2
Illiquid Assets, Market Size and the Investor Base
In setting the scene for this book, this chapter starts by defining the universe of illiquid assets. Specifically, we stress the structural nature of illiquidity as the major defining characteristic of the asset classes we cover in this book, as opposed to asset classes that may become subject to cyclical market liquidity breakdowns in periods of financial stress. This definition limits our focus to private equity and real assets consisting of real estate, infrastructure, oil and gas, and forestry.
The most common form of investing in private equity and real assets remains the limited partnership. As we discuss in greater detail in Chapter 4, limited partnership funds provide a particularly appropriate framework to harvest the illiquidity risk premium these asset classes offer. Specifically, fund structures allow the use of a common risk measurement and management approach that can be applied across different asset classes. Between 2000 and 2011, around USD 4 trillion were committed to private equity partnerships and funds targeting real assets. While this amount may seem small relative to investments in traditional asset classes, such as public stocks and bonds, we show in this chapter that illiquid investments represent a sizable share in the portfolios of some investor classes, especially those who are less constrained by their liabilities.
In the final part of this chapter, we look at recent trends in the community of long-term investors. A particularly important trend is the secular shift from defined benefit pension plans to defined contribution plans, with the latter requiring a significantly higher degree of liquidity in their investments. In this context, we also discuss the emergence of long-term investors in developing economies and their potential to at least partially offset the possible decline in the supply of patient capital from advanced economies.
2.1 DEFINING ILLIQUID ASSETS
Asset classes are subject to different degrees of liquidity, requiring different risk management approaches. Figure 2.1 shows a range of selected asset classes according to their degree of liquidity versus their time horizon (WEF, 2011, p. 14). Private equity and real assets represent one end of the spectrum, whose opposite pole comprises high-grade short-term and long-term government bonds and public equity (Figure 2.1). In the middle lie hedge funds, commodities and corporate bonds. Importantly, market size is not necessarily the key determinant of liquidity. For example, at the end of 2011 the outstanding amount of corporate bonds in the United States was USD 7, 791 billion, not dramatically less than the stock of debt of USD 9, 928 billion owed by the US Treasury.1 Yet, as Chacko (2005) notes, the median corporate bond trades approximately only every two months, which makes this asset class significantly less liquid than investments in US public equity, where the median stock trades every few minutes.
Private equity investments are sometimes narrowly defined as leveraged buyouts (LBOs) of companies. While companies may be privately held or publicly listed, LBOs generally involve firms that are already mature, generating revenues. This distinguishes LBOs from investments in start-up companies where earnings have yet to be generated. Such investments involve venture capital (VC), which especially in the United States is often seen as a separate asset class.
In this book, we follow a broader definition of private equity. Instead, we generally define private equity investments as investments in unlisted companies, irrespective of their maturity and earnings history. While start-ups and younger companies are privately held, acquisitions of mature firms frequently involve public-to-private transactions, where the acquired company is delisted by the new private equity owners.2 Thus, from the perspective of this study, private equity is seen as a form of financing to which companies may turn during their entire lifecycle (Cornelius, 2011). In their start-up phase, firms often turn to venture capitalists as banks are usually unwilling to lend to companies that have yet to generate earnings. As companies expand, private equity investors may provide the necessary capital to support the growth process. In the more mature phases, leveraged buyouts aim to create value by redesigning corporate strategies, improving operations and optimizing the capital structure under tax considerations. Finally, firms that are experiencing economic difficulties may seek turnaround capital to re-establish prosperity.
Buyouts and VC transactions represent the most common form of private equity investments. They differ in a number of important ways. First, in a leveraged buyout the private equity investor and the management team typically purchase all or the vast majority of the shares in the company. By contrast, venture capitalists usually acquire only minority stakes. Second, companies involved in a buyout are generally mature with predictable cash flows, which allows the investor to finance the transaction with a significant amount of debt, amplifying the expected return on his equity investment (as well as the risk, we hasten to add; see Axelson et al., 2009). In VC deals, investments are usually made with equity capital only. Third, buyout capital is invested across a broad range of industries, whereas the vast majority of VC transactions are concentrated on technology-driven sectors, such as information technology, life sciences and clean technology.
