Investors (particularly pension funds and sovereign wealth funds) continue to increase their allocations to alternatives2, favouring the high absolute and risk-adjusted returns3, reliable income streams and the inflation hedge that they offer when compared to public assets. These trends sit alongside significant capital consolidation with 50% of all capital raised in 2019 going to funds of over $2.5bn in terms of fund size4. This influx of capital from the public to private markets has brought with it challenges for fund managers – including intense competition for assets, high valuations and heightened demand from ever-more sophisticated investors for managers to demonstrate value in ways stretching well beyond just returns.
The most successful managers have become increasingly adept at developing solutions which display a broader responsiveness to investor needs and wants. In doing so, many of the traditional boundaries demarcating different strategies, participants and products in the alternatives space have become increasingly blurred – putting transactions, managers or investors in boxes defined by their participation in specific asset classes, primary versus secondary markets or where they sit in the capital stack has become too rigid an approach.
Blurring the boundaries between public and private assets
One limitation traditionally associated with investing in private assets is the requirement to commit capital for a fixed fund term, with often limited returns during the initial investment period. The alternative asset space has developed various ways to mitigate this issue and provide private investors with the liquidity characteristics traditionally reserved for public assets – these range from the growth of open-ended fund structures to a now large (and highly developed) secondary market5 offering limited partners the opportunity throughout a fund's life to trade out of their position, often at par or above.
The sharp growth of GP-led solutions6, which look to tap the secondary market in order to offer liquidity options to existing limited partners, is proof of the commitment of alternative asset managers' to actively respond to their investors' demands for enhanced liquidity from their private assets. Increasingly innovative fund-level debt or preferred equity solutions (in the form of capital being lent against the value of a fund's portfolio of assets) have also provided a means by which liquidity can be offered to investors at a time when exits or other distribution events are not on the short-term horizon. A further development on this front which we may see offered by more managers as standard are commitments in fund documentation to engineer scheduled 'liquidity windows' during the life of a closed-ended vehicle.
Blind-pool exposure is often also identified as a concern for some investors when considering allocating more capital to alternative assets. However, the growth in managers operating large and sophisticated secondary strategies7 now provides investors with an opportunity to gain exposure to portfolios of highly diversified, liquid and non blind-pool assets which are more akin to portfolios of public securities. Added to this is that more companies are staying private for longer and getting privately funded for longer, meaning for some investors that increased allocations to alternative assets are simply necessary to maintain exposure to high-growth businesses8.
Who's who in alternative assets
Further ameliorating concerns for investors around limited visibility on portfolio make-ups is their increased participation in more direct routes to market via ever more popular SMAs (separate managed accounts) and co-investment vehicles. Higher private asset allocations, heightened sophistication of institutional investors and a sharp focus on management fees has meant that being given the opportunity to invest via such structures, in addition to traditional pooled fund vehicles, has become a key requirement for limited partners when deciding which managers to place capital with9 and the traditional roles of asset manager and passive investor have, therefore, increasingly converged. The continued successful fundraising by managers such as Neuberger Berman's Dyal Capital10, who specialise in taking minority stakes in alternative asset management companies themselves (including H.I.G Capital, Bridgepoint and Arcmont Asset Management as examples to date), provides further evidence of investor appetite for a piece of the asset management pie.
Growing numbers of institutional investors and traditional secondary buyers have identified other means of gaining direct exposure to desired asset classes at return rates unencumbered by fee leakage. Good examples include (i) the likes of AlpInvest, Whitehorse and HarbourVest developing their own preferred equity solutions, providing them with relatively lower risk exposure to traditional private equity, infra or other alternative assets and (ii) the recent trend for insurers and other institutional investors (including Aberdeen Standard Investments and Crestline) to deploy capital directly into low risk, capital efficient fund finance debt products11. The traditional bright lines between investors, managers and even lenders in the alternative asset space have, as a result, somewhat faded. On the lending side in particular, with more and more traditional private equity funds expanding into private credit strategies themselves (Ares, Apollo, KKR and Bridgepoint to name but a few), it is no longer unusual to find such houses holding equity and debt positions in the same portfolio companies.
