Aberdeen Standard Investments

Today’s defined contribution (DC) pension schemes face the multi-faceted challenges of providing a default fund that delivers adequate returns for its cost-conscious members alongside the prospect of a rise in opt-out rates1 and the attendant shortfalls that may ensue.
The pressure is on to drive growth and achieve sustainable returns that traditional investment assets alone are hard pressed to deliver.
Roger Pim, Head of the Aberdeen Standard Investments Private Markets Product Strategy and Solutions team, puts forward the case for investing in private markets and the potential it offers DC schemes to increase returns, enhance portfolio diversification and protect against inflation.
What do we mean by private markets?
Private markets encompass real estate, infrastructure, private equity and private credit – the land, buildings, systems and services on which our cities and countries depend; investment in business and ventures that are not traded on the stock exchange; and the provision of debt directly to businesses or projects that is not traded on an exchange. Each of these sub asset classes offers different risk and return characteristics.
Real estate
This has long since been a valuable component of pension investment portfolios. Opportunities in property have widened to include student accommodation, residential housing, logistics, and development assets, which offer the potential for capital appreciation over the long term, combined with cash flows from rents.
Infrastructure
Investments in infrastructure have also been embraced by the pension investment community, particularly local government; it is highly valued for its ability to generate predictable, stable and reliable cash flows. Many such investments are natural monopolies and have built-in inflation escalators.
Private equity
Thanks to the wide range of companies now under private equity ownership, investing in private equity is an increasing component of overall asset allocation among institutional investors. Instead of focusing on quarterly earnings, the average private equity fund will own a company for five to seven years, allowing management teams to drive through operational or strategic improvements in order to maximise revenue and increase profits. Private equity is fundamentally about creating value through the transformation of companies.
Private credit
Private credit affords investors another means of expanding their opportunity set. While regulatory constraints have curtailed the amount that banks have been willing to lend to businesses and projects, the provision of debt from the private sector has seen substantial growth. Private credit offers a diverse array of strategies and a number of advantages, particularly in a low return environment. Target return, risk and liquidity are among the most important considerations; these strategies offer the potential to achieve different objectives, with differing degrees of liquidity.
Key features of private markets sub asset class investment Gross Total Return
The potential returns in each of these sub asset classes varies, depending on whether it is a core investment or positioned towards the value-add end of the spectrum. These are long term investments. Real estate would typically involve five to ten year holding periods; private equity, five to seven; infrastructure would be five or more, in some cases in perpetuity; and private credit can extend across the spectrum. Importantly, investors can choose varying levels of volatility, income, and inflation linkage, and the extent to which correlation is a consideration. At one end, there is infrastructure, which offers low volatility, high inflation protection and yields. At the other, there is private equity, which can be more volatile, but with the potential for high performance.
Higher returns than traditional assets
As the chart below illustrates, it is widely accepted that an allocation to private markets can improve the risk-adjusted return potential of a long-term investment portfolio. Here we see the potential to benefit from an illiquidity premium of between 200 and 300 basis points above listed assets, which is a very substantial opportunity.
Low correlation of returns to public markets
Importantly, private markets offer low correlation of returns to traditional asset classes in public markets, and if this is built into a portfolio, there can be very attractive risk/return benefits.
The challenges (cost, valuations, illiquidity) and how we are meeting them
Many defined benefit (DB) schemes have been active in private markets for some time now, particularly endowments, in order to achieve capital growth, reduce deficits, and support income generation as they become cashflow negative. Although the benefits are clear, investing in private markets is not without its challenges. A wide range of expertise is required in order to successfully take advantage of, and implement, these strategies. Unlike DB, DC schemes have less flexibility in the way that they can invest. The three main challenges that we are confident can be overcome, are cost, valuations, and liquidity.
Investing in private markets requires active management and DC schemes are constrained by the 0.75% charge cap. If these investments are not structured correctly, cost can be an issue.
At Aberdeen Standard Investments, we are focused on net returns for investors, which in private markets have been strong in the past two decades. We are presently working with DC schemes to ensure that they can gain access to private markets, at a reasonable cost.
The second key challenge is the issue of valuations; given that private assets are not listed on the stock exchange, there is no daily pricing. Assets are frequently valued on a quarterly basis and usually audited at least once a year. This process is undertaken using a prescribed methodology, for example, taking a basket of equivalent listed stocks and applying multiples to that. It is important to remember that private equity management fees are based on cost and there is no incentive in terms of fees to increase valuations. On average, we see a 20 to 25 cent uplift on exit, when the companies in which we have invested are sold, which gives us confidence in these valuations.
The third challenge is illiquidity. Private market assets are long term, illiquid investments; the pension fund has to be comfortable with this illiquidity and have an appropriate time horizon for the assets to be held within a suitable structure.
It’s time for DC to benefit from opportunities in private markets
Many pension professionals will be aware of the exemplary performance of the Harvard and Yale university endowments, which have invested material proportions of their portfolios in private markets for the past two decades, and have consistently achieved very attractive annual returns. These markets need not be off-limits to UK DC schemes. Secondary markets are developing across these sub asset classes and we are working with a number of investors to develop solutions that enable private markets to be part of DC portfolios, leveraging our deep sector experience and expertise in strategic asset allocation, implementation risk, and portfolio risk management.
Our view is that we will see a greater use of private markets in the DC sector so that they too benefit from the opportunities that this asset class has to offer.
For further information on Global Private Markets at Aberdeen Standard Investments, please contact Ross Hayter. [email protected] 
This blog has been adapted from a paper on presentations which took place during a Pensions Intelligence Seminar on 18 May 2018. A copy of the document can be found here.
The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.

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