The LP blueprint 2018 - Insights on alternative investments
For the second year running, Intralinks and Global Fund Media have collaborated to produce an in-depth survey on how global LPs view alternative investment opportunities over the next 12 months. The survey covers a diverse range of topics including investment preferences, the ODD process, transparency and direct investing. Global Fund Media editor, James Williams (pictured), reports on the survey’s key findings…
Last year’s survey helped alternative fund managers get a steer on how investors viewed them and attracted interest in numerous markets outside of the US. This included the likes of Germany, where one of its leading business newspapers, Handelsblatt, which has a circulation of 2.3 million, reported on the survey’s findings on 12th September 2017. The survey highlighted a range of issues, from LP concerns with GDPR to transparency concerns in respect of reporting.
Leveraging on its success, this year’s edition sought to broaden the survey to get more information from LPs on the types of GPs they intend to invest with over the next 12 months, their approach to ODD and what their regional preferences are.
In total, 190 LPs responded to the survey, compared to 140 LPs last year. Of these, 22 per cent were family offices, 23 per cent were endowments and pension funds, while 19 per cent were fund-of-fund investors. With respect to geographic breakdown, 46 per cent of LPs were located in North America, 41 per cent in Europe and 7 per cent in Asia Pacific; this is a slight decrease on 15 per cent of Asian LPs in 2017 due to a higher response rate from European LPs, up from 31 per cent.
ASSET CLASS PERFORMANCE REVIEW
As the survey responses show, alternative portfolios continue to satisfy LPs’ return objectives. More than half of LPs (55 per cent) said they had delivered performance broadly in line with their expectations over the last 12 months, with only one in five rating performance as ‘average’.
In terms of asset class preference, private equity was the standout asset class according to 57 per cent of LPs, followed by private debt and real estate, both of which attracted 29 per cent.
In Bain & Company’s Global Private Equity Report 20181, they point out that since raising USD3 trillion in capital since 2012, private equity funds face a growing challenge over the next 12 months in terms of how to put capital to work. This is no easy task when deal multiples remain elevated.
Private equity fundraising activity remained strong in the first quarter of 2018. Some 157 funds closed on USD117 billion in commitments according to EY’s April edition of its monthly Private Equity Capital Briefing report. While this represented a 33 per cent decline from the first quarter of 2017, EY notes that it was broadly in line with the first quarter of 2016, when USD114 billion was raised.
“Our expectations over the long term are to deliver a mid- to high-teen IRR on our portfolio,” says Jean- Francois Le Ruyet, Partner, Quilvest Private Equity, a London-based private equity investor. “We focus on mid-market PE managers and we haven’t decreased our performance objectives from previous years.”
Not all investors are convinced by the merits of private equity, however.
Ron Barin was formerly VP and Chief Investment Officer, Pension Investments at Alcoa Inc and Alcoa Corporation, a position he held from 2008 before departing in May 2018. Over that period, Barin managed a USD9 billion defined benefit pension portfolio. Barin says: “I’m somewhat sceptical of the merits of private equity relative to public equity. Over the last 10 to 15 years or so private equity hasn’t outperformed public equity by the typical institutional benchmark of 300 basis points above the S&P 500 when measured on an apples to apples net of fees public market equivalent (PME) basis. Therefore, I’m a little surprised that the asset owner community has increased their exposure to private equity in light of the relative PME underperformance.”
Within the global real estate space, The 2018 Capital Raising Survey3, published by INREV, ANREV and NCREIF, revealed that 2017 recorded a total of EUR152.3 billion in new capital raised globally by real estate investment managers; that is a 25 per cent increase on 2016. In total, EUR152.3 billion of new capital was raised for non-listed real estate in 2017, up from EUR121.8 billion in 2016.
Having enjoyed improved performance in 2017, hedge funds recorded net inflows of USD17 billion in Q1 2018 according to Preqin, pushing total hedge fund assets to USD3.6 trillion as of the end of the quarter.