Real assets are generally defined as physical or tangible assets, as opposed to financial assets whose value is derived from a contractual claim on an underlying asset, which may be real or intangible. Real assets include three broad categories: infrastructure, real estate, and natural resources, including farmland. These assets are often lumped together in investors' portfolios as an asset class providing protection against inflation, although there is a significant degree of heterogeneity in terms of their risk/return characteristics. As far as infrastructure is concerned, Fraser-Sampson (2011) distinguishes between economic (communications, transport, utilities) and social infrastructure (education, health, security). Infrastructure investments can be made to fund the planning and construction phases of a project. Such investments are sometimes called primary investments, distinguishing them from secondary investments, which are related to the operational period. Depending on the specific project, secondary investments often have a very long investment horizon, sometimes several decades. Therefore, they are sometimes likened to a bond where the investor acquires the right to receive a stream of income over time.
Real estate investments include a variety of assets, such as office buildings, industrial warehouses, shopping and apartment complexes. High-quality real estate holdings have in common with infrastructure investments that they generate significant and stable cash flows. In the case of real estate, cash flows are generated by long-term lease contracts with creditworthy tenants. As Swensen (2009) notes, real estate assets combine characteristics of fixed income and equity. As in the case of infrastructure investments, the investor acquires the right to receive regular payments as specified in the lease contract. At the same time, he has an equity-like exposure in the sense that there is residual value associated with leases for current or anticipated future vacant space.3
Finally, investments in natural resources focus especially on commodities, such as oil and gas, forestry and farmland. As far as the former are concerned, investments fall into two distinct categories. While holdings of proven oil and gas reserves generate cash flows that are highly correlated with energy prices, investments in exploration activities essentially represent real options. Usually, only the former are considered as real asset investments, given their protection against inflation. By contrast, investing in highly risky drilling operations is typically subsumed under an investor's private equity allocation. Forestry investments, finally, are unique in the sense that the cash flow stream is not based on the depletion of the underlying asset – provided, of course, that the timber owners manage holdings in a sustainable fashion. At the same time, timber shares the characteristic of inflation sensitivity, although the protection it offers is comparatively less, given the limited role it plays in the overall economy.
Private equity and real assets are structurally illiquid investments. Their degree of liquidity is low due to the long ex-ante lock-in period of investors' capital. This sets structurally illiquid investments apart from other asset classes whose degree of liquidity is generally relatively high, but ex post – that is, after the investment decision is made – may deteriorate sharply in periods of financial stress. The recent financial crisis in 2008–2009 provides plentiful examples of cyclical illiquidity. During this period, various markets (including money markets, corporate debt, securitization, collateralized debt obligations (CDOs)) completely shut down, while a significant number of hedge funds limited or stopped redemptions. To be sure, in these markets liquidity was not simply a question of a seller reducing prices to a level where he would find a buyer who was willing to step in. Instead, there were no bids at any price as whole classes of investors simply decided to exit entire markets (Tirole, 2011). Various explanations have been offered for market liquidity breakdowns, among which adverse selection has probably received the greatest amount of attention.4 While cyclical, or dynamic, liquidity risk has attracted a great deal of attention from academics and regulators alike (see, for example, Ang et al., 2011), this discussion is beyond the scope of this book.
There are many ways to invest in private equity and real assets, which are discussed in detail in Fraser-Sampson (2011). This includes investments in listed private equity, quoted real estate investment trusts (REITs), or simply exchange-traded funds tracking infrastructure or oil and gas companies. However, by offering ways that make investments in these asset classes more liquid, investors who choose these routes are arguably disabled to access potential liquidity risk premia. From the viewpoint of this book, such investments are of little interest. Nor do we consider direct investments in these asset classes. Recently, direct investments, especially in private equity, have gained in popularity, not least in an effort to reduce costs associated with investments through limited partnerships. However, direct investments – and to a lesser degree co-investments alongside funds – have been limited to large investors and hence have remained the exception. The risk profile of such investments varies substantially across individual sub-asset classes, requiring highly heterogeneous risk management techniques.
Therefore, the discussion in the remainder of this book is confined to investments through fund structures, the most common form of investing in private equity and real assets. This includes funds-of-funds and secondary funds organized as limited partnerships. In such partnerships, the general partner manages the fund and the limited partners provide most of the capital. Generally, private equity partnerships are closed-end funds with a typical lifespan of 10 to 12 years. During this period, capital commitments are drawn down by the GP to pay for investments made by the fund. Investors cannot withdraw their capital before the fund liquidates itself, and failing to meet the GP's capital calls essentially means that the LP is in default. In fact, as we explain in Chapter 4, the very characteristics of limited partnerships, which make investments highly illiquid, are essential for enabling investors to harvest a risk premium.
