There has been a flood of capital into the alternative asset market over the past couple of years, particularly into private equity, leading to questions about whether the market is overcrowded. But, how do we know if it is overcrowded, and if it is, what is the potential impact?
Private Equity Trends
First, let’s evaluate trends in alternative asset allocations.
In the 2017 Preqin Global Private Equity & Venture Capital Report, Christopher Elvin, Head of Private Equity Products at Preqin said, “The private equity model is working and in a low interest rate environment the asset class will continue to appeal to investors looking for high absolute returns and portfolio diversification.”
Preqin’s data shows that institutional investors are looking to increase their alternative asset allocations.
Private equity, in particular, has seen large inflows from pensions and sovereign wealth funds.
Inflows have been a key contributor to record levels of dry powder, or uninvested committed capital.
According to Elvin, “With the majority of investments in 2006-2011 vintage funds still to be realized, there is potential for high distributions to continue… [A]lthough welcomed by LPs, record levels of capital back from GPs can present further challenges to investors, namely how and where to reinvest capital in order to maintain, or increase, their allocations to private equity.”
There are a number of factors causing the illustrated 50% increase in dry powder since 2012:
In these graphs we see:
PE owners freeing up cash by exiting latter stage investments from the pre-crisis boom
Increased fundraising, reallocation, and flows into private equity
These factors combine to create a scenario where there is more investable cash (dry powder) but fewer investment options, putting strain on PE firms to look harder for attractive investment options or sit on capital until opportunities arise.
Let’s take a deeper look at this trend from the LP’s perspective, with a particular focus on pensions.
Note that assumed returns for U.S. public pensions have decreased every year since 1992. This was a slow, steady decrease for 15 years.
Since the 2008 financial crisis, however, there has been a more dramatic drop, and indications are that number will continue to drop as pensions adjust their actuarial expected returns to accurately reflect true market conditions.
Lowering a pension’s assumed rate of return has a significant accounting impact; reducing the plan’s funded status and potentially requiring increased contributions. A plan only does this when its previous estimate is no longer realistic and the combination of growth and contributions is not enough to sustain the plan.
With lower return expectations from traditional asset classes, pensions have gravitated toward alternatives.
U.S. public pension data from the Center for Retirement Research at Boston College, highlights a shift from the 60/40 model (60% equity, 40% fixed income, and a small side bet in Alternatives) to what’s now closer to a 50/25/25 model, with nearly 25% of pension assets allocated to alternatives.
From 2005 to 2009, allocations to alternatives saw a significant increase, at the expense of public equities. Bond allocations increased slightly during the same period, following a general flight to quality around the 2008 financial crisis.
Around 2008, that dynamic changed due to a confluence of these factors:
Central banks subsidized interest rates. The Fed’s target rate dropped from 5.25% in mid-2007 to 0.25% by the end of 2009
Correlations between public bonds and public equities increased. Globally high correlations have held, but they’ve trended back up in the U.S. more recently.
In the U.S., correlations dropped back into negative territory by 2011, a good sign for debt as a diversification play, but correlations have been on the rise again over the last couple of years.
So bonds are yielding less, there is less of a diversification benefit when coupled with equity, and the general definition of quality requires rethinking. On top of that, impending Fed rate increases make current allocations to low yield bond holdings that much less attractive.
Diversification and the search for yield are two of the most common justifications for exploring alternative investments.
This is not a U.S.-specific trend. According to Towers Watson’s 2017 Global Pension Assets Study, the end of 2016 saw the average global asset allocation of the seven largest markets at 46% equity, 28% bonds, 24% other assets (including real estate and other alternatives), and 3% cash.
Alternative Asset Returns
We’ve established there has been a global influx of funds into alternative assets, particularly into Private Equity with record amounts of dry powder waiting to be deployed.
When that capital is deployed, there is a high probability that it will be invested in riskier assets with a less attractive return profile than we have seen historically. Simply put, there is less investment supply and more demand, which does not bode well for the investor.
Early indicators for recent vintage year investments hint at downward pressure on returns. The State Street GX Private Equity Index (GXPEI), built on daily cash flows from State Street’s custodial services, show a peak in 2011 with decreasing IRRs for each vintage year since. Granted, more recent vintage year investments have not yet matured, nor have they seen much in terms of distributions, and are weighted more heavily toward GP-estimated residual value, but the early signs don’t look great.
What does this all mean and what should you do about it?
Analyze Macro Factors Influencing the Movement Toward Private Equity How will rising interest rate and other macro factors influence correlations and the diversification effect of private equity? How do different correlation scenarios influence the attractiveness of private equity within a larger multi-asset class portfolio? Track the potential impact of rising interest rates on your portfolio and decompose its exposures and sensitivities to key macroeconomic factors.
Dig Deeper Into the Alternatives Market Is the recent downward pressure on alternative asset returns representative of a new norm, or is it part of a recurring market cycle? Monitor whether the same story holds true for buyout funds versus venture capital, private debt, real estate, infrastructure, and other alternatives.
Understand the Concessions Made in Exchange for a Premium In an efficient market, where would private equity’s favorable returns come from? Why do these assets appear to be paying a premium? Ten years ago, the search for yield led to CDOs. Today, investors are flooding into private equity. In both cases, investors sacrificed transparency and the ability to understand what they own in exchange for higher yield. Similarly, there is a non-normal liquidity profile. Positions in both asset classes are significantly more difficult to exit when things start to go bad.
Demand Transparency and Conduct Extra Scrutiny on Managers and Potential Investment Opportunities Given the influx of capital, are there enough attractive opportunities to justify the risk? It is possible that the PE market has evolved to the point where it can handle the excess capacity, but we cannot take that assumption for granted. Evaluate the risk profile of individual alternative investments and ensure that managers are not scraping lower in the barrel and taking on riskier investments to deploy capital.