Korean instos’ use of alts middle-men raises risks
Over the past two years Korea's securities companies have increasingly struck upon a profitable new line of business: sourcing and acquiring real estate and infrastructure assets for the country's asset owners.
Why do the securities companies act as middle-men? Essentially, it’s down to two things: they're nimble, and it's profitable work. There's also a lot of demand from local asset owners eager to put money into private assets that promise a better return than volatile equities and minimally yielding local bonds.
But this combination doesn't necessarily create a match made in heaven. Indeed, securities companies and the asset management firms that are supporting them are not private asset experts; instead they are mostly motivated by short-term profit making. Due diligence of assets - particularly over extended periods - is not their paramount concern.
Meanwhile the desire of asset owners to get exposure to these assets raises the risk that they are asking less questions than they should. That combination of raising the risk of the wrong assets ending up in the hands of overly credulous asset owners.
DIVERSIFICATION DRIVE
Despite the risks, it's easy to see why this relationship has developed.
Like many of their peers around the world, local pension funds and life insurers have diversified their portfolios into alternatives to secure better investment returns after years of low interest rates. The asset owners’ total assets have continued to rise, while local investment opportunities remain limited. So they have sought to secure more alternative assets overseas.
Korean insurers in particular are looking to further diversify their investment portfolios into alternatives ahead of the introduction of the Korean Insurance Capital Standard (K-ICS), a new regulatory standard that will oversee insurers’ risk-based capital (RBC).
The Financial Supervisory Service (FSS) was meant to implement K-ICS in 2021 but it has so fa been postponed it to 2022. That gives the insurers three years to prepare, but the new rules are on their minds when it comes to allocating assets.
“We have seen increased investments in private credit, infrastructure and real estate products on the debt side, not equity, over the last couple of years. That trend is likely to continue,” said Elizabeth Oh, head of investment advisory in Korea at consulting firm Mercer. Offshore investments are likely to remain popular; the FSS allows insurers to invest up to 30% of their assets overseas.
“If you are an institutional scheme with continued monthly cash flow you will continue to be motivated to diversify, geographically and across asset classes,” said Simon England-Brammer, senior managing director and head of Asia-Pacific at investment manager Nuveen.
HOW IT WORKS
Despite this desire, Korea's asset managers and institutional investors cannot conduct due diligence and set up a fund vehicle fast enough to grab appealing physical assets that come onto the market. So the securities companies do it for them.
They can act much quicker, bringing their capital to bear to snap up appealing assets, which they then hold for the investors – for a generous fee.
“It’s not because we are strong capital-wise compared to the eventual end investors here in Korea, but because we can move quickly. Also, there are not enough blind funds (containing pre-approved asset owner capital that let asset managers to quickly invest their behalf) working in the market,” said the senior investment manager at a Korean securities company.
Of late, the market with the most appeal has been Europe, because it’s far cheaper for Korean companies to convert euro-denominated assets back into won than US dollar ones.
Preferred asset areas could shift however, depending on what risk-based capital requirements the incoming rules place on each asset category. Many industry participants believe the final numbers will impact how the Korean insurers diversify their portfolios, as certain types of alternatives will likely gain more capital relief than others, especially government-backed infrastructure.
GROWING THE PIE
For all the appeal of this relationship, the business model is throwing up some issues.
For one, there are some questions as to whether the three to six months period that securities companies are prepared to hold assets on their balance sheets is sufficient for slow-moving asset owners.
An executive familiar with risk management at a Korean life insurer told AsianInvestor that its alternatives investment team has been pushing through investments into these sourced deals despite requests from the risk management team for more time to conduct more thorough due diligence.
“Investment teams, all the way up to the CIO, are under pressure to invest the regularly inflow of capital, and preferably not in fund vehicles where some of the capital will be shelved as dry powder without creating a return immediately,” said the executive. “That creates an incentive to rush investment decisions to get to execute the next direct investment in the pipeline.”
There’s also a problem with enthusiasm versus experience. According to asset manager and advisory sources, some smaller and new asset managers have become very eager to get involved in these deals, even accepting a relatively smaller share in the sourcing fee.
That makes them appealing partners for the securities companies. On condition of anonymity, a senior investment manager at a Korean securities company working on sourcing alternatives assets told AsianInvestor that his company prefers working with less experienced asset managers, which it typically brings in as a capital partner from day one. “In some cases we go with the asset managers with strong reputation and a track record of performance. But it is generally done on a first come, first serve basis,” he said.
But this makes for a potentially risk combination: securities companies seeking to quickly flip assets team up with asset managers that are eager to grab the business and lack the experience to conduct thorough enough due diligence.
The securities investment manager agreed that securities companies lack sufficient interest in the long-term viability of the assets they source. He claimed that his employer is actively working to add inhouse personnel to conduct initial due diligence on the assets, as it sees this as a competitive advantage versus less proactive securities companies.
“Some of my competitors are only focused on the acquisitions, because that is the way they the get their fees,” he said. “On the other hand, the end-investors are aware of this situation – and not happy about it. So, they are focusing [more] on the sellers of the product and whether they don’t care about what is coming later on.”
COMPETITION CONCERNS
At the same time, increasing competition between the securities companies has led to cases where they directly compete for assets, especially in Europe.
Several sources independently pointed to one extreme example where four Korean bidders fought for a particular, unnamed real estate asset in Paris, driving up the price and making investments less attractive for the end-investors.
The increasing competition is forcing Korean investors to learn fast. But as the institutional investors raise their expectations, the securities companies will come under pressure to become more selective in their deal sourcing or more capable in their underwriting. In essence, they need to spend more money and time on due diligence of these assets.
The securities companies also face a more conservative risk approach among Korean asset owners. While their overall appetite for offshore assets will keep rising, it’s likely the investors will seek smaller investment allocations in individual deals in order to limit risk. That means more investors will need to be involved in each deal, making it harder for the securities companies and their asset manager partners to execute deals.
As the Korean investment model develops, securities companies will probably have to adapt to a more comprehensive service to accommodate investors’ increasingly assertive demands. The easiest days of making money may be drawing to an end.
This article was adapted from an earlier feature that originally appeared in the AsianInvestor Summer 2019 edition.