Where does primary end and secondary begin?
Increased private capital allocations have not only lured traditional private equity players into the private debt space, but have also encouraged managers to develop their secondary offerings (Blackstone's Strategic Partners arm being just one example). Inevitably, this has led to these managers seeking talent within the existing secondary manager pool to build out their capabilities in diligencing portfolios of secondary assets in addition to their existing expertise in understanding underlying primary investments. Perhaps baseball-style trades will take off in this area – given that a concurrent trend has emerged amongst traditional secondary investors for investing in single asset GP-led restructurings12, which themselves bear many of the hallmarks of a classic M&A sale in the primary buy-out market where expertise in detailed asset diligence, SPA negotiations, management incentive packages and W&I insurance cover all come to the fore.
In the context of this concertina effect on the traditional primary and secondary market boundaries, it is perhaps unsurprising that fund finance lending has itself ballooned out from the traditional underwriting teams in order to service the whole range of transaction types and collateral packages now requiring leverage. Traditional subscription line lenders now look increasingly to their asset level lending teams to provide expertise on underlying buy-out, real estate, credit, infra or other assets as appropriate for any given NAV or hybrid facility and asset level debt teams have looked to upskill on their fund structure and documentation expertise to enable them to enter this market13.
Economies of scale versus dexterity
Liquidity in the alternative assets space has increased apace, both as a consequence of increased investor allocations and the strong fundraising environment14 coupled with increased product and strategy innovation from various alternatives market participants. The flight towards the largest managers may be seen as evidence of a belief by investors that the so-called "mega-funds" are best placed to exploit their economies of scale and expand their investment offerings into growing alternative assets strategies such as private debt or secondaries. However, given the fluidity that now exists across strategies, players and products in the space, it will be interesting to see whether mid-market managers are able to challenge the scale of the one-stop-shop approach with nimble, opportunistic investing unburdened by a rigid approach to public versus private, debt versus equity or primary versus secondary investing.
Senior Associate Katie McMenamin authored this briefing note.
1 Preqin 'Alternatives in 2019' Report.
2 CalPERS increased its private equity commitments by $1.4 billion during fiscal year 2018/19 and CalSTRS plans to decrease its allocation to public markets by 8% to invest more capital in private equity, real estate and what it terms 'inflation sensitive real-assets' (Institutional Investor 3 Feb 2020)
3 PE buyout funds have outperformed the S&P 500 by 5% per annum since 2000.
4 This percentage increases to 70% for fund sizes of $1 billion+ (Preqin Update presented at FFA Global Fund Finance Symposium 2020).
5 Annual transaction volumes in the secondary market have grown at a CAGR of approximately 40% in 2013 to an estimated $90 billion in 2019 (Preqin Update presented at FFA Global Fund Finance Symposium 2020).
6 Greenhill have projected that GP-led secondary transactions will have doubled to 40% of total secondaries deal volumes in 2020 compared to 2015.
7 Preqin now count over 43 active private equity secondary funds.
8 As of 2018, the median age of venture-capital-backed technology companies at the time of IPO rose to 10.9 years, up from 7.9 years in 2006 (Pitchbook Private Market Playbook 2019).
9 It is estimated that now nearly one third of all private equity investment activity is delivered through co-investing (Apex Co-investment Trends Whitepaper 2019).
10 Dyal Capital closed its fourth fund at $9 billion of commitments in December 2019 in a fundraise which was reported to be oversubscribed by $3.5 billion.
11 Aberdeen Standard Investments' fund finance platform deployed £500m of insurance capital into the market in 2019 with ambitions to grow this to £2-3 billion of AUM by 2021. Crestline Investors closed a fund finance vehicle of $600m in November 2018.
12 The investment strategy of ICG's latest $1.6 billion fund, ICG Strategic Equity Fund III, is dedicated to complex GP-led secondary deals including single asset restructurings.
13 The fund finance market is now estimated to be worth over $525 billion globally.
14 Preqin estimate that 2019 saw fundraising of $1 trillion of private capital (Preqin Update presented at FFA Global Fund Finance Symposium 2020).