2.2 MARKET SIZE
Between 2000 and 2011, LPs committed around USD 4 trillion to nearly 10, 500 partnerships targeting private equity and investments in real assets (Figure 2.2). Taking into account investments that have already been liquidated, funds managing private equity and real assets are estimated to have managed around USD 2.25 trillion at the end of 2011.5 Of this amount, around 60% was managed by private equity funds (buyout, growth capital, VC, distressed, turnaround and special situations, mezzanine). Furthermore, private equity funds-of-funds and secondary funds managed another 11%, while AuM of partnerships investing in real estate, infrastructure and natural resources funds are estimated to have totalled USD 660 billion at the end of 2011, or nearly 30% of all AuM of limited partnership funds.
The United States has remained by far the largest market for investments in private equity and real assets, accounting for almost 60% of all inflows to limited partnership funds between 2000 and 2011 (Figure 2.3). Europe represents the second largest market, with a global share of 23%. Although the market for illiquid investments in the rest of the world has remained comparatively smaller, economies outside the United States and Europe have been playing catch-up in recent years as magnets for private equity and real assets. Whereas such markets had attracted just around 10% of global investments at the beginning of this century, by the end of the first decade their share had more than doubled.
Almost half of the global capital inflows to private equity and real assets funds during the period from 2000 to 2011 occurred in just 3 years. Between 2006 and 2008, commitments to illiquid assets surged as more partnerships were formed and individual fund sizes ballooned. However, although the past cycle was particularly pronounced, it was not unique. While in all cycles macroeconomic shocks have played an important role, research by Gompers and Lerner (2000) and Diller and Kaserer (2009) suggests that the particular characteristics of illiquid investments through partnerships have contributed to the pronounced cyclicality of fundraising.
Figure 2.4 looks more specifically at commitments to US buyout funds, the largest market for private equity investments. To emphasize their cyclicality, inflows to these partnerships are shown not only in absolute terms but also as a share of the capitalization of the US stock market, which itself has been subject to considerable fluctuations due to cyclical changes in valuations. While this share has averaged one-third of a percentage point in 1980–2011, during the first buyout wave in the late 1980s it had already risen to 0.6%. This substantial increase was dwarfed in the most recent wave when commitments to buyout funds reached 1% of public market capitalization.
The cyclicality in commitments to limited partnerships has been attributed to imbalances between the supply of, and the demand for, private equity capital. Following a market correction, which usually coincides with an economic downturn, capital inflows to private equity funds tend to be small, limiting the amount of capital fund managers can deploy. As a result, less money is chasing a finite number of attractive deals. In this phase, purchase prices tend to be low. As economic growth begins to recover, earnings start to improve. While interest rates are still low, yield spreads usually narrow as investors' risk appetite gradually returns. This permits portfolio companies to refinance their debt at cheaper cost and make dividend payments to investors. However, as private equity returns recover, inflows to funds rise. As this process gains momentum, fund managers find it increasingly difficult to source attractive transactions, causing average returns to fall (Gompers and Lerner, 2000). Investors' return expectations are increasingly disappointed, prompting them to adjust their commitments to new funds in an effort to de-risk their portfolios. This adjustment sets the stage for a new cycle.
Illiquidity plays a decisive role in what has become known as the “money-chasing-deals” phenomenon. As Ang and Sorenson (2011) explain – and we shall return to this issue in Chapter 5 in greater detail – optimal asset allocation approaches usually assume continuous portfolio rebalancing. In a frictionless world, an investor continuously sells assets that have risen in value and buys assets that have fallen in value in order to maintain constant portfolio weights. However, the discrete nature of commitments to private equity funds and the illiquidity of such investments render continuous rebalancing impossible. Instead, adjustments are made infrequently, resulting in pronounced investment cycles. As we shall see later, the cyclicality has important implications for cash flows and hence for the management of liquidity risk.
Although illiquid investments have attracted increased attention as an asset class for long-term investors, their relative significance has remained small. In 2011, the global stock of illiquid investments through limited partnerships was estimated to have totalled USD 2.25 trillion. This is equivalent to around 5% of the market capitalization of global stock markets. If we add the global outstanding stock of public and corporate bonds to the global market capitalization of publicly listed stocks to get a sense of the importance of illiquid investments relative to traditional (and generally marketable) assets, the ratio drops to less than 2% (Figure 2.5). Even in the United States, the largest market for illiquid investments by far, investors' exposure to private equity and real assets accounts for just 3.3% of the stock of debt securities and public equity market capitalization.
