For myriad reasons, the world’s largest institutional asset owners – pension funds, sovereign wealth funds, insurance companies, and endowments – are investing ever-increasing amounts of their portfolios in the private markets. This shift toward a greater allocation to private, less-liquid investments like private equity, private debt, real estate, and infrastructure isn’t new – alternatives as a broad asset class has grown rapidly over the past decade.1 But it is striking when considered on a global scale. Because these firms are so large, even relatively small shifts in their asset allocation models have an outsized impact on the investment industry – a 1% change in allocation could equate to roughly $190 billion in new commitments (and redemptions).
With few exceptions, this trend towards illiquid alternatives shows no signs of abating. A 2019 McKinsey report remarked that alternative investments have grown twice as fast as non-alternatives since 2005 at an annualized growth rate of 10.7%.2 A recent report from Preqin forecasted continued growth in alternatives from $8.8 trillion in AUM in 2017 to $14 trillion in 2023 – a roughly 8% growth rate.3 This is a remarkable story, made even more so given the growth in private assets we’ve already witnessed.
Tracking the movements of large-scale asset owners offers a variety of insights. Given their size, they have the capacity to change markets and to influence asset manager product development and merger and acquisition activity – a storyline that has been playing out over this past decade. Changes in asset owner behavior can also be a bellwether for smaller investors making educated decisions about their portfolio, some of whom may not be able to secure the same access or establish the necessary oversight to effectively manage private market exposures. Here’s a rundown of the key private market alternative asset classes and how large investors are deploying capital to these areas.
Private Market Asset Classes
Private debt may be the most impressive growth story of all the illiquid asset classes over the past decade. Its emergence as an asset class has been, in part, fueled by big banks’ retraction from many of their long-standing, core lending activities coming out of the 2008 financial crisis. As regulators imposed stringent capital requirements for banks, many private equity firms stepped in to fill their void. According to the Wall Street Journal, “non-banks – many private equity firms – held more than half a trillion dollars’ worth of loans to midsize companies at the end of 2017, up from roughly $300 billion in 2012.”4
Closed-end private real estate fund AUM grew from $63 billion in 2000 to over $810 billion in 2017.5 Average returns from these funds have been impressive and helped fuel additional year-over-year fundraising growth in the asset class. Managers have distributed almost $900 billion from closed-end private real estate since 2013. Many institutional investors have plowed those distributions back into the General Partners’ next funds, contributing to another healthy year in 2018 with $757 billion in total raised capital.6
In nearly every corner or the world, major infrastructure projects are increasingly financed and developed through private funding. Global infrastructure investment has seen a notable evolution over the past decade, as projects that have historically been government-financed have transitioned to other funding sources. Many government institutions are increasingly finding it difficult to generate the political capital to align long-term infrastructure financing needs with current-state political realities. According to recent BCG research, “The Global Infrastructure Hub, a G20 initiative, identified a funding gap of $15 trillion from 2016 to 2040.”7
The availability of private capital is an opportunity to transfer risk and accountability from governments to corporations and developers. Infrastructure fundraising for private funds has grown from roughly $1 billion annually in the early 2000’s to over $80 billion raised by closed-ended funds in 2018.8
Private Equity & Venture
The growth of private equity and venture capital in recent years is unprecedented. As McKinsey put it, “Private equity’s net asset value has grown more than sevenfold since 2002, twice as fast as global public equities. Consider the growth in US PE-backed companies, which numbered about 4,000 in 2006. By 2017, that figure rose to about 8,000, a 106 percent increase. Meanwhile, US publicly traded firms fell by 16 percent from 5,100 to 4,300 (and by 46 percent since 1996).”9
In parallel, the global venture capital market had another impressive year in 2018 and now has significantly more dry powder than any time in the past 18 years.
