Despite Headwinds, Institutions See Opportunities

Art by Klaas Verplanke

The first half of the year has been rocky for institutional portfolios. Public markets exposure is dragging down total portfolio performance in several high-profile funds. Japan’s Government Pension Investment Fund, the world’s largest pension fund, lost 1.1% during the first quarter, reducing its total assets to 196.6 trillion yen ($1.46 trillion), according to its most recent performance report. Swedish pension Alecta’s DC fund posted a negative return of 12.7% for the first half of the year, driven by losses in its public equity portfolio. The defined benefit plan had a negative return of 8.7% over the same period.

 Private asset classes, including private equity, private credit, real estate and infrastructure, have generally held up better, but these asset classes tend to lag public markets both in performance reporting and in showing signs of distress. This means that looking at first-half data from institutional funds may not show the totality of current portfolio performance.

 Valuations are down broadly, according to a mix of private funds performance data, and deal activity is slowing. Well-capitalized funds and businesses can often muscle through short-term volatility with their own resources. For funds and investors, negative impacts to performance may not show up immediately, or may be smoothed out as a function of being locked into those investments for several years.

 Institutions that are already committed to funds appear to be waiting it out rather than making significant changes to private market allocations. Lessons learned from prior crises may also be at play. Investors that missed out on recovery rallies don’t want to do it again, and portfolios overoptimized to the past decade of market conditions may be low on inflation hedges, many of which are found in illiquid asset classes.

 Respondents to Invesco’s most recent survey of sovereign wealth funds and central banks said they are planning to stick with allocations to private markets and may increase them in some cases. Allocations to private markets have risen to 22% in 2022, up from 18% in 2019, according to the survey.

 This trend isn’t limited to the biggest institutions; it also tracks with what Peter Burns, president and CEO of Commonfund Capital, is seeing in his client portfolios. Commonfund works primarily with foundations, endowments and nonprofits. “I think institutions learned a lesson coming out of the financial crisis that pulling back during times of uncertainty can mean missing out on a significant portion of the recovery,” he says. “Institutions weren’t making consistent allocations in 2009, 2010. Then they ended up with a hole in their portfolio and those funds turned out to perform really well. With private markets it can be hard to try to make up for it by making bigger allocations when things look more certain—by that point you’ve traded away a lot of upside.”

Pain Points

Despite a willingness to hold the line, there are some pain points showing up in the private side of the portfolio. Jill Shaw, a managing director and senior investments specialist at investment firm Cambridge Associates, notes that the denominator effect is likely to become a real risk for institutions over the near term. Because of the drop in listed markets, institutions with hard-target allocations could find themselves overallocated on a relative basis as a result of losses or selling out of listed markets. When this occurs, some institutions may be forced to sell into a downturn to maintain the target levels.

 The denominator effect could result in institutions having an overallocation to their illiquid asset classes relative to their overall portfolios. This could play out in changes to portfolio valuations and performance over several quarters, because it can take a long time to rebalance illiquid allocations. Often, this rebalancing comes at a more significant cost than selling out of listed investments if boards decide to start making changes to the portfolio in response.

 This could be especially painful for institutions that have overallocated to private investments that have been popular in the past few years but are facing unique pressure now. “I think we’re going to see a lot of pain in the late stage venture market,” she says. “There are a couple of issues at play there. Entry prices were extremely high and there aren’t many value-add levers to pull to counteract market declines. For investors looking to offload that exposure, sales into the secondaries market are likely to come with a significant haircut and it may be hard to find a buyer – many investors are faced with this problem.”

 She adds that many hedge funds have adopted a hybrid investing style that mixes public and private investments, and late-stage growth equity has been a popular niche. As a result, investors may find they have more exposure to this part of the market than they realized, through both traditional private equity funds and mixed-asset hedge funds. This could compound issues with target allocations and valuation across asset classes.

