Ramping Up PE Exposure in 2014?
Insurers are rethinking their investment strategies and beginning to increase their exposure to private equity. Some are even looking at it from an asset-liability management perspective.This is an excellent comment but let me chime in and state flat out that private equity, including real estate and infrastructure, should be the exclusive domain of public pension funds and sovereign wealth funds, not private insurers. Why? Because the investment horizon of the former is a lot longer than that of insurers which have to manage assets and liabilities much more tightly (ie. liquidity risk is more pronounced).
Insurers have begun to shrug off their risk-averse attitude to investing. While caution remains the watchword as the world economy braces itself for a potentially bumpy exit from quantitative easing, companies are becoming less afraid of certain assets that had spooked them during the dark days of the financial crisis.
One such asset class is private equity. Most insurers either froze or reduced their allocations to this class as they waited to ride out the storm that broke in 2008. Now some are taking furtive steps back into the market and investing in private equity assets.
Like other alternative assets such as infrastructure and corporate loans, private equity works at the fringes of insurers’ portfolios to generate the high-yielding returns needed to compensate for anaemic growth in their fixed-income bucket.
Investments in private equity are rarely substantial for insurers, typically being less than 5% of the total portfolio, but the asset class has pushed itself to the forefront of chief investment officers’ (CIOs) minds regardless. A recent survey of 206 insurers by asset management firm BlackRock and The Economist Intelligence Unit revealed that 54% of CIOs were either “moderately likely” or “highly likely” to increase their allocations to private equity.
A similar survey conducted by Goldman Sachs Asset Management in early 2013, which quizzed 189 CIOs on their short-term strategies, found that private equity was the third most frequent response to the question: ‘What asset class do you expect to deliver the highest total return in the next 12 months?’ This was right behind US and emerging market equities, which tied for first place.
Whichever way you look at it, private equity seems to be back on the agenda.
Investment specialists at insurers speak candidly about their future plans for the asset class. Scandinavian banking and insurance group Skandia has increased its exposure to private equity fivefold over the past five years and is looking to increase this further. Jonas Nyquist, head of buyouts at the Stockholm-based group, says: “Up until 2007 invested capital in private equity was around 1.5% of our balance sheet. Then it was decided we would increase our allocation to 10% over a five-year period. Now we’re around 7.5% invested, a little below target, although 10% is still our aim.”
French insurer CNP Assurances is also planning to funnel more capital into private equity, albeit not to the same extent as at Skandia. Mikaël Cohen, Paris-based investment director at the firm, says: “Our policy is to increase our allocation. Currently our investment in private equity is roughly around 1% of our overall portfolio. We would like to increase this to 1.5%.”
The same story is true of Zurich, which boosted its allocations to private equity and hedge funds combined by a fifth in the 12 months from September 2012, from $2.04 billion (£1.2 million) to $2.48 billion.
Private equity offers insurers a range of benefits that dovetail well with their business models. Investments usually take the form of strategic allocations to bespoke private equity funds run by third parties, taking the management burden off the firms themselves. Capital is committed for the long term, typically between eight and 15 years, allowing insurers (especially life and multi-line firms) to reap an illiquidity premium that they are well placed to take advantage of thanks to the long-term nature of their liabilities.
Private equity investments can yield 5% more than low-risk government bonds, much more than other alternative investments such as commercial mortgage-backed securities (2.9% additional yield) and property (3%), according to research by industry trade body Insurance Europe and consultancy Oliver Wyman.
Wim Vermeir, chief investment officer at Ageas in Brussels, which has between €150 million (£124 million) and €200 million invested in private equity, extols some of the other virtues of the asset class: “Private equity offers access to the unquoted part of the economy, and acts as a diversifier for our cash equity portfolio. It’s also not an instrument you can mark-to-market, so in terms of balance-sheet volatility you don’t have the same kind of swings as with assets listed on exchanges.”
Traditionally, private equity has been considered a pure yield-enhancement play for insurers as the risk, irregular cashflows and illiquidity make these investments ill-suited to asset-liability management.
