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Many insurers seek to invest in private markets, even though private assets are not straightforward to access, manage and exit. So why exactly do investors want illiquid assets in their portfolios and what are the challenges of doing so?
A roundtable organised between Natixis Investment Managers and Insurance Investor featuring senior insurance investment executives and insurance-focused asset managers, provides some answers.
To read the full transcript from the debate, click here.
Given low yields on traditional bond assets and regulatory restrictions on riskier parts of the market, the attractiveness of private assets is rising.
“Illiquids play a very important role for us,” says Natalia Soboleva, Head CIO Office (Governance, Compliance, Sustainability), at Generali Insurances in Switzerland. “We consider illiquids because of the high yield, as well as adding diversification to portfolios.”
Fuad Ahmed, Private Markets Oversight Specialist, Phoenix Group says illiquid assets form a key part of strategy within its policyholder business, including in with-profits and unit-linked funds. “What we are looking for is diversification, as well as solid returns,” says Ahmed. “A lot of companies are staying private for longer and we need to be tapping into these opportunities.”
In particular, private markets can provide access to smaller, faster-growing companies. “As a UK life insurer, a key part of allocating to private assets is to invest in smaller and less developed companies within the UK and this forms part of our venture and growth strategies,” Ahmed adds
Alongside the benefits, there are significant challenges to allocating to private markets. One of these is the “J-curve”, whereby investors may experience negative performance in the first months after committing capital.
Next, cashflows are only received several years after putting capital to work. Third, there is lower transparency in private markets. Fourth, there is decreased flexibility to mould a portfolio to an investor’s individual needs, as the typical way to access illiquid markets is through co-mingled closed-ended funds.
Then there are high fees, and the requirement for insurers to devote considerable resources to manage a private asset portfolio. There is also a question mark over whether private asset strategies are sufficiently scalable to justify creating such resources.
Perhaps the greatest obstacle is liquidity. As Carlos Vilares, Head of UK Business Development - Insurance Clients, Natixis Investment Managers, says: “The main challenge that we hear from our investors is about locking up capital for the long term, often 7-10 years with no liquidity.”
Investors in illiquid assets are well aware that their capital will be tied up for a number of years. “When we talk to investors, we ensure that they are long-term investors,” says Murtaza Merchant, Partner, MV Credit. “This product is not designed for investors who want to buy and sell into the strategy.”
There is the possibility of accessing liquidity, even in an illiquid strategy. This can be achieved by combining liquid and illiquid credit so the liquidity needs of the investor are met through the liquid part of the portfolio and higher returns through the less liquid assets, says Merchant. The liquid part of the portfolio is a primary driver of MV Credit’s strategy, he says, and over time it rebalances the portfolio to find the ideal allocation of illiquid and liquid assets.
Many investors have a long-term mindset but want the comfort of some sort of liquidity option, says Vilares. With the emergence of second markets, long lock-ups are no longer a necessity, he says.
Liquidity can be obtained through the selection of illiquid assets. “Loans in larger companies have some trading in the secondary market,” says Merchant. “We would never call them liquid loans, but there is liquidity within these private assets.”
Fuad says: “We don’t need daily liquidity for these assets, but we do like to have optionality so co-investments and secondaries are very useful.”
In introducing liquidity to private asset portfolios, insurers must be mindful of their key objectives. As Fuad notes: “Fundamentally, we are accessing private markets because of the long-term nature of the lock up, the illiquidity premium and the excess return that we are hoping to generate.”
In a cost-conscious era, fees have become a prime concern – and private assets tend to have higher fees than many other asset classes. Fuad says: “We and our policyholders have limited appetites for fees. We need to make sure that the net returns stack up; we are not just looking at the pre-fee return.”
It is also necessary to consider how the scalability of private asset opportunities is impacted by regulatory constraints on insurers. The private debt portfolio must make a meaningful difference in terms of overall portfolio returns. Whether it has a material financial impact will influence whether insurers are prepared to corral the resources needed to oversee and risk-manage a complex asset class.
“The skills and knowledge of your team need to be considered, especially for due diligence procedures,” says Soboleva. “Our local regulators have rather high standards of what should be in place in order to enter into these investments, as well as the legal requirements and documentation.”
Although transparency and reporting have become a fact of life for institutional investors, private assets provide another level of challenge.
Fuad says: “If we have a situation where there is a very large allocation to private equity assets, and potentially something happened in that quarter as we had last year with markets moving all over the place, it is very hard to sign off with 99% or 100% confidence on valuations. This does impose some additional requirements on us and some constraints as well.”
There are many inherent challenges associated with investing in illiquid assets. The key is to meet these challenges in a way that improves the risk-adjusted returns of the portfolio.
We look at how this can be done in our next article: “How To Invest in Illiquids and Win”.