Venture capital (VC) has also seen massive growth from newer entrants with over 2,000 new VC firms founded since 2010. That’s compared to just 800 managers in the VC industry prior to 2010.10
Much of the continuing growth in private markets has been driven by the search for yield. Take the returns of Yale’s endowment, which has had an outsized allocation to alternatives for decades. According to its 2017 annual report, Yale had 75.1% of its portfolio allocated to alternatives and less than 4% allocated to domestic equities. Over the past 20 years, Yale’s portfolio has averaged an annualized return of 12.1%. Contrast that to a more typical 60% stock, 40% bond portfolio which averaged an annualized 6.9% return over the same period.11
In 2018, Yale increased their already significant exposure to private assets – most notably taking their allocation to venture capital to 19%, private equity to 14.1%, and real estate to 10.3%.12 Yale’s remarkable performance hasn’t been lost on other large, institutional investors.
Additionally, sophisticated investors learned key lessons from the 2008 financial crisis. Perhaps one of the most significant was that global financial markets were far more correlated than most investors realized, especially in times of stress. Accepted principals of diversification across asset classes, sectors, and geographies were put to the test. Across the globe, stock prices fell and credit markets tightened.
While private investments weren’t immune to the crisis, fund managers had the latitude to exercise patience and hold their private investments until the market showed signs of recovery.
The Largest Investors
The top 100 global asset owners accounted for approximately $19 trillion in assets worldwide in 2018, which is roughly 35% of the total capital worldwide. Of the top 100, 61% of the assets were from pension funds and 32% in sovereign wealth funds. These investors are relatively evenly spread across the world with 36% in Asia-Pacific, 34% in Europe, the Middle East and Africa, and 30% in North America.13
With such varied mandates, it is worth exploring the environments these investors are navigating and, ultimately, the underlying drivers that might be behind this broad shift toward alternatives.
US and European Pension Funds
The 2008 financial crisis highlighted systemic issues within many of the pension funds in the US and Europe. One notable issue was the sizeable gaps between funds’ liabilities and the underlying assets needed to generate returns that keep pace with those liabilities over time. While individual storylines differed, other key themes emerged. Global markets correlations, mentioned above, was one. Another major theme was overly aggressive assumptions around sustainable investment returns.
What’s most striking is that despite an unprecedented bull run that has seen the S&P 500 generate annualized returns over 13% over the past decade, these systemic issues have, in large measure, worsened.14 According to Federal Reserve statistics tracking state and local government pension funding ratios, in 2004, 37 of the 50 state and local funds had at least a 60% or better funding ratio (the ratio of the pension plans assets as a percentage of liabilities). In 2008, that number dropped to seven states. Almost ten years later, despite a remarkable decade for the stock market, little has changed.15 California, the world’s eighth largest economy, has a 51.1% funding ratio, which means they have $750 billion more liabilities than assets. Illinois and New Jersey “lead” the way with 25.1% and 30.1%, respectively.16 More broadly, the gap between assets and liabilities has broadened since the financial crisis, from $3.5 trillion to $3.8 trillion.17
The California State Teachers’ Retirement System (CalSTRS), with $230 billion in assets, recently increased their allocation to real estate, leaving the US’s largest pension fund with a 26% target to both private equity and real estate (13% for each).18 In 2018, the top 200 defined benefit plans in the US “saw assets in private equity, specifically, increase by 10.7% to $367 billion as of Sept. 30.”19
The pension systems in Europe are structurally different, but the theme of sizeable asset liability gaps is consistent with the US. In the UK, numerous FTSE 100 firms, including Royal Dutch Shell, BP, BT Group, and BAE Systems (all with gaps of close to $8 billion or more), continue to amass larger and larger deficits – some while paying out larger dividends each year. A broader look at twenty OECD countries by Citi in 2016 estimated a “staggering $78 trillion [in underfunded government pension liabilities], or almost double the $44 trillion published national debt” of those countries.20
Asian Sovereign Wealth & Pension Organizations
Asia is home to some of the world’s largest institutional asset owners, including insurance, pension, and sovereign wealth funds. These names include Japan’s Government Pension Investment (GPIF) with $1.4 trillion in AUM, China Investment Corporation with $900 billion, South Korea’s National Pension with $582 billion, and Singapore’s Global Investment Corporation with $359 billion. While each operate under unique regulatory environments and with different mandates, they are all focused on providing foundational retirement income to aging populations.
