The influence of trends in the global pensions industry on alternative investment product design
December 2015 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
Institutional investors, particularly large pension funds, are major investors in alternative assets such as private equity, infrastructure, debt and real estate funds. Their influence on these funds’ product offerings is significant.
This article examines how current trends in the global pensions industry are in turn setting trends in product design in the alternatives funds industry.
Long term trends in the pension market
OECD figures indicate that in 2013 institutional investors such as pension funds (PFs), public pension reserve funds (PPRFs), mutual funds and insurance companies held $92.6 trillion in assets, approximately double the combined GDP of OECD countries and up from about 1.4 times GDP in 2001. These investors are enormous contributors of capital to alternatives investment funds.
A key concern for PFs and PPRFs in particular is the capacity of their investment programmes to match their potential outgoings, particularly in view of two long term trends which, are far as pension providers are concerned, are moving in the wrong direction – firstly, ageing populations are leading to higher expected outgoings, and secondly, traditional asset classes, such as listed equities and fixed income, are providing lower than expected returns, in part because the current low interest rate environment was expected to be a short term phenomenon as economies recovered from the global financial crisis but looks increasingly likely to be the new normal.
A separate but related trend is a global shift from defined benefit pensions (where beneficiaries are guaranteed a particular sum on retirement, e.g., a percentage of their final salary or lump sum equivalent) to defined contribution (where beneficiaries and/or their employers contribute a defined sum and the payout on retirement depends on the performance of the pension scheme in the meantime).
The search for returns
These trends are driving pension funds to look away from traditional assets for higher returns. One of the most popular strategies for increasing returns is an increase in allocations to alternative asset classes. Such asset classes include private equity and the related asset classes of private debt, infrastructure and real estate.
Equally, stability of returns is an issue for PFs and PPRFs, given the need for certainty of returns to their beneficiaries. Alternative assets are also seen as a way of increasing the stability of those returns, through reduced exposure to market volatility.
We are also seeing a trend toward consolidation of fund manager relationships by institutional investors – investors are looking to put more money to work in alternatives but with a smaller band of fund managers, with the natural consequence that institutional investors are looking to write larger cheques to those fund managers that they favour. This, in turn, is driving the favoured alternatives fund managers to seek ways to soak up this excess demand. Two ways of doing this are to move into adjacent asset classes (e.g., a private equity fund manager adding private debt or infrastructure to its product line) or to develop new fund structures to maximise the appeal of the manager’s offering in existing asset classes (e.g., an infrastructure manager adding a longer life, lower risk/return fund to its product mix alongside its existing higher risk/return development-focused fund). We are seeing both of these developments in increasing numbers.
Consequences for alternatives fund product design
We see a number of product design consequences for alternatives fund managers resulting from these institutional investor trends. Firstly, institutional investors looking to private debt and real assets to replace traditional fixed income. Institutional investors are proactively approaching alternatives fund managers seeking new products which provide returns exceeding those available from traditional fixed income investments but which are more stable than those available from public equity markets, and which match the long term investment horizon of these institutional investors. We expect the main beneficiaries to be private debt and real estate funds and, increasingly, infrastructure funds. We expect a particular focus of new infrastructure fund demand from institutional investors to be the longer-life, lower risk/return funds discussed previously, as these tick both the return and stability boxes for institutional investors. We are also seeing increased demand for new infrastructure and real estate debt funds, for the same reason.
Secondly, long term investments with interim liquidity. In markets where defined contribution schemes are prevalent, or are beginning to replace defined benefit schemes as the prevalent model, there is growing appetite for more liquid alternative investments – defined contribution schemes have a particular need to combine the ‘illiquidity premium’ for returns generated by alternative investment classes with more frequent liquidity than many alternatives funds offer. This is particularly problematic for traditional private equity, infrastructure and real estate funds, which offer limited to no liquidity within their eight to 10 year terms. It is also in direct contrast to the move within infrastructure to longer life funds.
Although this issue is, to some extent, insoluble, we are seeing attempts to manage it via liquidity ‘windows’, whereby at (say) five to seven year intervals, investors may request an exit from some or all of their investment. Critically, this is rarely an absolute right but more commonly a best endeavours obligation to supply liquidity to investors, thus respecting the inherent illiquidity of alternative assets.
Thirdly, there is ESG. Hard data on the importance of ESG to institutional investors is hard to find. That said, survey results support an increased emphasis on ESG in pension funds’ investment programmes and this tallies with our own experience. Of particular focus, in our view, are green/renewable investment funds, social impact investment funds and ethically screened investment programmes. In the latter case, a focus on acceptable labour practices, anti-corruption and other social and ethical issues is a logical development of the pension industry’s role as custodian of workers’ retirement savings. In our view we may see pension funds taking an increasingly vocal approach to supporting labour, social and ethical issues where they believe it will be in their members’ interests to do so.
Finally, there will likely be increased public scrutiny of the alternatives industry. We also believe that the pensions industry will play a large part in driving another key trend in the alternatives fund industry – increased transparency. This trend has, until recently, been regulator driven. For example, in Europe via the disclosure requirements of the AIFMD, but in the last 12-18 months, there has emerged a separate source of pressure on fund managers to disclose performance, fees and costs – large pension funds and their representatives such as the Institutional Limited Partners Association.
These pension funds are, in turn, coming under pressure from sections of the financial media to be more vigilant in their scrutiny of alternatives funds investments. The ever-increasing importance of pensions to society has led to a greater media focus on their role as the custodians of ‘mums’ and dads’’ retirement incomes; while their increased allocations to alternatives has led to media focus on whether these investments actually provide the outsized returns that that their proponents claim. In order to justify increased allocations from institutional investors, alternatives fund managers will need to provide sufficient information to permit an informed comparison of their funds with other alternatives funds, and of their asset class as a whole with other asset classes.
We see these moves toward greater disclosure by alternatives funds as a long term trend that will move fund terms, and fund economics, in investors’ favour.
The requirements of pension funds are significant drivers of product development in the alternatives funds industry. We expect this level of influence to continue as pensions funds’ assets under management increase, and as long term trends in the pensions industry drive these funds’ asset allocations toward alternative investments. In our view, the search for long term, predictable investments which generate a premium over returns from traditional asset classes will continue and pension funds will become increasingly proactive in seeking suitable new products from fund managers they know and trust. At the same time, the importance of pensions to society and alternative investments to pensions will combine to create a significantly increased level of scrutiny of alternative investment fund returns, fees and costs. This will drive greater levels of disclosure by these ‘private’ funds as the alternatives industry seeks to reliably quantify its return premium over traditional asset classes.
Peter Olds is counsel at Cleary Gottlieb Steen & Hamilton LLP. He can be contacted on +44 (0)20 7614 2333 or by email: firstname.lastname@example.org.
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Cleary Gottlieb Steen & Hamilton LLP