Investors doubt PE risk, but love it all the same
It seems that institutional investors are relentlessly optimistic creatures. In quant service provider SigTech’s latest Institutional Investor Report, a total of 75 per cent of the more than 100 respondents expect they’ll generate stronger returns over the next two years compared with the past decade, and that the trends that have dominated equity markets through the 2009-22 bull run will mean revert.
Value stocks will outperform growth stocks; the tech-heavy US market will lose its crown to European and Middle East-based stock markets; and the largest reallocations will be to real estate and fixed income asset classes, while private debt and infrastructure venture capital will see their allocations cut.
“Perhaps surprising to some, investors believe stocks tilted to strong ESG credentials will underperform,” the SigTech report says. “One possible explanation for this, advanced by larger institutional investors, is the significant valuation premium of many ESG stocks relative to the general stock market.
“Thus, ESG-tilted stocks are at a higher risk of being negatively impacted by a contraction in valuation ratios. Little consensus emerged among investors regarding the continued outperformance of developed markets compared with emerging markets, with opinion divided evenly.”
But the new favourite toy of many an institutional investor, private equity, is also the one that’s causing them the most consternation. The performance gap between public and private equity has been significant this year, a phenomenon sometimes attributed to the possibility that private companies actually perform better than public ones but which most investors believe stems from their less frequent valuation.
And around 72 per cent of respondents agreed that, due to infrequent mark-to-market valuations, the stated risk levels of illiquid alternatives like private equity underestimate their true risk. Some 17 per cent “strongly agreed”, while only one per cent “strongly disagreed”.
“Besides having a material impact on realized return numbers, the resultant smoothing of returns has a significant impact on realized risk,” the report says. “This is highly relevant for both portfolio allocation and performance assessments.”
“Recently, various investors, such as AQR’s Cliff Asness, have raised the question of whether the oft-stated low risk levels of private markets investments correctly reflect their true underlying risk. Our study confirms that this is a real concern among institutional investors, with nine out of ten (89 per cent) mistrusting the stated risk levels of private market investments.”
But performance that’s too good to be true is still performance that’s too good to be true, and the generalised mistrust of PE valuation practices has not yet manifested in any material changes to asset allocation decisions. However, sentiment “could quickly change” if and when mark-to-market valuations are updated to better reflect the new market environment, awash with higher financing costs, lower valuation multiples, and a “generally negative market sentiment”.
Australian super funds are also leading the way on internalisation, a trend that is gaining momentum globally, with 69 per cent of institutional investors looking to increase the level of assets managed in-house over the next three years, and 18 per cent expecting to increase “a lot”. Globally, Hedge fund and real estate strategies are the strategies most frequently managed in-house, while commodity, tail risk and alternative risk premia are most commonly outsourced.
“Against a backdrop of abrupt changes to the macroeconomic environment, a sharp shift is underway within the financial markets, which has forced institutional investors to reassess their asset allocations,” said Daniel Leveau, SigTech’s vice president of investor solutions (photo at top). “It is no surprise that there is a strong desire to improve on the status quo by embracing both new investment ideas and technological innovations.”