Against this backdrop of strong capital inflows, the LP Survey 2018 reinforces the message coming from global LPs that alternative investments remain mission critical to their long-term investment objectives.
Two thirds of LPs said they expect to increase their allocation during 2018/19.
Private equity – chasing performance...?
While 60 per cent of LPs confirmed that this would be anywhere from 1 to 5 per cent, what is more revealing is that one quarter of LPs said that they planned to increase their allocation by 10 per cent or more (see figure 4). As figure 5 shows, private equity was cited as the most overweight allocation increase.
“We still see lots of interest from SWFs and large family offices,” confirms Le Ruyet. “We don’t see any signs of LPs shying away from private equity because they are worried that asset valuations are too high.”
Mark Roberts is the Chief Investment Officer for Ironsides Asset Advisors and for the Tuscarora Company. He expects the family office to increase its allocation to alternatives by 3 to 5 per cent.
“If you are making an allocation change and trying to address volatility, unless it is an extremely complex investment then a 1 to 3 per cent increase is not going to change your risk/return profile that much,” says Roberts. He is somewhat cautious on private equity, suggesting that part of its appeal among investors is down to chasing performance.
“With respect to private equity, as a family office we continue to move down the curve towards smaller fund managers. The question we continually ask ourselves and try to make sure we address at all times is: ‘Are we taking on more risk in this manager size?’.”
Meghan McAlpine, Director of Strategy & Product Marketing at Intralinks, says that while private equity continues to be an important part of investors’ portfolios, “we’re definitely seeing more niche strategies like infrastructure, private debt and real estate becoming more prevalent among investors. One concern that
has continued is the increasing amount of dry powder outstanding and whether or not GPs can put that capital to work.
“Overall, alternative investments continue to grow as a part of investors’ portfolios and that shows no signs of slowing down in the near term.”
In the hedge fund space, most investors benchmark performance to the S&P 500, which is a terrible way to benchmark. Relative to that benchmark, hedge funds have not performed well in this part of the cycle because their beta is a lot lower. That said, one in five LPs plan on being overweight on hedge funds during 2018/19, suggesting that this asset class remains important to LP portfolio construction.
“In 2017 and the first half of 2018 the markets have offered a good environment for single stock dispersion and a return to fundamentals,” says Alexandra Coupe, Associate Director, PAAMCO, one of the industry’s leading fund of hedge fund managers. “After a long period of passive strategy outperformance, LPs are once again returning to active investment strategies and I think you are seeing signs of that in the results of this survey.”
Infrastructure fails to excite
The survey would tend to suggest that private equity and hedge funds remain the two primary sources of alternative investment allocations for the next 12 months.
Despite nearly 30 per cent of LPs confirming they were happy with their real estate investments over the past 12 months, only 8 per cent said they planned on increasing their dollar commitment to global real estate managers during the next 12 months.
There could be numerous reasons for this, not least a belief that there are too few attractive deals. Equally, it could indicate that LPs are already at their target threshold for the asset class or they plan to invest directly in real estate; a trend that has grown in momentum over the last two years.
One LP said that real estate feels “late in the cycle” and that some of the concern in this asset class, from a US perspective, is how US interest rates might move in the near future.
Another LP, discussing infrastructure, confirmed that while they have one sizeable niche investment, the fact is that returns are not exciting or compelling enough to warrant serious attention. “The absolute return is just not there for us in terms of how we think about illiquidity risk,” they said.
“Infrastructure is a harder sell,” comments Barin. “It’s a newer asset class and most investment committees and CIOs are reluctant to recommend more than a small allocation to this asset class. The infrastructure value creation story has yet to really play out as a number
of infrastructure deals in the US haven’t generated the expected revenues.”
GP SELECTION CRITERIA
The way LPs think about how to select alternative managers consists of multiple criteria, each of which will differ depending on the idiosyncrasies of the investor and the scope of their investment activities.
