How to overcome the challenges of investing in private assets

The following article was originally posted on the?Mercer Yield Point Blog.?You can find this article along with more wealth news content?here.?

There are many good reasons for not-for-profits to invest in private markets, the potential for enhanced returns being one. There are barriers, of course, but with the right approach, they can be overcome.

Institutional investors, including not-for-profits (NFPs), are increasingly interested in moving towards private markets and alternative asset classes. However, this great migration will require a higher governance threshold and increased ongoing management and oversight.

In our 2022 survey of NFPs around the globe, 65% say diversifying away from traditional asset classes is their greatest opportunity over the next three years, while 61% intend to increase their allocation of private equity over the next two years.?

Speaking on our recent podcast, Richard Pugmire, Alternatives Business Leader of US and Canada, said investors are interested about private equity and other strategies like private debt, real estate, and infrastructure because of the potential for alpha or excess returns through active management.?

The ability to potentially generate enhanced investment returns was the main reason for investing in private markets for 78% of investors in our survey.?

Pugmire said during growth environments, private equity managers have helped companies enter new markets, develop new products, and hire top talent. During recessionary times, companies have helped to acquire a competitor or other add-on acquisitions to strengthen their position for when the market starts growing again.

The second highest reason for investing in private markets is to help reduce downside risks in the portfolio. While the public equity and fixed income portfolio has done well over the last 10 years, the next 10 years are not expected to be the same. Pugmire said the number of publicly traded companies has gone down since the 90s, which means there is less opportunity to diversify.

Also speaking on the podcast, Dina Richard, Chief Investment Officer at Trinity Health, said one of the benefits of being in the private markets is having access to high-growth, innovative companies, which are staying private longer.

Trinity previously had a small exposure to private assets and after conducting a risk study realised it needed to increase its growth assets overall to seek more return. Trinity selected a 7% allocation to the asset class, which has since grown to 15%.

Trinity was very focused on finding top-tier managers to invest with over multiple funds and early on looked for opportunities in secondary markets as well as private credit.

Challenges of governance budget

The main challenge with NFPs investing in private assets is their governance budget is restricted and it can be quite daunting to take the plunge and commit to building an allocation.

Lack of resources, complexity of investments, and fees being too high are some of the key reasons for not investing in the asset class, according to our survey.

One challenge is that the dispersion of private market returns is wider among managers than traditional asset classes, which makes the process of evaluating managers resource-intensive, said Pugmire.?

NFPs have taken various approaches including building internal staff, using an advisor to help employees, outsourcing either part of the programme, or all of it.

More than half (55%) of respondents in our survey have outsourced some services to a third-party provider, while almost 30% changed nothing and felt they were prepared. Almost one in 10 have hired more people while 7% have not changed anything but acknowledged they need to do something.

Fees in private assets are much higher than for traditional asset classes. Educating a governance board on fees and incentives is an important part of implementing a private markets portfolio, said Pugmire.

Another challenge is that these assets are long term and illiquid with assets locked up for as many as 10 years.

Trinity has a very talented but lean internal team, so they used an advisor to help them build the portfolio. Richard said it also helped to have modelling commitments and projected cash flows, and keeping these going on an ongoing basis.

According to Richard, having a good education process with the board or investment committee from the beginning is very important to gain their support. She said it is also helpful to conduct a deep-dive annual review with the committee to keep them engaged.

Focus on ESG and D&I

Private assets can enable investors to take environmental, social and governance (ESG) issues into account. Pugmire explained there are more concentrated strategies in private markets, and managers often have more control of the assets, so they can set the organisation's goals around ESG considerations.

Venture capital managers are focusing more on climate technology and finding companies that are helping solve issues caused by climate change, he said.

Trinity, which is very focused on ESG, diversity and inclusion, has been successful in hiring firms that focus on ESG with many being signatories of the UN’s Principles for Responsible Investment. Richard noted Trinity’s focus on ESG and DE&I initiatives is really important to her team and had great success in private markets finding diverse-owned and also diverse senior leadership at their funds.

In fact, Richard said Trinity has more diversity in its private allocation than in its public portfolio. She added that funds are promoting DNI in their hiring practices, and they are also able to influence the underlying companies.?