Despite proven returns from private markets, institutional investors remain under-allocated to this significant growth opportunity, notes Navin Lala, client director at Old Mutual Alternative Investments
Recent changes to Regulation 28 of the Pension Funds Act in South Africa have allowed retirement funds to significantly increase their exposure to private markets and infrastructure opportunities in particular. And while interest in this space is growing, adoption rates have been slow due to the limited understanding of this new investment paradigm.
Over the past decade, private markets, also known as alternative investments, have gained prominence in multi-asset portfolios, offering compelling features from a risk-return and impact perspective. These investments provide unique opportunities not readily available in public markets.
The US listed equity market, representing approximately 45% of the global equity market cap, has experienced a steady decline in the number of listed companies. In 1996, there were over 8,000 listed companies, decreasing by more than 50% to about 3,700 today.
Similar declines are observed in London’s FTSE and in South Africa on the JSE. Furthermore, companies stay private for longer periods, with approximately 95,000 private companies globally having annual revenues exceeding $100 million, compared to around 10,000 public companies with similar revenues.
The private assets universe, 850% larger than the listed space, therefore offers access to more growth and unique opportunities in niche sectors not readily available in public markets.
Private market assets, including infrastructure, private equity, mezzanine debt, and private debt, typically have lower correlations to traditional stocks and bonds. Infrastructure, in particular, offers long-term, predictable cash flows with lower volatility, more diversification, greater risk mitigation and enhances overall portfolio returns and stability.
Real assets like infrastructure provide inflation protection due to built-in escalation features in revenue streams, similar to inflation-linked bonds, making them well suited for hedging long-term liabilities.
Private market investing is well-suited to active ownership compared to publicly listed companies. Managers can play a transformative role, not only providing growth capital but also driving strategic alignment with social or environmental goals such as clean energy transition, gender equality, and access to decent work, unlocking sustainable value.
Private market investments are inherently long term, allowing companies to focus on implementing their strategies without the pressures of delivering short-term earnings. A long-term investment horizon provides certainty, enabling sustainable improvements and compounding incremental gains.
Engagement with the pension fund industry reveals a clear intent to serve as responsible asset owners, recognising that there are limited opportunities for impactful agendas within a public market construct. The industry aims to increase allocations to private markets, acknowledging their alignment with impact goals such as those outlined by the United Nations Sustainable Development Goals.
Key challenges
The challenges and constraints of allocating to private markets include limited expertise and experience in conducting private market due diligence, challenging manager evaluations and selection decisions, complexity in understanding fund structures, legal arrangements, and fee structures, additional costs compared to traditional public market assets (legal, due diligence costs) and a lack of liquidity.
Private markets are still relatively new in South Africa, with many pension funds having limited exposure to this asset class. A lack of familiarity is understandable, as investors don’t invest in what they are unfamiliar with, especially regarding long-term illiquid assets.
With limited investment return opportunities in the South African market, where listed equities (7.3% SWIX) have underperformed bonds (8% ALBI) over 10 years (according to data by SBG Securities), investors cannot afford to be earning roughly 2% in real returns from equities over 10 years. In this case, other sources of return, such as private markets, cannot be ignored.
The “New World Portfolio” introduces exposure to alternative returns across the full capital structure, providing more sources of return and more diversification. The critical difference is that listed assets are traded on an exchange, while private market assets are privately negotiated .
For pension funds looking to develop their expertise and knowledge in private markets, there is tremendous value in getting exposure to experienced private market managers who have managed private assets across the capital structure, and through various cycles, who can share their knowledge and learnings.
The evaluation and selection of private market managers are not too dissimilar from the process of evaluating public markets managers, with a few aspects that require more focus.
With private market investments being long term, the track record and sustainability of the manager are critical, as investors would want to partner with someone of stature and stability who will last the test of time and still be there to manage and exit assets and return capital. Investors would want to avoid the risk of partnering with a manager who may not be around in 10 years.
Managers must have the ability and track record to originate (source), execute, and exit transactions and generate returns for investors. An inability to do this results in investors holding cash in uncommitted assets, resulting in unnecessarily long periods of cash drag, ultimately leading to underperformance.
Lack of liquidity is a reality in private markets. However, it’s important to remember that this allows the asset to grow and compound returns over time. Short-term liquidity is always at the expense of long-term returns, so it is essential to construct a portfolio where liquidity can be accessed from shorter-term listed assets such as cash, bonds, and listed equities.
The investment opportunity
Private market investing may have more complexity than public market investments in certain aspects and is not without its trade-offs. However, it should never be seen as an asset class that replaces public market investments. It should be viewed as a complementary strategy to public market exposures – especially in the current environment where there is a dire need for greater real returns. When looking at the holistic portfolio, the portfolio enhancement and impact attributes make it a worthwhile investment.
Private markets can be viewed as a pure form of active management, given their direct influence on transforming and growing businesses, making them well suited to creating a positive impact at the intersection of profit and purpose.