Looking at the survey results, mid-sized managers running between USD100 million and USD1 billion in AUM have tended to be the preference among investors. If one compares figures 6 and 7, for the past 12 months and the following 12 months, approximately four out of 10 LPs have chosen such managers.
The biggest year-on-year change is that 10 per cent more LPs confirmed that they plan on allocating to managers running USD1 billion or more in AUM.
Although it is hard to discern from the survey results, it could be that LPs are adopting a barbell strategy, investing in smaller managers in one part of their portfolio and a selection of large-cap managers in the other, for complementary benefits.
Commenting on the findings, Le Ruyet says: “I think it is interesting that a large percentage of respondents said they would prefer to invest in managers between USD100 million and USD1 billion. By contrast, if you look at the reality of the market, investors are flocking to ‘mega funds’, which I think probably track closer to listed equities (than mid-market funds). The large-cap space is attractive but you have to recognise that correlation.”
The fact that only 11 per cent of LPs said they would be favouring GPs with more than USD5 billion in AUM is more likely down to the size of LPs who responded to the survey.
Manage pedigree counts
When asked to rank the importance of different selection criteria, seven out of 10 LPs said the calibre of the portfolio management team was the top priority. This was followed by evidence of multi-cycle investment performance, with investors clearly seeking evidence of a strategy’s ability to generate returns during market downturns.
One criterion that came with an average weighting of importance was the quality of a manager’s operational/ IT infrastructure. Only 20 per cent of LPs, on aggregate, ranked this as #1 or #2, with 44 per cent of LPs ranking it #3. Certainly the institutional look and feel of a manager has become more important in recent years and it is arguable that it has become a bigger priority than previous years. With so many operational demands being placed on managers, the more they can demonstrate efficient processes and controls to investors, the better.
“I would rank the calibre of the portfolio management team as the number one criteria. We are still partnering as LPs with management teams, and I’d like to think this hasn’t changed. These are long-term investments, so the quality of the management team (including team dynamics) is really important,” comments Le Ruyet.
Nearly two-thirds of LPs cited commitment to ESG principals as the least important criterion, with 48 per cent of respondents confirming that the quality of reporting was their second least important criterion.
This is slightly surprising but could be a sign that the level of transparency in the GP/LP relationship is improving. It could also depend on the type of investment vehicle the LP is using. A segregated managed account means that the investor will already be getting position- level transparency. As such, the formal end of month report takes on less importance.
“The formal reporting of a manager becomes less important when the LP and manager have established a good dialogue and an understanding of a portfolio’s risk and return drivers. From a managed account perspective it becomes more about the LP’s own internal infrastructure and systems to evaluate the portfolio,” comments Coupe.
ODD trends & insights
Ninety per cent of LPs surveyed confirmed that the depth and breadth of their DDQ process when evaluating managers had either increased or remained the same.
To navigate the ODD process, some LPs look to combine their own internal capabilities with those of external ODD consultants; something that one third of LPs said they did in the survey findings.
As LPs spread their wings and seek out niche investment strategies, using external counsel to ask the right questions and properly get under the hood of a manager’s business can go some way towards mitigating selection risk and future complications.
During his time at Alcoa, Barin confirms that hebuilt a hedge fund programme from scratch using a boutique hedge fund consultant to help with investment manager due diligence as his internal staff resources were modest.
“I recognised when I began building the hedge fund portfolio that I needed significant external due diligence resources to help source and monitor best in class hedge fund managers and outsourcing this was an important element when it came to selling the hedge fund allocation recommendation to my investment committee. Given the additional complexities of having a hedge fund allocation, I needed to assure them that we had the proper manager and operational due diligence in place.
“One reason for LPs increasing the depth of their DDQ could be the move from fund-of-funds to directly investing with single managers. When LPs go direct, they need to figure out some way of doing their own effective due diligence.”
This was previously a key benefit of using FoF managers. LPs were effectively paying them for their due diligence and manager selection expertise. One of the deductions to be drawn here, is that LPs are becoming more sophisticated in the scope and profile of managers they are willing to allocate to.