Figure 2.5 Stock of illiquid investments and size of equity and debt securities market.
Source: Preqin; IMF.
2.3 THE INVESTOR BASE
Figure 2.6 depicts the market for illiquid assets, where capital supplied by institutional investors is channelled (mostly) through limited partnerships to companies and investment projects in the real estate, infrastructure and natural resource sectors.
Investing in fund structures in private equity and real assets requires patient capital that limits the universe of investors to those with an appropriate liability structure.
2.3.1 Current investors in illiquid assets and their exposure
Given their liability structure, the most important investors in illiquid assets, measured by their total amount of investments in such assets, are pension funds, life insurers, family offices, endowments, foundations and sovereign wealth funds. Although banks are less predestined as long-term investors, they have also provided significant amounts of capital – sometimes in an effort to cross-sell other services related to M&A transactions (Lerner et al., 2007). However, new regulations such as the Dodd–Frank Act in the United States will make it more difficult for banks to invest from their own balance sheets.
Figure 2.6 Financial intermediation through limited partnerships in illiquid investments.
Table 2.1 shows the number of known investors in private equity funds by investor category. According to information reported by Preqin, a data vendor, there were almost 4, 600 private equity investors worldwide. While the true number of investors is likely to be even larger, there is reason to assume that those investors that are not included in Table 2.1 are probably smaller institutions. Around 25% of identified investors in private equity funds are endowments and foundations, the overwhelming majority of which are based in the United States. This investor group is particularly well positioned to invest in private equity and other long-term assets, as they face relatively few investment constraints. Unlike many other investor types, endowments and foundations are generally not affected by regulatory policies, and although they usually face significant yearly payout requirements for beneficiaries, these are proportional to the assets. One of the most well-known long-term investors is the Yale University Investments Office, which, under David Swensen's leadership, raised its allocation to private equity to 21.3% in 2010 from just a bit more than 2% in 1999 (Lerner and Leamon, 2011). Real assets accounted for another 15.6% in 2010, implying that more than one-third of Yale's capital was allocated to illiquid assets.
Table 2.1 Number of limited partners in private equity funds, as of October 2012
Yale's substantial exposure to long-term assets and absolute return strategies has been copied by many other endowments as the “Yale approach to investing”. While not all of them have such a significant allocation to non-traditional instruments as Yale does, endowments are generally more willing to accept the idiosyncratic risks of illiquid assets than most other investors.
Family offices are even less constrained in their asset allocation. On the liability side, they face minimal yearly payouts, allowing them to focus on wealth preservation and accept short-term mark-to-market losses. There is little consistent information on their exposure to long-term assets in general and especially to private equity, but Preqin reports some individual cases where family offices have allocated a third and even more to private equity funds.
Unlike endowments, foundations and family offices, DB pension funds face fixed payments with an average duration of 12 to 15 years, with regulatory and accounting constraints limiting the share of illiquid assets in their portfolios. On an (AuM) unweighted basis, US public pension funds currently target an exposure to private equity of about 7.5%, US corporate pension plans somewhat less. In Europe, public pension funds and private pension funds are reported to have a target allocation of 4.5% and 4%, respectively. However, these averages mask a substantial degree of variation, with some large North American pension investors, such as CalPERS, CalSTRS, Ontario Teachers' Pension Plan and Washington State Investment Board, having built up double-digit exposures to private equity.
Life insurance companies, which are confronted with similar liability structures, typically have a somewhat lower exposure to private equity than pension funds. Their investment decisions are largely constrained by accounting pressures, combined with regulatory requirements they have to comply with. In contrast to pension funds, publicly listed life insurance companies tend to have a higher focus on stable quarterly results, which might be another explanation for their relatively lower allocations.
Sovereign wealth funds, finally, have generally been set up to invest a country's foreign exchange reserves in asset classes whose risk characteristics make them inaccessible to central banks. Serving as a store of wealth for future generations, SWFs usually do not have clearly defined liabilities. Facing minimal yearly payments, they are much less constrained by accounting and regulatory pressures than pension funds and insurance companies and are therefore particularly well positioned as long-term investors.
