Australia’s Future Fund has A$133.5 billion ($158 billion) under management and aims to hit A$200 billion by 2026. It has a relatively large allocation to alternative assets, including private markets, of around 40% (as of June 30).

AsianInvestor spoke to chief executive David Neal about how Future Fund is approaching illiquid investments these days in light of much-increased demand for such assets.

Q  As a large investor in private markets, how has Future Fund reacted to the big rise in competition for illiquid assets?

What we’ve seen over past several years is that investors that have been squeezed out of bond markets and moved into things like core real estate, high-yield debt, core infrastructure type assets – [these are] moving up the risk curve but [are] still seen to be quite dependable cashflows.

But the bond markets are very big and those other markets are much smaller, so you’ve seen a lot of capital squeezed through a smaller pipe and asset prices have been pushed up. Those sorts of core assets have been expensive for a while.

David Neal

We’ve found a few to put in our portfolio, but by and large they’ve been expensive. We’ve spent much of our time building a portfolio of investments around the edges of those markets, more idiosyncratic, slightly higher-risk investments that require more intensive management.

You think of it as building a core exposure: buying something that’s not core for some reason and turning it into core.

Q  Can you give me an example?

It might be a power station where the energy contracts are just about to roll off. A core investor does not like to buy those assets, because they want the long-term contracts; that’s their security for having a dependable cashflow stream.

But if the contracts are just about to roll off, you can buy those assets much cheaper because typical core investors don’t like them. You’re taking the risk of the re-contracting process, but then you get to revalue those assets up to the core price afterwards.

We’ve been finding similar types of opportunities across real estate, infrastructure, credit and even in the private equity space.

[For instance, Future Fund and investment house TH Real Estate bought a 33-storey tower at 685 Third Avenue in Manhattan for $190 million in 2013 (the former with a 49% stake). They renovated it to draw in new tenants and sold it this year for $467 million.]

Q  Where are you seeing the most competition in the alternatives space?

It’s becoming broader. That wave of capital looking for higher yields has continued to progress up the risk curve into more niche opportunities, so we’ve had to continually re-assess the portfolio.

[For example,] private middle-market lending in Europe is an area we moved into pretty early after the [2008] financial crisis. The banks had their balance sheets several curtailed, so there was an excellent opportunity for our capital to step in. It has progressively become a slightly less excellent opportunity – we still think it’s good, but the wave [of capital] has started to arrive in that sector as well.

Our job is to keep on finding the next place to go. It’s moving across credit, across real estate, across infrastructure. You’ve seen the record levels of capital being raised in private equity. That’s another sign of people moving up the risk curve.

Q  Future Fund invests entirely through external asset managers. How does that work with these types of off-market deals?

It’s very much a hands-on approach in using external managers. We have a skilled investment team who can interact with those managers as peers and effectively sit looking over their shoulder and be involved in the process.

There are various different models for the different sectors. In real estate, you might describe it as a partnership approach. We might have a joint venture to build a particular exposure, where the partner will operate the JV and we will be more passive capital, but still very involved in the key decisions.

Q  So the managers find the opportunities?

Yes. Our team understand the landscape, but [the manager] would find a particular opportunity.

A good example at the moment is senior housing in the US. We think there are lot of good tailwinds for such assets, and we’ve found an operating partner we think is skilled in that space. Our team oversees the investment thesis, but the partner deploys capital into specific assets.

But for private equity, it would be more typical co-investment activity – a hybrid of direct and traditional fund investing.

This is an extract from a longer interview that appeared in the October/November issue of AsianInvestor magazine, including material that appeared in the cover story of that edition.