Cyber remains low priority
Whereas 92 per cent of LPs regarded the quality of the investment management team as the most important element of the DDQ, followed by quality and frequency of reporting (39 per cent), it was perhaps slightly surprising to find that only 26 per cent cited cybersecurity policies and procedures.
At a time when global cyber attacks are becoming increasingly sophisticated, costing between USD445 billion and USD608 billion in 2017 according to McAfee and the Center for Strategic and International Studies (CSIS)4, one might have expected the cybersecurity element to feature more strongly.
“I’m surprised cybersecurity policies weren’t as important for LPs,” comments McAlpine. “Given the introduction of the GDPR and the priority the SEC is putting on cyber, I would think that would be higher on the list.
“It is interesting to see reporting and a robust IT infrastructure are important to LPs. We’re seeing LPs pushing their GPs for more transparency and looking for solid systems in place to assist with reporting. Both of these could definitely help give fund managers an advantage while raising capital in this competitive fundraising market.”
One LP, who asked to remain anonymous, remarks that they gave priority to different elements of the
DDQ compared to those used in the survey: “We are interested not only in the quality of the investment team but also their decision making process, team dynamics, how they deal with conflicts, what the fee structure is and so on.”
A final key takeaway on the DDQ process, which managers could take succour from, is that 47 per cent of LPs confirmed they would consider reinvesting in a fund that their investment committee and ODD team had previously vetoed.
Philippe Ferreira is a Senior Cross Asset Strategist at Lyxor Asset Management, a Paris-based fund management business running one of Europe’s largest managed account platforms, as well as a hedge fund advisory solutions business. From a manager selection perspective, Ferreira says there have been cases in the past where funds have not complied with investor requirements and were initially vetoed, perhaps because they were only able to provide weekly liquidity and not daily liquidity.
“The 47 per cent finding is encouraging because if investors outline their constraints, we can do some fine-tuning to the funds we work with to achieve the right format/outcome. If the product is then in line with what they expect, they will typically commit to deploy capital, even if the fund had initially been vetoed,” comments Ferreira.
Knowing investors’ regional preferences with respect to their allocation programmes can help GPs to not only streamline their capital raising efforts but also design future investment products.
To that end, it was in line with expectations that North America came out as the leading region, confirmed by 51 per cent of survey respondents, followed by Europe with 37 per cent and Asia-Pacific just trailing behind with 35 per cent (see figure 10).
This is also reflected in manager sentiment with Lyxor’s Ferreira stating that from a GP perspective, “those who are running global mandates seem to be preferring the US this year”.
Lyxor monitors a universe of 150 different hedge funds and has a performance peer group of approximately 250 hedge funds, so is well positioned to comment on this. Ferreira says that from an LP perspective, until May this year, there was a bias towards Europe because of the economic recovery, “but since the Italian election there has been a renewed threat to the Euro and investors remain a bit reluctant to buy into Europe. This has led investors to shift their attention more towards managers who are investing in the US.
“Asia remains quite uncertain due to the threat of trade wars and what the potential impact could be on supply chains across the region.”
Coupe says that at PAAMCO they are seeing the barriers to entry come down in Asia-Pacific. On the trade wars point, she says that one of the consequences of this is increased volatility in the region, which can lead to more opportunities for active managers. “It is interesting that the trade war is escalating just as China is opening up to international investors.
“I’m surprised the results for Asia-Pacific weren’t higher than Europe. Based on discussions we have both with investors and managers there is a lot of interest in difficult to access opportunity sets in that region,” says Coupe.
The decision taken last year by MSCI to include China A shares (renminbi denominated domestic stocks) in its Emerging Market benchmark index could be a catalyst to attract more investment dollars into the region.
“For quant funds, the China A shares market has been a hot topic of conversation. The inclusion of China A shares into MSCI EM indices should increase the potential to short single name securities in China. The China A shares market is more liquid than all MSCI Emerging Markets combined, yet it currently has less than USD1 billion of short selling availability,” confirms Coupe.