CNP Assurances, for instance, holds more than €200 billion in relatively liquid liabilities derived from French savings products that offer tax exemption to policyholders who invest for a minimum of eight years, known as assurance-vie policies. An insurer offering these products can suffer withdrawals at any time, and so is vulnerable to lapse risk. CNP Assurances therefore needs relatively liquid assets at its disposal to cater for a mass withdrawal scenario. “This is why we commit a small amount to private equity, because of the liquidity aspect,” says Cohen.
However, the orthodox approach to private equity investment is being replaced by new ways of thinking by insurers. Firms are considering the asset class in greater depth than in previous years and reimagining the role it plays within their portfolio.
Kishore Kansal, head of private equity risk solutions at interdealer broker Tullett Prebon in London, says insurers are taking a more strategic approach to selecting private equity assets. “They are no longer saying ‘let’s invest in private equity and include every asset type within that bucket’. They’re asking ‘what do we want in terms of private equity?’ because it is quite a broad term,” says Kansal.
The term private equity can cover investments in real-estate projects, infrastructure, mezzanine debt and venture capital among others. Insurers, says Kansal, are thinking more critically about which sub-class to invest in. “Insurers are building strategies based on whether they want to invest in large-cap, mid-cap or small-cap projects. The other key consideration is infrastructure. More insurers are looking critically at this as a private equity investment,” he says.
This new type of thinking around private equity is manifest in the actions of some European companies last year.
Ageas, for instance, is looking for lower risk investments. “There are a lot of different segments in this private equity market,” says Ageas’ Vermeir. “We go for somewhat more mature funds, rather than the seed-capital approach where you only invest in start-up companies. We are not going for the most risky part of private equity.”
In addition, part of Ageas’ private equity allocation goes towards infrastructure projects. This is an area in which MEAG, the global asset manager for Munich Re and its life insurance subsidiary Ergo, is also targeting.
Infrastructure is a core part of its private equity strategy, says MEAG’s managing director, Holger Kerzel. The firm is committed to a €1.5 billion infrastructure programme combining both equity and debt investments and, in November 2013, acquired a 50% stake in Marchwood Power, owner operator of a gas power plant in Southampton. “By investing in infrastructure, we are further diversifying our portfolio with manageable risk and attractive returns,” says Kerzel.
When it comes to the geographical spread of investments, attitudes vary depending on prevailing regulatory conditions. In the Netherlands, for instance, insurers tend to focus solely on domestic and European investments because of strict local rules, according to Jelle van der Giessen, CIO at ING Insurance in Amsterdam. But in France, the constraints are fewer, so CNP Assurances, for instance, has a fixed 20% allocation to the US private equity market in order to reap the benefits of diversification, says Cohen.
Insurers are also increasing their scrutiny of the environmental, social and governance (ESG) policies private equity houses have in place. A firm commitment to being a responsible investor is a sure-fire way to win insurance partners, says van der Giessen. “Insurers find ESG increasingly important, and look for private equity firms that have strong ESG policies in place,” he says.
Some firms are even considering how to make cashflows from private equity investments work as part of their asset-liability matching strategy.
Patrick Liedtke, head of the financial institutions group for Europe, the Middle East and Africa at BlackRock in London, says: “What traditionally happens with private equity investments is that there’s an initial phase where you don’t see any returns, and a returns period right at the end of the investment. However, if you construct a strategy where you invest in consecutive periods you can start harvesting returns as your investment programme matures over time.”
For this strategy to work, says Liedtke, a more sophisticated approach by insurers is required. Utilising private equity opportunistically is no longer the way to get the most benefit out of the asset class. “We’ve been talking about a sustained strategy, step-by-step, whereby insurers have different vintage years that they allocate to. This helps get around the problem of lumpy cashflows,” he says.
It’s not only economic considerations and concerns about corporate responsibility that are influencing insurers’ private equity strategies. As usual, regulation plays a role too.
“Solvency II is not very friendly to private equity,” says CNP Assurances’ Cohen. That’s an understatement: under Solvency II private equity counts as type 2 equity, meaning insurers using the standard model to calculate their solvency capital requirement (SCR) have to slap a 49% capital charge on their total private equity holdings.
