Alternative assets such as private equity and properties continue to attract institutional investors, who like their uncorrelated and decent returns.
The assets can do so in part due to their private nature. But the fact they are not marked to market is beginning to weigh on the minds of some asset owners, particularly at a time when an abundance of capital is flooding the alternative fund industry.
Market participants are growing concerned that too many funds with overflowing liquidity will bid up the value of potential investments, causing internal rates of return that once stood comfortably in the double digits to deteriorate.
This anxiety is rising amid a belief that the world's economic cycle will take a turn for the worse in the not-too-distant future.
Kang Shin-woo, chief investment officer of Korea Investment Corporation also doubted the longevity of the alternative investment boom when speaking at AsianInvestor’s Korea 13th Institutional nvestment Forum on April 10.
In response, the sovereign wealth fund is bolstering its in-house capabilities, seeking direct investments and co-investing with reputable general partners to ensure greater control and access to its private assets.
But reliable information and comparable data for alternative investments remain far and few between. That can it challenging for asset owners to allocate to assets whose valuation is hard to ascertain at any given moment.
Given this scenario, what risks arise from alternatives assets not being marked to market, and how can investors mitigate them?
AsianInvestor asked three industry professionals for their takes.
The following extracts have been edited for brevity and clarity.
Shu Watanabe, director of capital transactions
Nuveen Real Estate
Alternative assets include diverse range of asset types and countries even in Asia, resulting in a wide range of maturity as an investable asset. For example, multifamily [housing] in Tokyo is very mature and proven asset class with over 20 years of track record and ample liquidity, backed by stable institutional and occupier demand.
However, if you move out of central Tokyo or away from key public transport even within Tokyo, occupier demand and liquidity diminishes quickly, making it difficult to effectively mark to market the asset properly.
Some risks are easily identifiable if [you are comparing a] locational difference between Tier 1 like Tokyo to Tier 2/Tier 3 regional cities, but some risks are not obvious like micro-location of the assets. Even within Tokyo, this makes a large change depending on the neighbourhood and proximity to the station. One example statistically proven is a walking distance to the station exceeding 10-minutes in Japan significantly reduces the liquidity and occupier demand.
There is abundance of capital flowing into alternative assets like multifamily buildings in Japan, but the ability to select the right sub-market and micro-location requires a deep dive on the assets including the local market trends, culture and neighbourhood. These make a huge difference in the long-term performance in the alternative space. institutional investors also need to conduct rigorous and detailed analysis … to understand the asset class and location given they generall have less familiarity [with the assets], the unavailability of data and less reliable tenant covenants/credit.
Given that operators in the alternative space are generally inexperienced in managing institutional capital, there exists a gap to be filled in terms of finding such an expert whether it’s a manager, operator or your internal personnel.
Barry Tong, joint APAC head of transaction advisory services
Grant Thornton
Alongside the potential macroeconomic challenges, investors are right to be concerned about the non-marking to market nature of alternative investments, strong flows and record-high level of capital accumulated.
Unlike traditional investments, alternative assets are vulnerable to liquidity risk and because they are not marked-to-market like stocks they are much more difficult to be valued. This may not reflect the underlying performance of the investments during the episodes of market turbulence.
Sometimes the investors may struggle to find an exit route which provides a satisfactory return in difficult times…With a high level of dry powder caused by a decade-long low interest rate environment, there are other challenges including high purchase price multiples and over-valuation to the assets, which could damage returns if assets were sold at an unfavourable time in a cycle.
Nowadays, an increasing number of investors are setting up co-investments or joint ventures to manage their private assets in order to obtain more control over the assets. In general, a higher return would be expected due to lower or no transaction fee and management fee.
Investors are also entitled to exercise a certain degree of management control by co-investments and joint ventures where they could participate in the process of decision-making and forming of a strategy...In particular, co-investments further allow investors to gain better insights and knowledge regarding private equity assets by working alongside fund managers.
In regard to mitigating the risks of private assets investments, investors are strongly recommended to conduct a thorough, professional due diligence on private assets. This could include understanding their market position, industry trend and the business and financials. Investors are also advised to sort out a clearly exit route and forecast the expected return prior to making an investment.
Mina Nazemi, managing director of alternative investments
Barings
In the private equity industry there is always the risk that the manager (GP) is not able to exactly capture the true mark to market value of an asset. This is where allocators need to ensure at the time of underwriting that they understand the manager’s valuation process. The quality and integrity of a manager’s valuation process is critical.
Our experience has been that there are larger deviations in the marked valuations to realised values in developing markets and especially in the venture segment. This is a challenge that will absolutely be exacerbated in distressed market environment.
The investors may get closer to the asset by co-investing but typically the investors are still relying on the GP to drive the value creation of the company. Furthermore, co-investors are rarely of size to take control of the assets. They may have a sizable investment but the GP is still leading the direction of the investment and controlling the board.
An investor with a more sizable position in a company may be positioned to get access to more information on the company by negotiating board seats and information rights however the investor needs to know how appropriately utilise its informational advantage and corporate influence to effectively mitigate risk. Few investors are adequately equipped with the experienced staff to take that active role to make a difference.
