Over the past decade, institutional investors have increasingly sought to offset their low yielding bond portfolios with higher yielding unlisted asset classes.
In the insurance and pension fund industry, a growing divergence between balance sheet assets and liabilities due to low interest rates has triggered this gradual re-allocation trend. Sovereign wealth funds, large corporates and to a lesser extent central banks have increased weightings to private markets in a search for enhanced performance.
Structural shifts within the real asset economy and more mature operational processes within private markets have equally facilitated investment in unlisted asset classes. Given the specificity of private markets investment, institutional investors have begun to address gaps in their own operational model to best manage this transition.
In 2012, only 3%¹ of the average institutional investor portfolio was allocated to private markets. This allocation is now approaching 10%¹, and Prequin estimates an almost 60% increase in private markets’ assets under management by 2023, the vast majority of which is held by institutional investors.
Source: Preqin, The future of Alternatives, 2018
¹Prequin annual reports 2012-2018
Structural trends facilitating higher allocations to private markets
Key structural shifts within the economy have promoted the popularity of this asset class amongst the institutional investor community.
The biggest sub-segment, private equity, continues to lead in terms of fundraising (50%)¹ and assets under management (59%)¹. At an institutional investment level, growth has been supported by an inflow of financing requests to private markets due to lower cost and reporting requirements compared to the listed IPO market.
Increasing private financing of public infrastructure and the ongoing energy transition has driven institutional interest in greenfield infrastructure. Recent years have seen an increasing convergence in investment portfolios between private equity and brownfield infrastructure strategies.
The success of the originate-to-distribute model of banks has led to a transfer of corporate, infrastructure and real estate debt to mutual funds. The fastest growth area of private debt remains direct lending based on unitranche financing (50% of corporate private debt market), typically used for financing corporates.
¹Annual private equity Prequin reports 2018
Managing fiduciary duties to investors
For institutional investors, private markets are one of several asset classes to which they allocate. An increasing allocation to unlisted assets brings an increased operational burden and requires specific capabilities not offered by traditional middle office and back office administration platforms.
Equally, this asset class brings analytical and monitoring challenges, compounded by today’s heightened risk and reporting environment. This need for a specific skillset has resulted in the creation of front office teams dedicated to unlisted asset classes.
Institutional investors face increasing pressures for enhanced transparency, risk management and controls in order to discharge their fiduciary duties effectively.
Meanwhile, regulatory measures have imposed new requirements in terms of risk management and reporting. This, and volatility in traditional markets, has focused institutional investors’ attention on understanding their portfolios and accurately measuring the associated risks.
However, for institutional investors, obtaining accurate and timely performance metrics, quantifying the opportunity cost between investments and gaining detailed insight into exposure and underlying holdings is not an easy task.
A private markets’ general partner reports fund performance from the perspective of the fund, which may differ from that of the investor for various reasons, such as differences in base currency and financing arrangements.
Moreover, institutional investors struggle to aggregate the returns of diverse market valuations and reporting.
Transparency is another issue. Investors want to understand and consolidate their underlying exposure, and therefore risk, according to different sectors, regions, industries and fund managers.
But keeping track of accumulated exposures and allocations is tough when each underlying private capital fund makes up to 50 investments with diverse structures domiciled across different jurisdictions. The complex cash flows of private market investments can also cause difficulties.
Data analytics and operating model optimisation
A scalable next generation solution capable of monitoring the granular detail of private markets’ investments has now become a key priority for institutional investors.
An institutional investor can opt to either dedicate resources to develop the platform internally or to partner with a third party service provider.
Specialised private capital service providers hold insight into the specificities of private market assets and institutional requirements.
Although there is no full scope service offer at the moment, the key third party fund accounting service providers have been extending their services to develop middle office outsourcing and investor reporting services for private capital. Having access to the source data necessary to provide portfolio analysis, fund accounting providers’ reporting, performance and risk analytics capabilities can be utilised to provide timely, transparent and consistent data to investors in customised formats.
Key performance and risk metrics will help investment managers monitor and benchmark performance against external indices (for both listed and unlisted asset classes) and the digital warehouse of historical data will allow the front office to conduct cash-flow forecasting and simulation analysis.
An integrated front-to-back office platform, capable of gathering and housing all relevant data, enriched with data analytics, market data and modelling functionality has become an imperative for institutional investors invested in private markets and committed to upholding their fiduciary duties to underlying investors.