How is UK schemes' appetite for private market assets changing?

However, there has been a meaningful shift in the types of illiquid investments being sought, and increasing concerns over the ability to implement investment programmes.

Schemes have shifted focus

At the risk of over-simplifying the trend, pension funds have shifted their focus somewhat away from ‘growth-oriented' private market strategies, such as classic private equity, and towards sectors providing ‘protection’ and/or ‘income’, including private debt and certain real assets.

There tends to be a massive range of performance outcomes from managers and funds with supposedly similar strategies during periods of dislocations

Indeed, in some cases we have seen investors reducing exposure to private equity or remaining under-invested versus target allocations, such as not yet recommitting returned capital or selling positions in the secondaries market.

This focus on protection and income makes a great deal of sense in the current market climate. Such sectors are – to some extent – less vulnerable to ‘market correction’ considerations.

That being said, investors are not in wholly conservative mode: 2018 has also brought a wave of interest in more ‘value-added’ activity in infrastructure and real estate, given the very aggressive pricing of core strategies and the desire to maintain returns.

We are also seeing modest demand for private markets from UK defined contribution schemes, even though these asset classes are naturally somewhat less desirable for this group of investors than their defined benefit counterparts, given the lack of ongoing liabilities (ie lower requirement for income) and the relative immaturity of members (ie less need for protection).

Market concerns not the only driver

It is important to note that market concerns are not the only driver of the increased demand for resilience-oriented strategies.

Private debt, unlisted real estate and infrastructure have proven particularly popular among UK DB schemes throughout the past five years, in part due to adjustments in portfolio construction philosophy and methodology.

This community has, increasingly, sought to structure investments in such a way as to achieve a given overall return objective while simultaneously maximising the proportion of portfolio in income-generating and/or yield-generating investments.

However, DB scheme maturity and funding levels greatly affect the case for various illiquid sub-sectors, so it is important to avoid excessive generalisation.

Risks to financial markets remain profound

Today, investors in private market strategies must grapple with three key questions. First, which private market asset classes (and, crucially, sub-sectors of those asset classes) are likely to be more resilient to rising yields and economic shocks?

Second, will rising yields undermine the case for these more defensive private market investment strategies, particularly those that have functioned as an explicit replacement for public bonds, such as private debt?

And third, which asset managers are best placed to deliver robust performance?

On the first point, initial signs are mostly positive. Bond yields have now been rising gradually for several months. We have not yet seen this increase translate into a declining demand for private debt and income-generating real assets.

Much of the direct lending universe involves floating rate structures, such that investors are insulated from immediate harm. Meanwhile, there is still a reasonably decent spread over interbank rates available for new loans (private debt), although the spreads are evidently tighter than they were three years ago.

On the second, it does appear that more defensive and/or yield-generating illiquid investments have performed well during the recent period of aggressive pricing and geopolitical uncertainty, while listed equity markets have been rocked by Brexit, trade tariffs and military escalations.

However, the risks to financial markets remain profound and no asset classes should be considered entirely immune from a range of potential shocks.

Performance outcomes vary widely

The third point is perhaps the most critical in terms of ultimate performance. As we have seen from previous downturns, there tends to be a massive range of performance outcomes from managers and funds with supposedly similar strategies during periods of dislocations. The implementation risk greatly outweighs the overall strategy risk in individual portfolio cases.

For our team, the key priority of 2018 has been to identify the providers and partners that should be best placed to handle such dislocation.

Managers with close alignment with investors, a strong culture of transparency and investment discipline tend to deliver superior performance during such periods.

Private market investments delivering protection, yield and diversification should continue to be attractive to a wide range of investors in 2019. However, implementation choices will be key to ensuring that outcomes for schemes live up to expectations.

Peter Hobbs is managing director, private markets and Sam Gervaise-Jones is head of client consulting, UK & Ireland, both at bfinance