Some SWFs, such as the Abu Dhabi Investment Authority (ADIA), the China Investment Corporation (CIC) or the Kuwait Investment Authority (KIA), manage huge portfolios. Little is known about the structure of their asset holdings, but recent research by Bernstein et al. (2009) suggests that many SWFs have been involved in a significant number of direct VC and buyout transactions. ADIA, for example, the world's largest SWF, publishes a target exposure to private equity of 2–8%, which includes not only direct investments but also commitments to funds. Likewise, the Government of Singapore Investment Corporation (GIC) targeted an allocation of 10% to private equity.
Overall, endowments and foundations are the most important private equity investors in terms of the number of institutions as well as in terms of the average percentage of their AuM they allocate to private equity. However, their investment portfolios are dwarfed by pension funds, insurance companies and many SWFs. For instance, Yale University Investments Office, the second largest university endowment, currently manages a portfolio of around USD 20 billion, not even a tenth of the assets managed by CalPERS, the largest American pension fund. Thus, we find an inverse relationship between the size of investment portfolios and investors' exposure to private equity (Figure 2.7). This relationship holds not only for private equity investments but also for illiquid investments more generally (Figure 2.8).
Figure 2.8 Long-term investors' assets under management and allocation to illiquid assets.
Source: WEF (2011).
Unfortunately, there is no reliable and consistent information about the amount of capital committed to private equity funds by investor class on a global basis. However, data collected by the European Venture Capital and Private Equity Association (EVCA) for the European fundraising market suggests that (European as well as foreign) pension funds have accounted for almost 25% of the capital raised by European private equity funds between 2005 and 2010. Insurance firms added another 8%, while endowments and foundations and family offices were responsible for 2% and 3%, respectively (Figure 2.9). Thus, the denominator effect – the amount of AuM in investors' portfolios – has clearly dominated the numerator effect – the percentage of a given portfolio allocated to private equity.
2.3.2 Recent trends
While pension funds have been the most important investors in private equity and real assets, their role as suppliers of long-term capital might be curtailed by the secular shift from DB pension schemes to DC plans. In the United States, the share of corporate DB plans has fallen to around 35% in 2010 from 65% in the mid-1980s. As far as public and private plans in the USA are concerned, the share of DC plans has already climbed to almost 40% (OECD, 2011). In several other OECD countries – such as Australia, Denmark, Italy and New Zealand – DC plans dominate. And in the many emerging economies, the entire pension system is based on defined contributions.
The secular shift from DB to DC plans implies a significant redistribution of risks from employers to employees. In contrast to a DB plan, it is the contributions, rather than the benefits, that are fixed in a DC plan. On the other hand, DC plans are always funded, whereas the employee faces the risk of employer insolvency under a DB plan. From an investment perspective, the key difference lies in the fact that under a DB plan employers are under no obligation to pay benefits that might be expected but have yet to actually accrue. Thus, DB benefits are not portable from one employer to another, a critical precondition for such plans to make long-term investments.
By contrast, an employee covered under a DC plan has substantially greater flexibility. Usually, she is able to leave the plan assets under the administration of a previous employer, transfer the assets to a new employer's plan or transfer the assets to an individual retirement account. This requires DC plans to be able to provide a valuation of each member's assets at short notice, either for information purposes or to enable members to move their pension account to a different scheme. Thus, investments in DC plans are generally restricted to assets with a clear market price so that they can offer equitable treatment to those subscribing to or withdrawing from the fund and those remaining in the fund. Liquidity, therefore, becomes a critical consideration – it must be possible to price the assets fairly and allow the employee to take her investments with her.
Private equity and real assets generally do not meet these criteria, implying that DC plans are unable to harvest the illiquidity risk premium such asset classes may offer. However, as we shall discuss in Chapter 5, such premiums can be significant, which has motivated some to think about possible solutions. One proposal has been made by the Myners Report (2001, p. 106):
“There could also be more innovative approaches which would permit defined contribution schemes to invest in private equity. It is not the role of this review to design products, but for example, one could envisage an approach under which defined contribution investors would direct regular sums of money into a feeder fund. While this fund was accumulating, the assets would be invested in a passive equity fund. Once sufficient funds were accumulated and establishment of the private equity vehicle was complete, the index portfolio would be liquidated as and when required to finance new investments by the private equity fund. The defined contribution investor would either receive funds back on realisation from the private equity portfolio or the scheme promoter would establish a facility where proceeds would again be invested in a passive portfolio pending establishment of a new private equity vehicle. This brief description does not tackle all the possible issues raised by such a vehicle, but it serves to indicate that there is scope for greater innovation in this area.”