Take Japan, as an example. Japan’s GPIF is the world’s largest pension fund and serves multiple purposes, providing for an aging population, but also serving as a key, macro-economic stabilization lever for the Japanese economy. As Japan contended with a negative interest rate environment, Japan’s largest institutional investors have been forced to alter their traditional asset allocation models, which were heavily weighted toward Japanese fixed income investments. Over the past five years, many of Japan’s largest institutional investors have expanded first into international bank loans, then into less-liquid alternatives. According to a 2018 Private Equity International (PEI) article, “Japan Post Bank and Japan Post Insurance, two of the largest [Japanese] investors with more than $2 trillion of assets, set up their own PE fund management company in February” of 2018.21 Japan Post’s most recent three-year plan has it investing 1.5% of its $700 billion in AUM into real estate, infrastructure, private equity, and hedge funds.22
Cerulli reports that Australia’s Future Fund and the China Investment Corporation (CIC) have much larger allocations to alternative assets. More than half of CIC’s assets are invested in alternative strategies, while the Future Fund has almost 40 percent of its portfolio allocated to the category.23 Similarly, Singapore’s Global Investment Corporation (GIC) saw its private equity investments grow from 9% to 11% in 2018, which is still at the low end of their 11-13% target allocation.24
Nordic, Middle Eastern, and Latin American Southern Wealth
Nordic, Middle Eastern, and Latin American sovereign wealth have a key similarity: their respective economies rely heavily on natural resources. As volatility in the energy markets has become the new normal, the role sovereign wealth funds play in diversifying economies and stabilizing currencies has become paramount. When managed well, sovereign wealth funds can act as a source of longer-term economic security and as a currency stabilization tool that mitigates softening energy markets and volatility in oil prices. In these cases, asset diversification, both from an asset class and geographic perspective, is critical.
According to a recent Investment Pensions Europe (IPE) article, alternatives – particularly real estate, infrastructure, private equity, and private debt – “saw the largest inflows relative to other asset classes in 2018.” In Denmark, Finland, and Sweden, real estate allocations are high and rising, with the current levels comprising almost 10% of the total portfolio. Private debt appears to be the hottest asset class, particularly as credit spreads narrow and yields from traditional fixed income investments become less attractive.25
Norway is home to one of the world’s largest asset owners, Norges Bank’s Government Pension Fund Global, with more than $1 trillion in AUM. The fund’s assets originate from Norway’s oil revenues and are intentionally invested internationally to diversify investment, economic, and currency risks and to generate long-term returns. Norges Bank also has sizeable investments in real estate and formed a joint venture with AXA Real Estate Investment Managers – an arm of the French insurance giant, AXA – in 2013 to co-invest in European real estate debt.
Like many of the other large, institutional investors, insurance companies balance a number of considerations as they contemplate their asset allocation models. While many insurance companies have moved toward managing their own fixed-income portfolios, that trend appears to be changing. More and more insurance companies are using outside managers to access a broader set of investment capabilities – including alternatives.
The financial crisis brought quantitative easing and a low interest rate environment that stressed the standard asset allocation models and created a greater need for yield. Alternative investments, particularly private and real estate debt, offered higher yielding investments with similar risk. As a result, the insurance industry has seemed willing to trade liquidity for returns.