As it becomes easier to short sell in China over the coming years, it is possible that more active managers will launch APAC-focused investment strategies, potentially alongside existing global mandates.
Given that North America has the largest private equity market, in terms of deal flow and investment dollars, it is understandable that it remains the preferred region for GP allocations. What is interesting, however, is how the recent US tax legislation, which slashed corporate tax rates from 35 per cent to 21 per cent, is influencing US taxable investors.
Family offices structured as pass-through vehicles using a fund style structure rather than a corporate structure will now only receive long-term capital gain treatment for profits interest on assets that have been held for three years or more.
As Roberts is quick to remark: “The new US tax legislation has made us go back through our list and think hard about where we think real after-tax returns are for US managers. Surprisingly, I get blank stares from some of my family office contacts when considering after-tax returns, while others simply follow a philosophy of not letting the tax tail wag the dog. We just don’t operate that way. The fact is, family offices are not going to be eating what they thought they would because the returns won’t be there. It’s a real issue that folks need to pay attention to.”
More broadly, on regional allocations, Roberts says the team is always scouring different regions for managers that can differentiate and generate alpha.
“We think demographics is really going to come into play in the 2020s,” he says. “There will likely be money made and lost in healthcare systems across the globe. I’m fascinated by what’s going on in the Chinese healthcare area. I think that’s potentially investable.”
TRANSPARENCY – IS THE MESSAGE CLEAR?
Last year’s LP survey found that only 17 per cent of respondents were “very satisfied” with the level
of transparency from GPs. This year’s survey would suggest there has been some improvement. Although an extra level of classification was used, 29 per cent of LPs rated transparency as either “above average” or “excellent”.
This suggests that GPs are continuing to try to improve how they communicate portfolio performance and return attribution, but it will differ depending on the nature of the asset class. However, the fact that 68 per cent of LPs felt transparency was either “average” or “could do better”, illustrates there is still a long way to go in terms of making the message clear.
Although hedge fund managers in particular have ramped up their efforts to improve transparency in recent years, some hedge strategies remain opaque to LPs’ eyes.
One family office remarked that one of the reasons they had not gotten over the threshold and invested in artificial intelligence-focused hedge funds, for example, was because “in most cases you tend to feel you’ve lost transparency as models change and are constantly being adjusted. Do you really understand what the investment methodology is? We’ve self-selected away from that.”
Perhaps quant-focused fund managers should bear this in mind and simplify the transparency process to assuage potential fears in the investor community.
Barin confirms that he has seen some improvement in the hedge fund arena, but it varies by strategy: “We invested in long/short equity hedge, systematic and discretionary macro and I saw the most transparency in long/short equity. They were all pretty good at providing monthly and quarterly updates and describing changes to the strategy, what worked and what didn’t work, etc.”
That nine out of 10 LPs confirmed they set transparency expectations with their GPs before investing, either holistically or an a case-by-case basis, would suggest that they are trying to get the proper alignment of interests in place (see figure 12). In this respect, one could argue that transparency satisfaction would be much higher than 17 per cent. Clearly something is missing in the dialogue.
“Sometimes you just have to ask and know what you’re asking for,” suggests Coupe. “We’re in such a data-rich environment, there needs to be some balance between trying not to overwhelm investors with data versus providing them with the information they need to do their jobs better. That balance is still being figured out.”
INVESTMENT STYLE TRENDS
Aside from investing as limited partners in traditional commingled funds, the survey reaffirms the wider industry trend of direct investing. According to 43 per cent of respondents, they will be favouring this investment vehicle, with 31 per cent citing segregated managed accounts and 30 per cent citing co-investment vehicles.
Some 58 per cent of LPs said they planned on doing direct investments over the next 12 months, with six out of 10 specifically choosing to focus on the mid-market private equity space. One in four said they would be focusing on core real estate and regional infrastructure.