Insurers therefore need to weigh up whether to absorb the charge, use a hedging strategy to reduce it or avoid the asset class altogether.
For insurers using Solvency II’s standard formula for calculating their capital requirements, some capital relief for private equity should be allowed as the asset class provides a diversification benefit from listed equities and fixed income.
Those insurers using an internal model, meanwhile, can reduce the capital charge if they have sufficient historical data on the performance of their private equity holdings. ING’s van der Giessen says: “Insurance companies that are large enough to support an internal model and do have a lot of experience with private equity might be able to reduce the capital charge in their internal model if their historical data strongly supports lower volatility than what the standard model suggests.”
Another option for insurers looking to reduce the capital charge is to use a hedging strategy. In 2012, Tullett Prebon released a private equity hedge for insurers, hoping to attract firms wanting to maintain or expand their allocations to this class under Solvency II. The hedge is based on a contract for difference in which the insurer, the short party, and the hedge provider, the long party, make collateral payments quarterly until the fund the insurer has invested in is liquidated.
The quarterly margin payments are based on the value of the fund relative to an agreed strike price. The insurer would receive collateral from the counterparty if the fund value falls below the strike price, and post collateral if the fund value rises above it.
Tullett Prebon estimates the hedge would eliminate between 75% and nearly all the capital charge imposed on private equity by Solvency II.
However, Kansal explains that the constantly shifting deadline for implementation of the directive has turned firms off buying a hedge today when there is little clarity on how it will work in the future. “When we first provided that hedge, there was a hard deadline for Solvency II implementation – January 2013 – when investors would have to move to the new regime. That has been pushed back and pushed back, which means there isn’t the same urgency for insurers to go through a secondary sale process or hedge process. With institutional investors, if they can delay a decision they often will,” he says.
For some insurers, investing in hedging instruments might just be more trouble than it is worth. “The regular hedge instruments you could use at the moment are either extremely bespoke, hence very expensive, or are just regular market instruments, and then you have an immense basis risk,” says van der Giessen at ING Insurance.
Even if the high capital charge cannot be reduced, insurers say they are not troubled by this. Skandia’s Nyquist is confident the company’s internal model will result in a lower capital charge for private equity, but isn’t overly concerned if the charge remains high. “There is Swedish regulation we follow today that is even tougher on private equity than Solvency II, because we are only allowed to admit 10% of the value of our private equity as regulatory capital to back liabilities,” he explains. “In this context we can’t see how Solvency II will affect how we invest in private equity,” he adds.
Other CIOs judge that the benefits of investing in private equity outweigh the costs, and seem happy to absorb the capital charge unhedged. Vermeir at Ageas points to the fact that the 49% capital charge on private equity is only 25% higher than the 39% charge on type 1 equity. “We like the long-term character, we like the illiquidity premium, we like the fact it does not show the same mark-to-market swings as listed equities. So we think the 25% additional charge is worth taking for a limited part of the equity portfolio,” he says.
Cohen at CNP Assurances agrees the costs of private equity are worth bearing, adding that if the capital charges start to weigh too heavily, the insurer always has the option of freeing capital by reducing the discretionary yield on its assurance-vie products.
“Each year we evaluate the yield we will attribute to the customer. This capability can dampen the effect on the SCR for our allocation to private equity by absorbing some losses,” he says.
Yet some major insurance groups appear to be pulling back from private equity. Generali, for instance, offloaded a €500 million portfolio to Lexington Partners in July last year, and Axa disposed of its private equity unit in October 2013 (though retained a 21% stake in the business).
This, suggests Tullett Prebon’s Kansal, could be evidence that the burden of regulation is causing insurers to retrench from this class, especially those large groups facing additional supervisory pressure from national or supranational regulators.
Others downplay the impact of regulation. “Does the status of a company as a global systemically important insurer in any way hamper their ability to invest in private equity solutions? No,” comments BlackRock’s Liedtke. “Obviously there is more intense supervisory scrutiny, but they still have the ability to invest in this asset class. They need to demonstrate that they will invest in it properly, of course, but that is what any savvy investor should do anyway,” he adds.