As a testament to the potential of that trend, two of the world’s largest alternative managers, Apollo and Blackstone, have made noteworthy investments in their own firm’s expansion into insurance. Apollo was an early entrant through Athene, its $85 billion life insurance affiliate. And last year, Blackstone announced the formation of Blackstone Insurance Solutions, which is being led by industry veteran, Chris Blunt, who was the former head of New York Life’s investment group. Blackstone has said they expect to grow business to $100 billion. According to Blunt, the industry is ripe for growth: “there is an estimated $23 trillion of insurance assets globally, a vast, largely untapped market for us and for just about anybody else, except strictly high-grade sellers of product.”26
By almost any measure, the world’s largest institutional investors have embraced alternatives as an integral part of their portfolio composition. While each of these investors contend with different obligations and risk profiles, the overall trend line suggests this cohort represents many of the new power-brokers in the global investment industry. It may also portend a new set of risks for the underlying beneficiaries of the world’s largest institutional investors.
It is unclear if many of these institutional investors have the sophistication to manage their growing allocations to private market investments. As portfolios of less liquid assets grow, so too does the need for the people, systems, and partners necessary to provide effective oversight. Many of the tools used to manage private market portfolio exposures and risk are different and more nuanced.
In parallel, it is important to consider whether global regulators have the capacity to effectively monitor a growing book of privately marked assets. What does an appropriate risk and oversight model look like, both for investors and for the regulators entrusted to protect them? Is it possible to effectively monitor systemic risk when a growing percentage of assets are privately held and therefore nearly impossible to aggregate and measure?
These questions will inevitably be answered, though how soon and under what circumstances remain unclear. Regardless, private market investments now represent a substantial footprint for most large investors and that trend looks likely to continue. Ideally, this rising private market tide will lift all asset owner boats, delivering alpha returns, closing asset/liability gaps, and insulating them from market risk during the next downturn. Then again, this level of unprecedented growth suggests many of the players involved may lack the experience to weather unforeseen storms and the private market implications of a public market downturn. As is so often true in financial markets: only time will tell.
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1 Preqin – Alternatives in 2019, February 2019
2 Private markets come of age, McKinsey & Company, 2019
3 Preqin – Alternatives in 2019, February 2019
4 WSJ – The New Business Banker: A Private-Equity Firm, 8/12/2018
5 Preqin Special Report: Real Estate Fund Manager Outlook, H1 2018
6 Preqin Special Report: Real Estate Fund Manager Outlook, H1 2018
7 BCG – Infrastructure’s Future Looks a Lot Like Private Equity, 11/7/2018
8 Infrastructure Investor – Infrastructure Investor Fundraising Report 2018
9 McKinsey – Private markets come of age, McKinsey Global Private Markets Review 2019
10 McKinsey – Private markets come of age, McKinsey Global Private Markets Review 2019
11 Institutional Investor – We crush Stock Indexes, Yale Claims, April 11th, 2018
12 Chief Investment Officer – How Does Yale Do It? By Being Different, March 13th, 2019
13 Willis Towers Watston - Thinking Ahead Institute reveals the ‘most influential capital on the planet’, November 12, 2018
14 Morningstar Data
15 Federalreserve.gov – State and Local Government Defined Benefit Pension Plans by State (10/4/2018)
16 Federalreserve.gov – State and Local Pension Funding Status and Ratios by State, 2002 - 2016
17 The Rise and Rise of Private Markets, McKinsey & Company - 2018
18 PERE – CalSTRS increases allocation to real estate, March 22nd, 2019
19 Pensions & Investments – Largest funds top $11 trillion; assets up 6.4% - February 4th, 2019
20 The Coming Pension Crisis, Citi 2016
21 Story of the year: Private equity moves in on Japan – PEI, January 1, 2019
22 Inside Japan Post Insurance’s $10 bn alternative investment plan – Infrastructure Investor, November 7th, 2018
23 Institutional Investor – Sovereign Funds Carve out More Room for Alternative Assets, October 3rd, 2018
24 Pensions & Investments – Singapore’s GIC positioning its portfolio more cautiously amid growing risks, July 12, 2018
25 Asset Allocation: Innovation for the future, November 2018
26 Forbes – Apollo and Blackstone Pick Insurance as Their Next Bet to Disrupt Wall Street, February 1st, 2018