The rise of the ‘new’ alternatives
As yields have compressed and forward-looking return expectations fall, multi-asset managers have sought alternatives to traditional asset classes to find new sources of income and boost returns. Michael Howard, Head of Alternative Investments at Prudential Portfolio Management Group (PPMG) explores.
Hunt for uncorrelated returns
Driven by the search for income in a prolonged low return environment, the growth of alternatives has continued at a faster pace over the past two decades. Demand for these assets is expected to rise to a staggering US$ 13.6tn by 2020* as investors hunt for uncorrelated sources of return outside of equity and bond sectors.
"The opportunity set within the alternatives sector is truly global and spans a diverse range of often quite specialised sectors. Today this includes private equity, infrastructure, hedge funds, private credit, insurance-linked securities and pharmaceutical royalties to name a few. Yet it wasn’t that long ago that these types of alternative investments were the exclusive domain of institutional or specialist investors only," notes Michael Howard, Head of Alternative Investments at Prudential Portfolio Management Group (PPMG). "Newer alternative assets are often idiosyncratic in nature and uncorrelated with both traditional asset classes. Therefore, it is no surprise that they are being accessed much more widely than before."
Howard feels that rather than being a portfolio add-on, investments in alternatives can be a substitute for public equity or bond markets today. For example, private equity offers the potential for somewhere between 200 and 300 basis points of outperformance versus public markets over the long-term.
Private equity is one area Howard and his team has invested in significantly over the past decade. The growth of this asset class has been driven by a number of factors. He explains: “More than 6,000 companies were listed in the US in 2000; today that figure is less than 4,000. The reason for that shrinking figure is that IPOs have dried up and when companies are choosing to list they are coming to the market with a much larger capitalisation than average." Effectively the growth period and when higher returns are on offer is all happening at a much earlier stage and predominantly via private capital.
"You can see that quite clearly when you compare the investment return multiples since IPO for Amazon versus Google and Facebook; the latter two were much lower as the growth phase had been enjoyed by private equity groups."
While alternative assets are useful in providing sources of uncorrelated portfolio returns, in other cases, like private equity for example, returns may have a higher correlation to public markets.
Though private equity investments will be investing in different companies with varied outlooks, they are essentially affected by the same thing as publicly listed companies: the economic cycle. Of course, what you do get by investing in private equity is an enhanced return and that is a good reason to consider it over other equity investments in a multi-asset portfolio. Crucially, these enhanced returns are delivered net of fees.
Around half of Howard's team has a private credit and hedge fund background. Within some multi-asset
"We don't always look for what I would determine as 'classic' hedge fund vehicles. Our aim is to ensure the aims and structure of the fund we invest in matches the time horizon of the investment and the characteristics of the asset class. Many of our investments are long duration in nature to provide strong alpha or absolute return diversifying strengths. In the hedge fund space for example, we have recently invested in insurance-linked securities."
Insurance-linked securities are a way for insurers and reinsurers to transfer risk onto investors who underwrite them. Investors then collect premiums and pay-out on losses as and when they materialise. Though this niche asset class used to predominantly be the exclusive haven of hedge fund providers, demand for capital in this space has seen further opportunities from insurance companies themselves.
"Many investors may find there are significant structural and long-term barriers to entry in some types of complex alternative assets. Some of that is to do with regulation; but a lot of it is also down to the fact that capital has been constrained from a liquidity point of view ever since the global financial crisis. Few groups have the capital to lock away on a long-term basis in risk assets like alternatives because of the liquidity and regulatory constraints. Those that do, like PPMG, can benefit from these capital dislocations because they are able to step in and deploy long-term capital, sometimes alongside several expert partners."
Howard highlights an investment the group undertook in the Italian solar sector in 2016 as an example of this. Though one of the biggest solar markets in the world, it remains a fragmented marketplace with room for significant consolidation. PPMG invested via a newly created fund with Next Energy Capital, a market leading solar asset manager in the UK and Italy. This fund allowed it to invest £150m in existing solar photovoltaics plants in Italy and by managing them collectively, plant performance and operations is improving. This investment provides the group’s multi-asset portfolios with the potential for stable returns and an annual dividend of around 8%-9% backed by long-term government incentives.
Pharmaceutical royalty funds in general terms are a category of private equity funds which specialise in buying consistent revenue streams driven from the payment of royalties.
If a pharmaceutical company has a blockbuster drug under a patent; asset managers like PPMG are able to partner with a firm that will lend against specific royalty streams from that drug. Usually, asset managers will know the number of sales likely to be made (due to the patent held and lack of competition), which is what can make investing in this area profitable.
"Investing in pharmaceutical royalties generates a similar cash flow to a bond, in so far as you roughly know how much you’re going to get. They are also high-yielding and uncorrelated to traditional assets in investors' portfolios," explains Howard. “The return you can get for lending against these future royalties' cash flow streams is substantially more attractive than investing or lending through the high yield market."
Access to capital is not the only challenge for investors in this asset class. New regulatory changes and even natural disasters can impact the group's investments in areas such as solar and reinsurance. Meanwhile, the complexity of some alternative investments, especially those with long-lock structures, means many instruments are difficult to price. Once invested, the secondary market is often extremely illiquid and unattractive for those selling assets. This means due diligence is key, not just from an investment perspective but also legal and operational.
"The risks we face on the non-investment side of things are almost as concerning as financial risks," he explains. "Our investments are long-term, we invest for 10 or 15 years. So, it is really important we are comfortable with the risks we take on in some of these newer areas. We take a three-prong investment approval process that covers investment, operational and legal due diligence before any investment is made, and the process is quite involved. For example, we typically run background checks on all key employees and the company itself using a specialist background checking agency.
"We also instruct our own lawyers, often with the assistance of external legal counsel, to review all legal documentation and negotiate terms and protections that we are comfortable with before investing. These actions protect us and the partners we work with against some of the risks and things that can go wrong when investing in alternatives."
Despite the challenges, Howard remains optimistic about the evolution of alternatives as the sector branches out into new areas like emerging market private equity, renewable energy and battery storage. These are all areas Howard and his team have accessed through the group’s multi-asset vehicles.
"We continue to see attractive potential returns and yield premiums to traditional returns, despite the compression in recent years," says Howard. "Moreover, alternative assets are today very much being used to enhance the returns of multi-asset portfolios overall, with tailored mandates by the right providers able to provide investors with access to the best opportunities and at a discounted rate as well."
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