this environment, private market multi-asset strategies represent an attractive alternative to traditional funds, thanks to their structure that enables them to capture the most compelling ideas in the market. Underpinning this is the idea of flexible investment pacing which allows managers to adjust investment pace in line with the prevailing market environment, introducing the possibility of adding additional alpha. This may be through by deploying more capital in attractive market environments, or slowing down deployment in more challenging ones.
To show how a dynamic relative value strategy can increase long-term returns, we consider a real-world multi-asset private market fund:
This chart shows how new money was deployed over time, relative to the portfolio’s strategic asset allocation. Over the past 10 years, such relative value calls have added over 150bps per annum to investment-level returns1 self-sufficiency and will exist for up to another four decades, and will therefore be able to take the risk of investing in growth assets.”
Relative value can be an important source of additional alpha for private markets investors. Investors should consider the extent to which a manager has the flexibility, resources and dealflow to seek and identify the most attractive opportunities at the outset: do investment guidelines enable relative value? Can the manager credibly take views? Are they equipped to implement them effectively? By keeping these questions in mind, investors can put themselves in the best position to benefit from relative value over time.
Open DB schemes have more than £300 billion of assets, and their investment time horizons are a good match for growth assets.
Dabrowski says: “In recent years much of the interventions have been focused on DC with this part of the DB market neglected despite managing the same size of assets.”
In comparison to DC funds, these open DB funds will have more mature investment strategies and bigger resources as well as more experience in these markets, he adds.
WHO IS ALREADY INVESTING?
In fact, LGPS funds are already investing in UK assets. Dabrowski says: “The governance set-up – with councillors sitting on pension committees as well as regional pool structures – has led to a concentration of investment in local infrastructure projects such as student accommodation.”
James Brundrett, senior investment consultant at Mercer, says: “For example, Cornwall has a local renewable energy investment while Clwyd have joined with Manchester in their regional private equity fund which has made two investments in North Wales.”
Automatic enrolment DC funds also have long time horizons which are a good match for growth assets but have been reluctant to invest in more expensive asset classes.
Dabrowski says: “DC is a nascent market so while it has had rapid growth over the last decade, it lacks the expertise which comes with maturity and scale.” Only now are funds getting to the size which makes it feasible to invest in a broader range of assets.
Saron agrees: “DC assets will grow but it will be over time.” And it is not all DC funds which will be able to invest in these asset classes – it is those with sufficient scale and resources. In other words, only the master trusts. “These are currently still growing their assets,” added Saron. The government wanting DC schemes to invest in growth assets is putting the cart before the horse. Saron says: “It’s not until a DC scheme is big that it has sufficient resource and the ability to source good deals.”
DC schemes are essentially a cottage industry which is trying to compete with international behemoths for growth assets. “Not every problem can be solved with scale, but it makes it much easier,” adds Saron.
Brundrett comments: “Australia is good example of where scale allows DC schemes to become more sophisticated investors.”
Scale is not the only issue holding back DC schemes. Despite increased regulatory scrutiny of value for money, cost remains the key metric used to secure market share, resulting in an over-reliance on passive equities and a reluctance to include more expensive strategies.
Brundrett says: “There needs to be a greater focus on creating higher-quality, member-focused outcomes in DC schemes because at the moment there is a race to the bottom driven by fees.”
This is at odds both with using more expensive alternative assets and a value-for-money assessment of scheme members’ retirement outcomes, he adds. Liquidity has also been an issue. Many DC schemes rely on platforms with daily dealing requirements. This is a mismatch with the illiquid nature of infrastructure, private equity and venture capital.
Nor is it certain where the UK government wants pension schemes to invest. Saron says: “Infrastructure, private equity, venture capital and biotechnology have all been mentioned but they are very different markets.”
Even if pension schemes were to allocate more to growth assets, it is highly unlikely they would allocate assets only to the UK. As Gibson points out, “The UK venture capital market is not large enough for all pension schemes to invest in.” He adds that pension schemes would rather invest any asset globally in order to diversify.
Gibson continues: “For the majority of schemes, putting a significant allocation into UK assets does not make sense from an investment perspective. We welcome initiatives to facilitate investment, but if the government wants to mandate it, the industry is likely to resist strongly.”
Dabrowski concludes: “Pension scheme investment cannot be thought of as a silver bullet. Many of the issues which ail the UK economy today are systemic issues which need to be addressed with careful thought and plans.”
