When the winds of change blow, some people build walls, others build windmills.
– Chinese Proverb
Asset managers as change agents
Before addressing the central hypothesis regarding sustainability, it’s worth reaffirming: asset managers can effect meaningful change in the markets and by extension the wider economy and society at large. Asset management as an industry sits at the intersection of how investors and asset owners allocate risk and deploy capital. This, of course, has vast implications across the real world. That’s why a key pillar of asset management is investor education, as investors and asset owners seek guidance on asset allocation and future trends in order to commit their money with a reasonable level of confidence. Investment trends and preferences often dictate the future shape of the capital markets, and how certain companies, asset classes, and sectors fall into or out of favor.
It’s in the area of sustainable investing that is changing the industry – some argue for the better. For the most part, governments, investors, and policymakers across the globe are committed to reorienting capital flows towards a more eco-friendly and sustainable future. Case in point: European sustainable funds attracted record inflows of EUR 54.6 billion in the second quarter of 2020, accounting for almost of third of overall European fund flows in the same period, according to Morningstar.1 While investors look to the sustainability of their investment portfolios, asset manager must also look to the sustainability of their own business model and product offerings and ask themselves whether they are building walls or building windmills as the winds of change rise.
Road to recovery
As the global economy faces an uphill battle, asset management will be central to the required overall economic recovery. With macro-economic factors such as continued ultra-low interest rates and the effect of expansionary monetary policy elevating the assessment of traditional portfolio composition, many suggest that the traditional 60 percent equities/40 percent bond portfolio composition model may now be redundant and possibly gone forever. There is an ever increasing body of evidence, backed by governmental and institutional activity, that the most viable way to bridge an ever expanding global pensions funding gap is to reframe overall portfolio compositions and commit to longer term investment horizons, less correlation to traditional benchmarking weightings, and target higher yielding asset classes such as those primarily found in the private markets.
Just to be clear, the private markets refer to investments not traded on a public stock exchange or other publically available market venue. In the past, private markets were often considered too hard to access, opaque, or niche for traditional investors. Like many things in life, however, they have evolved, with private market funds providing a direct channel for investor pools of cash to flow to companies, assets, and projects that form the backbone of the real economy. Private markets investments are generally accepted as an attractive means to diversify a portfolio and achieve enhanced long-term return potential for many types of investors.
The case for increased private market investments has been further bolstered through a mix of higher regulatory obligations and attendant costs, which has seen fewer firms choosing to list on traditional stock exchanges, meaning a wider and more diverse set of opportunities in the private market space. We can save as a debate of the relative merits of listing or not for another day, but what is clear is that public markets are contracting in terms of number of investable public companies,2 yet the number of trading companies continues to rise, and so does their funding requirements.
The impacts of the COVID-19 pandemic cannot be ignored either. COVID-19 has imposed a generational economic shock denting governmental purses, savings, and pension pots the world over. It seems that stock market performance has completely decoupled from economic activity and perhaps painted a rosier picture of the challenges that lie ahead for the “real economy.” Global stock markets have risen almost back to pre-pandemic levels; the real economy, however, continues to suffer with the International Monetary Fund (IMF) expecting global gross domestic product (GDP) to fall by up to 10% in 2020.
Historically, economic downturns create investment opportunities that subsequently produce the highest returns. As the global economy remains somewhat in a state of animated suspension as the pandemic lingers, investors are evaluating the skill and ability of asset managers in identifying the right investments, and some of the most sophisticated investors have in-sourced those skills themselves, creating direct and co-investment teams.
In this context, the private markets — and all who participate in them — are assessing the role they wish to play. As always, there are both challenges and opportunities within these secular shifts. As investors and asset owners increasingly look at their investment portfolios, not only through the lens of profit and loss, but also on its impact and ability to drive positive societal change, there is a definite sense of purpose and change in the air, as the private markets ecosystem considers a re-calibration of its business model to meet the challenge and grasp the opportunity.
If “stakeholder capitalism” is a defining feature of this “new normal” then private markets business model must adapt accordingly. Larry Fink previously referred to it as a “Fundamental Change in Finance.” With the winds of change blowing strongly across society, private market managers too must contemplate the role they wish to play (and which their investors wish them to play) both in the road to economic recovery from the pandemic as well as the longer-term shift to more sustainable investment portfolios.
Five ESG Drivers of the Private Markets
Here are some evident trends and impacts to major asset classes which could be signals that the shift towards sustainability is a benefit to private market asset managers.
The Climate Emergency
Our House is on Fire – Greta Thunberg
Investor appetite for ESG and climate-change products continues to rise. An increasing percentage of pension funds now account for climate-change risk within their investment allocations. In the latest European asset allocation insights survey from Mercer found that 54% of respondents actively consider the impact of climate change-related risks on their investments, up from 14% in a 2019 survey. The commercial case seems more than solid.
