By Soo Shin-Kobberstad
In previous years, we have seen increasing appetite among investors for alternative asset classes. Moody’s believes that this trend will continue, as investors, notably pension funds, search for higher returns.
Pension funds have been prominent in driving this shift towards alternative investments, as low discounting rates caused their liabilities to increase excessively during the financial crisis. Compared to stocks and bonds, alternative asset classes offer higher portfolio returns and better protection against inflation and price volatility. In addition, investments in real estate and infrastructure, for example, offer long-term asset duration and cash flows that match the profile of pension funds’ long-term liabilities.
We expect that the increase in allocation to alternatives could be proportionately greater in the European pension funds industry. While European pension funds have historically had smaller allocations to alternatives compared to North American pension funds, the results of several surveys conducted in 2013 indicate that European pension funds have begun increasing their allocations in the past few years and, moreover, intend to further boost their allocations to alternatives.
This structural shift towards alternative investments will benefit asset managers with expertise in alternative asset classes, notably those with proven track records, such as Blackstone, KKR, Oaktree and Carlyle. However, traditional asset managers that have begun building their capabilities in alternative assets, such as BlackRock (rated A1) or Invesco (rated A3), are also likely to profit from this marked trend. For many traditional fund managers, building this expertise organically will be challenging. This is partly due to the illiquid nature of and longer holding periods for alternative investments, which means that it will take longer to produce seasoned investment professionals with the necessary experience.
BlackRock, for example, established its single alternatives asset management unit in 2010 and has been gradually expanding its alternatives product range since then, including several absolute-return strategy driven products launched in 2011. In addition, in 2013 BlackRock acquired MGPA, an independently-managed private equity real-estate investment advisory company in Asia-Pacific and Europe. Invesco started to expand its alternative AUM in the 2000s, which resulted in a 42% rise between May 2010 and September 2013. In December 2010, Invesco acquired the Asia fund and asset management business of AIG Global Real Estate Investment Corp., which included $5.4bn of alternative AUM.
In Moody’s view, asset managers who are well equipped to meet the investors’ shift to alternatives will benefit from incremental growth in assets under management (AUM) and management fees that are significantly higher than those of traditional investment products. In addition, alternative investment products offer asset managers performance-based fees while traditional asset class funds do not. In Preqin’s 2013 survey covering the alternative space, management fees amounted to 2% and performance fees ranged up to 20% over a certain pre-specified return level. While downward pressures on fees will increase as competition in the alternative asset-management sector grows, the marginal revenue from higher AUM due to the asset allocation shift to alternatives is likely to offset the pressure on fees.
One important concern for institutional investors is the alignment of interest between investors and investment managers. In an effort to better align interests, institutional investors increasingly demand increased co-investments and “skin in the game” by asset managers, as well as lower management fees based on AUM in exchange for continued emphasis on performance fees.
Although the asset manager’s co-investment tends to be only approximately 3% of total AUM, this could nonetheless represent a substantial amount of investments on the asset management company’s balance sheet. However, despite the resulting increase in asset managers’ cost of capital and operational leverage, Moody’s expects the higher management fees to outweigh the additional cost.
Soo Shin-Kobberstad is a senior analyst at Moody’s
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