“I’m rather surprised at that number, it seems high,” remarks Barin. “It is perhaps a recognition that the fees they are paying are high and they are probably not getting the performance (to justify those fees).
“Everybody expects PE to generate a premium to the public equity market of roughly 300 basis points. Given that the all-in PE fee load is around 5 to 6 per cent it’s a hard hurdle to overcome. I think it’s a recognition by LPs that it is more efficient to go direct, assuming that you’ve built a strong internal PE team that can compete against the GPs.”
Still, if an LP decides to go direct in private equity or real estate, the question is do they have the expertise internally to generate alpha relative to outsourcing it to a third party manager? And if they do, what are they doing with the rest of their alternatives portfolio?
With regards to the co-investing trend, it would appear that increasing potential returns, cited by 51 per cent, is the primary driver, followed by reduced costs (33 per cent). This is a fair reflection of the wider industry.
ILPA templates are a way to help standardise the reporting process within the PE arena and should encourage more PE groups to improve the level of granularity when reporting on investments.
Last year’s survey revealed that seven out of 10 LPs were not asking GPs to use the ILPA template. Contrasting that with this year, when asked if they have seen GPs increasingly use ILPA templates when reporting, two thirds replied in the negative. It is conceivable that LPs continue not to ask for them as opposed to managers flat out refusing to do so.
“While many LPs are not currently receiving ILPA templates,” comments McAlpine, “the need for an industry standard is becoming more important as GPs are getting inundated with numerous tailored requests from LPs. An industry standard would help alleviate these demands for GPs and provide increased transparency and consistency for LPs.”
“I’m not surprised with the answer here,” states McAlpine. “Co-invest has become an increasingly important part of LPs’ investment strategy. Given the reduced fees they are paying (and in most cases – no fees), this helps increase the returns.
“In addition, if the LP is overly optimistic about a deal, they can also increase potential returns by effectively doubling down on that investment. Another reason that wasn’t listed as a choice on the survey, that I think is important, is that co-invest gives LPs more control over the deployment of capital, which I think is of particular interest to many LPs.”
The use of segregated managed accounts (SMAs) was noteworthy. Likely more applicable to hedge funds, it reinforces the same principals of control and ability to lower fees that apply to co-investing in the closed-ended arena.
Greg Stento, Managing Director and member of the Global Investment Committee at HarbourVest Partners, one of the industry’s largest private equity FoF managers, says: “For years we’ve heard market participants predict that traditional fund-of-funds investing would fall out of favour, but we continue to see growth and demand, especially among LPs that are new to private markets investing. It’s still a very cost-effective way to build a portfolio that investors would be hard pressed to replicate on their own.
“In line with these survey results, we are seeing an increase in demand for custom solutions via separate accounts to target very specific allocations to geographies or asset types, as well as for access to co-investment opportunities, with many investors seeking to put up to a quarter of their PE allocation into co-investments.”
There are many reasons for cautious optimism in respect to how LPs currently view their alternative allocations. Mid-market private equity is clearly on a lot of investors’ radar screens but infrastructure and real estate were met with a more muted response. Regionally, North America is still in pole position but if the US:China trade war invective dies down, Asia-Pacific, and more specifically China, could well become the focus of greater LP attention.
Managers who embrace ILPA reporting and focus on further improving their operational infrastructure
and system architecture – which in turn will help them respond to regional LP preferences – should be well placed to meet the ever growing demands of global investors and become tomorrow’s winners in the battle for capital inflows.
The survey suggests that LPs are strengthening their ODD capabilities to improve manager selection and mitigate unforeseen risks. Quality of reporting and a robust IT infrastructure are important to LPs, aside from the caliber of the portfolio management team. Moreover, if, as the survey suggests, LPs increase their direct investments in alternative fund managers, they too will need to have the right systems to properly handle and interrogate GP data.
This is especially true when considering such strong interest among LPs, with respect to co-investing and direct investing in mid-market private equity over the next 12 months. The better GPs and LPs can share data, the more informed their decision-making will be and the more transparency will improve.