Art by Jam Dong
Institutional asset owners have long allocated to the broad class of investments beyond stocks and bonds, known as alternatives. The different categories of alts, from private equity to infrastructure, to commodities and private credit, are sought as sources of portfolio diversification and to reduce correlation.
In 2023, the CIO NextGen honorees pointed to different benefits and risks across a variety of alts, and as can be expected, shared a diversity of opinions in response to questions we posed. Institutional investors, including pension funds, endowments and foundations, have been in private equity for decades, with the average allocation, across all types of asset owners, now nearing 25%.
Brent Mattis Jr., a principal in the Cleveland Clinic Investment Office, cited the wisdom of the late investing pioneer David Swenson, who ran Yale’s endowment for decades, for leading the way on alts, particularly private equity.Swenson’s wisdom was “that investors could earn excess returns by committing capital to niches where capital is scarce,” Mattis wrote. However, Mattis cautioned that “the secular flow of capital from public to private markets is an excellent example of a ‘good idea taken too far.’”
Wagner Dada, managing director in the systematic strategies group for capital markets and factor investing at the Canada Pension Plan Investment Board, noted alternatives—namely private equity, private credit and real assets—are attractive for most institutional investors “given their diversification and return expectation potential.”. These asset classes are also attractive investments “due to their ability to generate compensated risk premia and stable cash flows. … Real assets can offer institutional investors a way to harvest illiquidity risk premia. In the post-COVID years, we have seen inflation protection become a key consideration … spurring an interest in inflation protection alternatives like inflation linkers and commodities.”
Charlotte Zhang, investment director at the Inatai Foundation, called private equity the most important alternative asset class, citing the significance of PE offering allocators the opportunity “to capitalize on asymmetric information that informs sourcing, due-diligence and value-creation initiatives, having the benefit of long investment time horizons that enable strategic decisionmaking and strong corporate governance to implement operational changes that grow the value of a business.”
Carrie Green, director of equities for the Tennessee Department of Treasury, cited the importance of the venture capital segment of PE to the overall institutional investing ecosystem.
“Innovation is where all economic growth begins,” Green wrote. “So I believe institutional portfolios need a reasonable allocation to venture capital. If new ideas aren’t funded, then the rest of the investment life cycle that makes up the bulk of institutional investment opportunities does not exist.”
Lin Maung, senior portfolio manager at the State of Wisconsin Investment Board, pointed to advantages of PE as compared with public equities. “I firmly believe that alpha in private equity comes from fundamental advantages in how a company is governed and the skills and hard work of the managers we back. The combination of governance and manager skill are not easily replicable in the public market and constitutes a repeatable framework that can contribute strong returns to any program that chooses to commit to private equity.”
But Zhang also acknowledged some growing challenges.
“As more capital has flooded into this asset class, gaps of market inefficiency are closed more quickly, which erodes the go-forward expected returns,” Zhang wrote. “Investors should be mindful of selecting for strategies that adequately compensate them for taking on illiquidity risk, especially as entry valuations in private markets have remained relatively sticky compared to drawdowns in public markets.”
Toshie Kabuto, deputy chief of asset allocation at the International Monetary Fund’s investment office, also cautioned that institutions have to be aware of the limitations of PE. “Alternative investments, including private equities … are not readily accessible when you want to add them, and it is hard to adjust the allocation or provide the right levels of allocation when you want them.”
Beyond PE, the NextGens cited the newer, evolving alts class—private credit—as offering both opportunities and certain unique risks.
SWIB’s Maung, who early in his tenure led an initiative to position SWIB’s current return portfolio (or private credit) higher up the capital structure, cited “the user-friendly characteristics of direct lending relative to public leveraged finance” as offering allocators access to a market that was “going to widen to large-scale borrowers who historically would have tapped the public market. In addition, we viewed the strategy as ‘all weather,’ given the seniority, floating-[rate] nature and prevalence of lender protections.”
He added, “direct lending has remained open for business through a volatile environment, large borrowers are increasingly choosing to finance privately in lieu of the syndicated market, and yields are in the low teens for senior credit, with lower leverage and continued prevalence of lender protections.”
But as private credit and direct lending have gained popularity in recent years, some of the NextGens are cautious about the sector.
Brian Clark, investment director at the Harry and Jeanette Weinberg Foundation, said he worries about some of the “very rosy growth and profitability projections” made for private loans before interest rates rose, but the same dynamic “should provide a large opportunity set for sophisticated credit investors who can navigate complex loan documents and is an area I continue to watch closely.”
About the risks, Clark wrote: “Most of these companies never expected to see interest rates as high as they are today. With these loans typically being floating rate, companies’ debt service costs have risen significantly, which will likely lead to many stressed and distressed situations. Many of these loans are covenant lite [which] can lead to creditor-on-creditor violence in which some investors get primed out of their senior positions and into more junior positions … in the capital structure. I believe this dynamic will take years to work its way out of the system and lead to significant capital impairment.”
Michael Cimmino, a portfolio manager of hedge funds at GE Investment Management, was one of several NextGens who cited the importance of certain hedge fund strategies for limiting drawdown in institutional portfolios, particularly “risk-mitigating strategies, such as directional macro, relative value credit and certain systematic long/short strategies.”
But he said the bright light for alts in 2023 is infrastructure that enables investors to further capture “long-term secular trends occurring within the global economy while also diversifying away from traditional buyout and private debt strategies.”
Among alts, Cimmino said, “Investors should continue to benefit from its defensive characteristics due to stable demand for the underlying asset and the long-term nature of contracts that include protections from inflation.”
Tags: Alternatives, Asset Allocation, direct lending, Hedge Funds, Infrastructure, Private Credit, Private Equity, Special Coverage: NextGens