Conference Presentation, Panel
Asset Management Outlook 2018
Milken InstituteJoseph Dowling, Rick Lacaille, Daniel Lopez-Cruz, Neal Wilson, Hoda Abou-Jamra, Mark Wycroft
- State Street targets a 300 basis point return over public equity for private investments but warns that surging capital flows may suppress future returns, anticipating a peak in flows will correlate with lower performance and expecting to hold private equity below the current 25% of client assets due to credit cycle late-stage risks.
- Significant solvency and liquidity risks for pension systems are forecasted given bond-like liabilities and a highly levered corporate sector, prompting plans to stress test portfolios for liquidity and correlation risks while maintaining an underweight position in Emerging Markets equities in the short term despite long-term optimism.
- EJF views the US regulatory relief act of May as a generational catalyst for bank consolidation, identifying regional and small banks trading at 1.5 to 1.6 times tangible equity as attractive, while anticipating that quantitative tightening and rising rates will drive the acquisition of legacy floating debt and benefit net interest margin businesses.
- The credit cycle is characterized as top-heavy with $3 trillion in leverage loans, 75% of which are covenant-light, leading to expectations that quantitative tightening will create challenges in the leveraged loan and CLO spaces despite confidence in the safety of US bank balance sheets.
- InvesCorp projects the private equity industry will continue propelling megafunds to deploy $12 to $14 billion within five years and predicts a market consolidation where the top 20 funds account for 30% of fundraising, though it questions the ability of funds reaching $20 to $25 billion to consistently generate 3 to 5 percentage points over public markets over the next 10 to 20 years.
- Opportunities in the secondary market are expected to grow as a mainstream mechanism for transferring LP interests, which InvesCorp believes will destigmatize the practice, bridge public-private valuation gaps, and positively influence ESG integration, while the IPO market is viewed as offering greater value for companies 9 times out of 10.
- State Street anticipates that currency fluctuations in Africa and Latin America could cause 30-40% investment losses over five years, creating management challenges for private equity outside Asia, whereas the resolution of trade tariffs around the US presidential election is seen as a potential catalyst for unlocking Emerging Markets value.
- Regulatory relief is expected to incentivize banks to issue fixed subordinated debt at 5% to 6% to refinance legacy LIBOR floating debt, with the Federal Reserve potentially targeting a consolidation of the banking system down to 2,000 banks due to technology and cybersecurity vulnerabilities in smaller institutions.
- China's economic transition toward a consumer and technology-driven model presents a long-term opportunity linked with ESG focus, though capital controls remain a possibility; conversely, a prolonged trade war is expected to benefit Southeast Asia as Chinese manufacturers relocate production to Vietnam and similar locations.
- InvesCorp notes that US pension funds' funding gaps widened from 20% to 30% between 2007 and 2017, driving a search for yield, while the Opportunity Zone legislation is expected to provide substantial tax deferral benefits for eight to ten years, stimulating construction and discretionary spending in underserved areas.
- Technology and data spending are identified as critical for survival, with asset managers investing up to $100 million annually in data and cybersecurity to mitigate ransomware risks, leading to expectations that firms failing to embrace these technologies will become obsolete.
- ESG factors are viewed as strong drivers of returns and risk management, with a specific expectation that achieving a 50-50 gender balance in investment decision-making will foster longer-term, less emotional investment choices and that the secondary market will further integrate ESG considerations.
- The outlook includes a prediction that institutional investors will increasingly seek separate managed accounts to negotiate fees better than the standard 2% and 20% structure, and that 9 out of 10 times, private equity valuations are influenced by the liquidity premium investors pay for public market access.
- State Street warns that the ETF industry, while satisfying regulatory systemic risk requirements, may facilitate herding behavior, and emphasizes that thematic drivers like ESG must offer substantial, enduring return stories rather than being transient trends.
- The credit cycle is described as very late by State Street with uncertain prospects for an extended US cycle without credit problems, while EJF notes that the number of US banks has dropped from 10,000 ten years ago to 5,200 currently, reinforcing the consolidation narrative.
- InvesCorp expects that the convergence of the secondary market and ESG will help close the gap between public and private markets over the next 10 to 20 years, while large corporate initiatives like J.P. Morgan's $500 million investment in poor areas are anticipated to act as catalysts for further private capital deployment.
- Emerging Markets are expected to deliver a return premium in the long term due to higher return on equity and lower price-to-book ratios, though private equity investments in these regions outside of Asia may not be proven sub-asset classes due to currency and regional experience variability.
- The regulatory environment is shifting in a way that distinguishes lending approaches, with state Street and EJF noting that corporate leverage and the lack of growth pose significant risks, while the Federal Reserve's push for bank consolidation aims to address security protections regarding smaller entities.
- EJF expects small insurance companies to generate strong returns during rate resets by borrowing from depositors to lend at higher rates, and notes that the US financial system remains sound with tier one risk ratios of 15% and tangible common equity over 10% for large banks.
- InvesCorp anticipates that only 15-20% of institutional investors are truly committed to co-investing due to time and speed constraints, driving a trend where those seeking separate managed accounts can access better deals, while the secondary market is becoming a mainstream tool for asset transfer.
- State Street expects that the private equity risk profile in Emerging Markets is difficult to manage due to currency movements that can annihilate investments with 30-40% swings over five years, whereas the industry views the ETF mechanism as having systemic risk safeguards but potential for herding behavior.
- The outlook suggests that the convergence of different global views on ESG is challenging but a focus area, with State Street believing that applying an ESG lens alongside other investment criteria will result in better returns and risk control, particularly as the industry moves toward a more integrated approach.