«Asset allocation and private markets»

LECTURE ESTIVALE. Extrait de l’ouvrage rédigé par Cyril Demaria, Sarah Debrand, Remy He, Maurice Pedergnana et Roger Rissi, choisi par la rédaction de «L’Agefi».

«Investors can be classified according to different parameters that have significant consequences on their asset allocation.

The first one, and probably the most obvious when it comes to investing in less traded assets such as private markets funds, is their time horizon. Retail investors have probably the shortest one (from a few months to a few years), but they are de facto excluded from private markets for regulatory reasons. Institutional investors, such as banks and insurance groups, have a specific timeline, from one to multiple years. Pension funds and high net worth individuals (HNWI) have a longer time horizon, varying from multiple years (in the case of ageing individuals) to multiple decades. The time horizon of family offices and sovereign wealth funds (SWF) spans at least multiple generations and could be even considered as infinite. Foundations and endowments can have infinite horizons by design (they are not allowed to spend their capital, just the proceeds of their investments), although some have a finite time horizon.

Regulations are essentially set up to protect investors, but there is no specific requirement that they have to follow when allocating their assets and deciding where to invest.

The second obvious dimension is the regulatory pressure under which investors operate, which itself is partially determined by the geographical location of investors (and thus the jurisdiction they depend on). The lowest regulatory pressure is probably on family offices and HNWI. Regulations are essentially set up to protect investors, but there is no specific requirement that they have to follow when allocating their assets and deciding where to invest. They are essentially unconstrained by regulations. SWF come next, with low to no regulatory pressure. Due to a lack of transparency, it is difficult to establish precisely the level of regulation they have to comply with. Endowments and foundations are lightly regulated. Most of the constraints come from their legal status as charitable institutions (or equivalent) and their tax exemption. In some jurisdictions, this implies the undertaking of specific actions. In the US, for example, university endowments have an obligation to spend a certain percentage of their total asset value every year. Pension funds, insurance groups, and banks have to comply with a high level of regulation. In Switzerland, for example, pension funds are not allowed to allocate more than 15 percent of their assets to alternative investments. In Europe, insurance groups and banks have to respect specific rules about their solvency and how to account each asset class they invest in using these solvency rules. 

Although less obvious, the third parameter is the size of assets under management. Investing in private markets is an activity that is not easy to scale. This determines the asset allocation and the portfolio structure of investors. Small investors cannot easily replicate the asset allocation of larger ones (and vice versa). 

A large size can have positive consequences. Dyck and Pomorski (2012) explain that Canadian pension funds with significant holdings in private equity perform better (740 basis points) than the ones with a smaller exposure, due to cost savings (25 percent of the gains) and superior gross returns (75 percent of the gains) that the authors attribute to the ability of investors with a larger exposure to «bridge the significant information asymmetries between investors» and fund managers. A large size can also have negative consequences. Large investors suffer from inertia (they respond more slowly to market changes) and suffer from higher home bias (Hobohm, 2010). This also leads to portfolio concentration, notably in large LBO funds. 

Investors with lower assets under management can diversify more easily, notably in niche strategies. Their small size limits them in their ability to diversify geographically (lack of reach), as well as in terms of access to private market funds (the minimum threshold to invest in funds can be rather high). They do not benefit from economies of scale and lower costs. Smaller investors have been addressing some of these drawbacks. An easy way is to invest through funds of funds, although this adds to costs and prevents a tailored exposure. Another, assuming a sufficient amount to invest, is to set up an investment mandate, which provides a tailored exposure at a lower cost. However, this solution requires $25 to $35 million to invest in private markets and still adds up costs. Investors can also join forces to set up a joint consulting firm, as non-profit organizations did in the US with The Investment Fund for Foundations (TIFF Investment Management) in 1991.

Experience is connected to the level of sophistication of investors. This parameter is the result of accumulated know-how and knowledge, the access to qualified internal resources, and a clear vision and understanding of private markets.

Another parameter is the experience (its length and diversity) of investors in private markets (Lerner et al., 2007; Demaria, 2015). Da Rin and Phalippou (2013) explain that this is a function of the total capital currently deployed in private equity (and by extension private markets). For them, it is what matters the most when sorting categories of investors, although in the context of asset allocation, this parameter is rather close to the size of the investor. The amount of capital to deploy will determine the financial resources that the investor can spend on analyzing private market investment opportunities (staff and due diligence). Investors deploying large amounts can have an influence on fund managers, assuming that they have the corresponding level of sophistication.

A long-standing presence of investors also determines the access to the best fund managers, which explains the outperformance of endowments in the 1990s thanks to their access to the best venture capital funds (Lerner et al., 2007; Sensoy et al., 2014). This access, combined with a persistence of performance (Kaplan and Schoar, 2005; Korteweg and Sorensen, 2017) is only one component of the overall skillset of investors. Cavagnaro et al. (2019) state that the «evaluation of [fund managers’] ability appears to be particularly difficult, consistent with [their] conclusion about the value of [fund investors’] skill.»

Experience is connected to the level of sophistication of investors. This parameter is the result of accumulated know-how and knowledge, the access to qualified internal resources, and a clear vision and understanding of private markets. For example, «smart investors have already screened the market before a new fund is raised» (Demaria, 2015, and Hobohm, 2010). Unsophisticated investors are more likely to use agents, such as gatekeepers. This, in turn, will condition the asset allocation of investors, as agents tend to be conservative and focus on supposedly safe investments. This creates a quasi-systemic risk: herding, as agents tend to advise their clients along the same lines. Sophisticated investors can have a solid reputation as savvy private market investors, and thus have an influence on fund managers.»

«Asset Allocation and Private Markets», de Cyril Demaria, Roger Rissi, Sarah Debrand, Remy He et Maurice Pedergnana. Editions John Wiley. 320 pages. 115 francs.


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