In fact, a variant of the Myners approach is in operation in Chile, whose pension system is 100% DC-based. At the end of 2011, Chile's six privately managed public pension funds (AFPs) controlled nearly USD 150 billion in AuM. In recent years, several international GPs – including Blackstone, HarbourVest, KKR, Lexington Partners, Partners Group and Southern Cross – have raised capital from five of these AFPs. Specifically, these GPs have registered a local feeder fund, which is a publicly traded listed vehicle, on the Chilean stock exchange, allowing the pension plans to meet their monthly liquidity requirements (for details, see EMPEA, 2011).
Whether similar solutions can be found in other jurisdictions will be a critical factor for the future supply of long-term capital. According to a recent study by the World Economic Forum (WEF, 2011), AuM of family offices, endowments, foundations and SWFs look set to rise. But this expected increase will only partly offset the negative effect of the shift from DB to DC plans and the continued de-risking of investment portfolios of pension plans and life insurers in response to regulatory and accounting changes in the post-Lehman era (Figure 2.10). Thus, the WEF study concludes that the net effect will be negative.
Importantly, the WEF study assumes that DC plans are unable to provide long-term capital. The Chilean example shows, however, that this does not have to be the case. While the role of pension funds as long-term investors in advanced economies is further diminished by rising payouts due to ageing, AuM of pension funds in emerging economies looks set to continue to rise rapidly as pension reforms are broadened and deepened. A recent study by the McKinsey Global Institute (2011) estimates that pension assets managed by DC plans and individual retirement accounts rose by 27% p.a. and 19% p.a., respectively, in China and other Asian emerging markets – albeit from a still relatively low basis.6 In Latin America, the growth rate averaged 24% p.a. (Figure 2.11). To the extent that the liquidity and portability issues can be addressed effectively, these funds could represent an increasingly important pool of capital for investments in private equity and real assets.
Figure 2.11 Increase in financial assets, 2000 to 2010 (compound annual growth, %).
Source: McKinsey Global Institute (2011).
Another potentially mitigating factor lies in the further liberalization of quantitative investment restrictions that DB plans and insurance firms in emerging markets are still subject to. Such restrictions may apply to particular asset classes, such as private equity and other alternatives, or foreign investments, or both. Quantitative investment restrictions may be motivated by prudential considerations as well as national objectives. As regards the latter, pension investments often serve to help develop domestic debt markets and are sometimes used as a source of funding for social investments, including housing loans and the construction of hospitals, schools and other infrastructure (Borensztein et al., 2006). Investment restrictions come at a cost, however, as they limit potential diversification benefits and tend to lower risk-adjusted investment returns.
In emerging economies, the costs of sub-optimal diversification are particularly significant as the growth of pension and life insurance assets outpaces the growth of domestic securities markets (Chan-Lau J.A., 2004). While asset managers have to deal with portfolio risk concentrated in a few government securities and corporate names, the low volumes of corporate bond and equity issuance in many emerging economies' pension funds heighten the risk of asset price bubbles, as increased AuM chase a limited number of securities. Apart from limiting potential diversification gains, quantitative investment restrictions affect asset managers' ability to match their assets with the liabilities of their institutions. This is particularly critical for pension funds. As we discuss in greater detail in the following chapter, the OECD Guidelines on Pension Fund Asset Management (OECD, 2006) therefore counsel against specific ceilings that undermine diversification strategies aimed at reducing risk:
“Portfolio limits that inhibit adequate diversification or impede the use of asset–liability matching or other widely accepted risk management techniques and methodologies should be avoided. The matching of the characteristics of assets and liabilities (like maturity, duration, currencies, etc.) is highly beneficial and should not be impeded.”
A still small, but rising number of governments in emerging economies have begun to follow the OECD's recommendations and started to liberalize quantitative restrictions on foreign investments and/or riskier asset classes. This process has generally commenced with a focus on asset classes as opposed to foreign investments. Investors in some countries may now invest – at least domestically – in long-term asset classes that hitherto were outside their permissible universe. In other cases, ceilings on particular asset classes have been increased, allowing more meaningful strategies. Within the (more generous) limits, investment decisions are guided by the principle of a “prudent investor” standard, as we will discuss in the next chapter. According to the OECD guidelines, this standard requires the governing body of the pension plan or fund to undertake investments with care, the skill of an expert, prudence and due diligence. As long as fund managers fulfil their fiduciary duties and operate under appropriate internal controls and procedures to effectively implement and monitor the investment management process, they may now be able to access risk premia and exploit diversification benefits by investing patient capital.