The climate crisis represents a massive opportunity for the private markets since the growing imperative to transition from a carbon dependent to more sustainable economic models requires the funding, building, and renovating of large swathes of real estate, infrastructure, and alterations to production and supply chains. Most building projects now come with environmental considerations from build of wind or solar farms to construction standards for modern buildings. Both on a sectoral and thematic basis, this trend opens a host of new product opportunities for private market investors.
Public Private Partnership (3P)
When something is important enough, you do it even if the odds are not in your favor. – Elon Musk
The economic recovery plans from the systemic shock of the global pandemic coupled with an ongoing climate crisis present a need for an unprecedented level of funding over the longer term. Governments and central backs across the globe have deployed “bazooka” monetary policies and have committed to “whatever it takes,” which has brought public coffers to the brink. Pooling public and private capital is not the solution but it is a solution. Public-private partnership (3P) is a cooperative arrangement usually between a governmental body and a private company to provide a project, product or service to citizens. 3P has benefits since it reduces the funding burden from being purely tax funded and increases stakeholder alignment if citizens of the world are part of the recovery story and creates a virtuous circle of mutual benefit and is at least worth considering.
In the United States, we saw the power of public private partnerships in the form of the space launch of the Crew Dragon, which was the result of a marriage of NASA and SpaceX. Reeling from a shuttered space program in 2011, NASA partnered with the free-wheeling private company to pull off an extraordinary, unprecedented feat which caught the imagination of the public. By pooling resources space flight enters a new era, one that doesn’t appear to be looking back. It was a much-needed bright spot of inspiration in what has been a grueling year. It also indicates the type of collaboration that might drive large projects into the future and as importantly where asset managers might have co-investment opportunities.
Retailization of Alternative Funds
Participation – that’s what’s going to save the human race. – Pete Seeger
Retail participation in private markets is currently one of the hottest industry debates. It is particularly raging red hot in the United States where in June, the US Department of Labor issued a letter permitting ERISA investors such as 401(k) plans to include private equity investments through target date and other multi-asset funds and still be seen to adhere to their fiduciary obligations. Whether it is via direct investment or indirectly through pensions or other long-term savings products, or driven by a desire for higher yields, it is very evident that there is appetite to allow retail investors access to asset classes that previously were the sole domain of institutional investors. Regulators will play a large role in how this develops but in theory we are trending towards a model where more investors and more capital will want access to the private markets. Will there be enough investable opportunities to meet this additional demand at a time when firms like Prequin suggest that private investors are already sitting on a record amounts of cash? With “dry powder” at its highest on record, and more than double what it was five years ago, will supply meet demand? In order to meet this demand, the way private investment deals (i.e. companies, assets and projects that need funding) are sourced, filtered and validated needs to evolve, digitize and be democratized.
Movies are a fad. Audiences really want to see live actors on stage. – Charlie Chaplin
With such fundamental changes to the structure of the economy, it is increasingly a market defined by relative winners and losers. These divergences are sometimes split by geography, sector, or industry specific, as certain mega-trends benefit some and constrict others. The market has seen a number of thematic funds successfully launch, although primarily in the ETF and mutual fund space for now, but these themes apply equally to investment opportunities in the private market space. Thematic funds ranging from video games and e-sports to lithium and battery technologies and even a focus on companies who benefit from Millennial lifestyles and buying behaviors have sprung up capturing evident trends which are likely to maintain over the longer term.
This dynamic does however often result in greater appetite for thematic funds. Thematic investing looks to invest in long term trends or themes. There are discernible examples already in the global private market space looking to take advantage of the large shift to remote working during the pandemic for example. This has resulted in greater investment into areas such as broadband and other digital infrastructure looking to benefit from the trend towards greater connectivity and digitization. As society continues to evolve, adapt, and change, asset managers are responding through new product innovation.
Be the change you want to see in the world – Mahatma Gandhi
Some in the industry argue that we’re entering an era of one of the largest generational wealth transfers in recorded history. As baby boomers – perhaps the wealthiest generation in recorded history – retire, much of their wealth will be transferred to younger generations. But here’s the rub: younger generations, by in large, have vastly different investment value sets than older generations, with a desire for financial products that mirror their philosophy around sustainability. Indeed, it is already clear that this is increasingly the direction of travel when investment flows and recent new launches are assessed. Also, the younger demographic wants more of an active say in their investments than perhaps prior generations who were more likely to defer to advisors and managers. As such asset managers must act as the intermediary to mobilize such investor capital to areas they demand and generally be able to “walk the walk” within their own business and through their investment products when it comes to areas such as environment, workforce diversity, social justice, labor practices and a range of other factors.
The modern investor and asset owner really do want their investments to represent the change they want to see in the world.
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1European Sustainable Fund Flows: Q2 2020 in Review.
2 In the United States, there are roughly 4,000 public companies today, roughly half the amount there was in 1996 (ref: SEC website)