It seems many insurers are happy to accept the cost of private equity in the pursuit of higher returns – and why not? When market-beating yields are rare, it doesn’t make sense to abandon an asset class that consistently promises rich returns, especially one so well suited to insurers’ long-term investment profile.
If I was a regulator, I wouldn't allow insurers to hold any private equity in their investment portfolio. Of course, the amounts they hold in their portfolios are marginal compared to large public pension funds and sovereign wealth funds.
Still, I agree with Generali and other insurers that are offloading their private equity holdings. They can find plenty of public pension funds looking to buy these private investments at a discount or work with a secondary fund like Lexington to offload their PE holdings.
So what are the prospects for private equity going forward? Henry Sender of the Financial Times reports that private equity cashed in on the Federal reserve's largesse and Steve Johnson of the Financial Times notes the surge in private equity disposals will run another year:
A continuing surge in disposals by private equity firms is still in its early stages and has at least another year to run, according to analysis by Deloitte, the professional services firm, and Listed Private Equity, a trade body.But the problem in private equity is deployment of cash. Tony Gibson and Brian O'Neill of the Financial Times report that private equity funds have been sitting on large amounts of capital since the boom fundraising period before 2008 and deploying this capital is harder than fund managers had anticipated. Some funds are moving to Asia but the pressure is on private equity to continue delivering outsized returns and as I stated in my outlook 2014, I'm not particularly bullish on this asset class:
A swath of private equity-backed companies were floated on public markets last year, including the Hilton hotel group and Plains GP, an oil pipeline operator, in the US, Merlin Entertainments in the UK and skiwear maker Moncler in Italy. Private equity-backed floats accounted for more than half of the volume and value of initial public offerings across Europe, according to Thomson Reuters, the data provider.
Despite this, analysis by Deloitte and LPEQ found that listed funds of private equity funds – which they view as an accurate proxy for the wider private equity industry – were still sitting on unusually mature underlying portfolios.
The weighted average of their holdings was 7.2 years in September, compared with six years ago in March 2010. With funds of funds typically operating on a 10-year cycle, Andrew Lebus, chairman of LPEQ and partner at Pantheon, a fund of fund house, said he expected to see an elevated level of exits for at least the next 12 months.
“The pick-up in corporate M&A [merger and acquisition] and IPO activity is likely to have a big impact on the listed private equity sector because a number of their portfolios are quite mature at this stage,” said Mr Lebus.
“With M&A picking up as a result of cash building up on corporate balance sheets, it bodes well for the next 12 months and probably beyond that.”
The research found private equity firms were increasingly investing in companies in the consumer discretionary and financial sectors. Interest in the latter is focused on asset managers, insurers and financial data providers.
Illiquid alternatives are frothy: In 2013, I warned investors about the bubble in private equity, infrastructure and real estate. I also explained why a lot of public pensions praying for an alternatives miracle are taking on too much illiquidity risk and are ill-prepared for a rough landing. Their approach is all wrong and they will get clobbered, especially if deflation sets in.No doubt, a handful of top private equity funds will outperform and capitalize on deals that present themselves over the next 12 months but it's a tough environment and it's getting harder and harder to find attractively priced deals. In this environment, you really need to choose your private equity funds carefully and I'm not convinced all the mega brand name funds are going to outperform.
Having said this, the new religion in pensions is all about alternatives so expect shares of Apollo Global Management, LLC (APO), the Blackstone Group (BX), Kohlberg Kravis Roberts & Co. (KKR), and the Carlyle Group (CG) to continue trending up but nothing like the past couple of years (some of them invest in hedge funds which are more liquid than private equity).
In fact, as Bob Rice, general managing partner with Tangent Capital Partners LLC discusses below, private equity funds focusing on smaller deals will continue to outperform. I like the small and medium sized private equity market but scale is an issue for large public pension funds and sovereign wealth funds.
And Bloomberg's Jason Kelly reports on private equity's bet on real estate on Bloomberg Television's "Money Moves." Oh brother, it's starting all over again! -:)