Real Estate

Alternatives’ alpha allure pulls in the big investors


In a break with its historically cautious investment stance, the world’s largest pension fund said last year it would make its first allocations to private equity, real estate and infrastructure.

The move by Japan’s ultra-conservative Government Pension Investment Fund marked the end of resistance to the role of illiquid alternative strategies by institutional investors worldwide.

The growing adoption of alternative strategies, including private equity, private credit, hedge funds, real estate, infrastructure and commodities, is arguably the most important shift under way in the global investment industry.

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Low-cost passive investment funds are attracting significantly more new cash flows than alternatives — but alternatives command a disproportionate share of overall fees and revenues. This development has important implications for both traditional asset managers and their clients, such as pension funds.

About 15 per cent, or $12tn, of the $79tn global pool of invested assets was run by alternative managers at the end of 2017, according to Boston Consulting Group. But alternative managers accounted for 43 per cent, or $117bn, of the $275bn overall revenue pool in the same year.

Some observers believe this underestimates the share of revenues taken by alternative managers because performance-related fees are difficult to measure with accuracy.

“Alternative strategies now represent over half of the fees paid by investors,” says Huw van Steenis, a senior adviser to the governor of the Bank of England and a former analyst at Morgan Stanley.

This raises the question of whether investors are receiving value for money.

As well as paying higher fees, investors such as pension funds also incur additional costs, including the need to spend on compliance and consultants.

The higher returns produced by alternatives are supposed to offset these additional expenses. A growing body of academic evidence, however, suggests that the additional return — alpha — delivered on average by hedge funds and private equity managers is close to zero once fees are taken into account. So picking the right alternative managers is critical to success, a challenge compounded by the fact that identifying likely persistent outperformers in advance of making an allocation is highly problematic.

Future return expectations for many alternative investment strategies have also declined, due in part to rising competition among managers. These difficulties highlight the risk of future disappointment for investors.

Charles Prideaux, global head of product and solutions at Schroders, says, however, that alternatives have “moved into the mainstream” because investors value their ability to add diversification and incremental returns at a time when publicly traded assets are not expected to deliver returns as high as those achieved historically.

“Alternatives can provide three to four percentage points of additional annual returns over public equities even though the fees are higher but investors have to be comfortable with longer lock-up periods, different transparency standards and to ensure that their alternative allocations are compatible with their overall risk and return profile,” says Mr Prideaux.

The shift is gathering pace, in spite of the inherent complexities of alternatives.

Just last week, Sweden’s parliament voted to permit four of the country’s state-backed AP pension funds to increase their exposure to illiquid and alternative investments.

Future Fund, the A$149bn ($107bn) Australian sovereign wealth fund, awarded alternative mandates last month to New York-based Key Square Capital and Clocktower, a California-based hedge fund seeding and technology investment group.

For traditional asset managers, acquiring or building alternative capabilities can help alleviate downward pressure on fees elsewhere in their business.

“Why try to compete on fees with Vanguard when a traditional manager can go more upmarket by moving into alternatives,” says Michael Cyprys, an analyst at Morgan Stanley.

Traditional managers can also leverage their existing infrastructure, distribution, operations, legal and regulatory capabilities, when moving into alternatives which can deliver significantly higher profit margins.

Profitability, measured as operating profits as a share of client assets, averages about 60 basis points for alternative asset managers, far above the 17bp average for traditional US asset managers, according to Morgan Stanley.

The combination of attractive profitability and rising investor appetite has inevitably led to an increase in deal activity.

Franklin Templeton agreed in October to acquire Benefit Street Partners, a $26bn private credit manager, from Providence Equity Partners, a deal that is expected to close early next year. Franklin also announced in September that it had agreed a joint venture partnership with Hong Kong-based Asia Alternative Management to provide a private equity fund of funds.

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BlackRock completed the acquisition of Tennenbaum Capital Partners, a US private credit manager, in August.

BrightSphere (formerly Old Mutual Asset Management) paid $240m in 2016 to acquire a 60 per cent stake in Landmark Partners, a Connecticut private equity and real estate manager.

Dean Frankle, a principal at Boston Consulting, says there is room for further consolidation as traditional managers need to strengthen their alternative capabilities to bring in more revenues and to attract new assets.

“A number of traditional asset managers that have historically been underweight in alternatives are looking to add new capabilities.”

He adds that it is important for both parties to avoid a “marriage of inconvenience” as alternative managers have different skills to traditional asset managers.

Mr Cyprys agrees that it can be difficult to achieve a meeting of minds on valuations in an acquisition process and often a challenge to ensure that there is a cultural fit between the businesses.

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“We have seen a limited number of acquisitions but it can be easier for a traditional asset manager to move organically into an area such as liquid alternatives that is closer to their existing expertise than to acquire a private markets manager,” he says.

London-listed Schroders bought Adveq, a private equity manager, in 2017 and Algonquin, a specialist European hotels investment group, this year.

“These two deals provide exposures to particular return streams that complement clients’ needs for diversification and additional returns,” says Mr Prideaux. He adds that Schroders will continue to expand its alternatives business organically and with acquisitions “where the valuation is right”. 

Syz, the $36bn Geneva-based private banking and asset management group, will launch a private equity business this week which will also target private debt and real estate investments. The Syz family has provided SFr50m ($50m) seed financing for the new venture, Syz Capital, which aims to raise up to SFr200m for its first fund. 

“Syz Capital aims to improve access to private markets for non-institutional clients and we already have commitments from a number of family offices,” says managing partner Marc Syz.

The higher profit margins commanded by alternatives and intense pressures on fees for traditional investment funds will undoubtedly push more asset managers to follow the examples of Schroders and Syz.

The high costs of alternatives, however, may yet prove an expensive bet if asset managers capture the rewards while investors are left holding the bill.



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