 Tiger Global Management, one of the biggest hedge fund investors in growth equity, posted losses of 14.3% in its growth-focused strategy in May. All-strategy returns for Tiger were down 52% through May, according to Bloomberg.

 Commonfund’s Burns is counseling his clients to avoid hard targets and consider investment ranges to get around some of the risk of the denominator effect. “Every portfolio is going to be different, but we are counseling people that if they don’t have to be locked into a specific target, it may make more sense to consider an ideal range for each asset class so that you don’t have to rebalance into volatility and end up with a significant loss.”

Playing Through

Apart from acute pain points, most private asset classes appear to be looking through current volatility. Many private fund managers are sitting atop piles of freshly raised capital that need to be put to work, with more still coming through the door as institutions look to private markets to hedge inflation and find bargains—at least on a relative value basis.

 “Our teams are continuing to deploy a steady pace of capital,” says James Barber, co-CIO and head of private investments at the Alberta Investment Management Corporation, or AIMCo. “In some respects, it’s akin to dollar cost averaging. You get more for your money investing during volatility than when everything is elevated.”

 AIMCo is focusing on finding relative value opportunities to help hedge against the myriad headwinds facing global markets. “We have seen some declines in valuation multiples on the private equity side of the portfolio, but that’s probably actually very healthy after the past few years. Managers are well-capitalized, and the underlying companies are also doing relatively well. They have stronger cash positions, solid revenues and earnings growth.”

 Cambridge’s Shaw adds that private equity’s focus on operational improvements in recent years has made the strategy and the underlying companies more durable. “We just don’t see the kind of financial engineering that you saw in 2008,” she says. “There is a bigger focus on long-term business growth and that approach is more likely to keep generating value during times of stress.”

 Private credit, which provides much of the financing for private equity deals, is also showing resilience despite recent markdowns. Many loans—both those held by banks and by private funds—have been repriced as volatility and interest rates increased, but AIMCo’s Barber thinks the yields are still attractive.

 “Private debt markets tend to be shorter duration and lower credit quality,” he says. “But we’re finding attractive underwriting terms with high levels of security and attractive spreads. Banks and hedge funds have already withdrawn some liquidity, but there are still loans on balance sheets that will likely move over to the private debt market over the next several months. There are potential opportunities to earn double-digit returns for the skilled investor.”

Build Back Better?

Infrastructure may turn out to be the growth story of the year for otherwise mixed institutional portfolios. Interest in global infrastructure deals has increased in part because they tend to be pegged to inflation, which can help limit the impact of inflation in other parts of the portfolio.

 According to the Invesco survey, inflation is top of mind for the biggest institutions—40% of respondents expect to see some measure of disinflation off the current global highs, but they anticipate that even with that inflation will remain elevated. Thirty-nine percent of respondents expect inflation to remain elevated and 17% said stagflation could be a real concern.

 Will Goodwin, head of direct investment at the New Zealand Super Fund, says that the focus on inflation is bringing more people to the infrastructure investing market. “Looking at infrastructure through the lens of an inflation hedge has changed the value of these investments for some investors,” he says. “Infrastructure tends to be positively indexed to inflation. That wasn’t a view that was always included in the valuation of this asset class over the past 10 or so years.”

 AIMCo’s Barber agrees. “There’s a real demand for quality infrastructure assets, especially those with inflation indexing,” he says. “We’ve actually seen some deals being pulled because the market thought the valuation was too low. I think that’s a reflection of a lot of institutional capital saying, ‘Hey I don’t have enough inflation protection in my portfolio.’”

 Goodwin notes that current geopolitical events, such as the war in Ukraine, are also putting pressure on governments to accelerate infrastructure investments, which could create new opportunities for investors.

 “A real energy transition is being forced on Europe right now at a very, very accelerated rate. That’s going to require significant investment over the near, medium and long term,” he says. “This is also coming alongside existing commitments around sustainability, so it’s not a flash-in-the-pan opportunity. I suspect people are going to look back 10 years from now and see that we went through a lot of pain but the infrastructure is much stronger.”