To be sure, lifting investment restrictions is a necessary but not sufficient condition for pursuing long-term strategies. If the United States were the appropriate benchmark, one would expect a significant increase in long-term investing – within the limits set by the regulatory bodies. In fact, as soon as the US Department of Labor clarified the “prudent man” rule in 1979 and explicitly allowed pension fund managers to invest in high-risk assets, including buyout and VC funds, pension funds reallocated a growing share of their AuM to illiquid asset classes. This set the stage for the rapid development of the US and global private equity industry, whose AuM ballooned from a few billion in 1980 to an estimated USD 1.4 trillion in 2011.
A counterexample is Brazil, where pension funds may now generally invest up to 20% of their assets in domestic private equity funds and up to 10% in foreign private equity funds, although they are still prohibited from investing in foreign currency-denominated funds. Internal restrictions may impose additional ceilings. However, current actual allocations are generally much lower than legal and internal investment restrictions. One example is PREVI, Brazil's largest pension fund, which manages more than USD 90 billion for Banco do Brazil. As of 31 March 2011, PREVI's exposure to private equity totalled only USD 555 million, or 0.7% of AuM, all of which was invested by domestic private equity funds. One possible explanation for this very small allocation to private equity might lie in the absence of appropriate risk management tools for illiquid asset classes, which has prevented the pension fund managers from accessing the risk premia potentially associated with such investments.
2.4 CONCLUSIONS
In this chapter, we have defined the universe of asset classes which constitutes the focus of this book. While most asset classes can become illiquid in periods of severe market stress, only a subset is structurally illiquid and hence appropriate only for long-term investors who are able and willing to accept ex ante long lock-in periods for their capital. These asset classes include private equity, real estate, infrastructure and natural resources, especially oil and gas and forestry. Their high degree of illiquidity results from the specific characteristics of limited partnership funds, the most common form of investing in private equity and real assets. Commitments to such funds totalled more than USD 4 trillion in 2000–2011. While this amount appears small relative to the size of traditional asset markets, for some investors illiquid investments are no longer a niche strategy. This applies especially to endowments, foundations and family offices, which have built up a substantial exposure to private equity and real assets, in some cases dwarfing their investments in public equity.
Nevertheless, DB pension plans and life insurance companies remain the most important providers of long-term capital, although sovereign wealth funds have gained substantially in significance as their AuM has continued to rise and their allocations to illiquid assets have expanded thanks to a liability structure that is generally conducive to long-term investing. While pension plans and insurance firms typically allocate a comparatively smaller share to illiquid assets than endowments, foundations and family offices, the total size of their portfolios is generally much larger. Given the dominance of DB pension plans and life insurance firms as suppliers of patient capital, this chapter has finally looked at recent trends in the institutional investor community. Specifically, we have focused on the secular shift from DB funds to DC funds, with the latter facing important constraints on investing in illiquid assets due to the portability of pensions under such schemes. As we have argued, the impact of this shift might be mitigated to some degree by the growing pool of capital accumulated in emerging markets. However, the extent to which such pools will be invested in long-term assets will be influenced substantially by investors' risk appetite and their ability to appropriately measure and manage risk in their portfolios.
1 Data are from the Securities Industry and Financial Markets Association (SIFMA) (2012).
2 Sometimes, private equity investors take minority stakes in publicly listed firms. These private investments in public equity (PIPEs) fall outside the scope of this book.
3 Note that real estate investment trusts (REITS) are financial assets rather than real assets. Similarly, commodity futures represent financial assets, not real assets.
4 This possible explanation goes back to the “lemons problem” we discuss in greater detail in Chapter 4 in the context of limited partnerships.
5 Hedge funds are estimated to have managed around USD 1.7 trillion at end-2011. Thus, alternative AuM as described in Chapter 1 amounted to around USD 4 trillion.
6 To be sure, the potential for playing catch-up remains huge. In China, for instance, pension assets (excluding assets managed by the national reserve fund) totalled just 7% of GDP, compared with 100% in the United States.