Written by: Alan Flanagan | Global Head of Private Equity and Real Estate Fund Services, Alternative Investment Services, BNY Mellon
Based on preliminary 2017 mid-year indicators, private equity and real estate funds are poised for another year of growth, following a 10% surge in assets under management last year1. According to data provider Preqin, the private equity real estate market saw a 15% quarter-over-quarter increase in deal flow in Q22.
While growth in private equity and real estate assets is viewed as a positive trend, it creates strains in the market. It challenges the capacity of managers to efficiently allocate funds and the ability of their business models to sufficiently flex with the broader expectations of investors and regulators.
In a highly competitive market, those that anticipate demand are more likely to accommodate it effectively. As managers start to think about their plans and budgets for the likely prospect of strong future growth in 2018 and beyond, we believe five key themes should influence their strategies.
Plan for growth—Stubbornly low yields from traditional assets are driving a wider range of institutional investors to increase allocations to alternatives as evidenced by Preqin data. The ongoing combination of low rates and higher levels of uncertainty have continued to fuel allocations, with investors seeking return premiums associated with longer-term investing. To meet rising investor expectations, managers must identify and exploit opportunities through fund and deal size as well as strategy diversification.
Tighten your belt—Competition among funds for expanding institutional investor inflows is driving down margins and forcing greater flexibility on both fee and cost structures. Increasingly, managers need to accommodate new client expectations to differentiate themselves in a fast-growing field, for example, through ad hoc reporting. Intense competition is driving investors to focus on total expense ratios (TER), which impacts structure considerations, while pressure on performance has seen some managers adopt more traditional expense methodologies. To keep on top of costs and ahead of competition, managers are switching from fixed operating costs to models that enable flexibility and variable costs.
Time to industrialize—Demonstration of best practice in investment operations is an increasingly important element of the due diligence process for institutional investors expanding their alternative presence. As they launch new funds, alternative managers must meet investor preference for robust, scalable and independent middle and back office capabilities. There are several means to acquire and/or access the necessary technology, controls and processes to build best-in-class operating infrastructures. Firms must continue to make the required investment or, alternatively, review market outsourcing options. Remaining static runs the risk of falling behind.
Meet your obligations—As assets under management grow in the alternative sector, inevitably, so does scrutiny. Higher levels of transparency and reporting are required by both regulators and investors in a post-crisis environment focused on minimizing systemic risks through greater accountability, with the broad regulatory trajectory reflected in AIFMD, Form PF and MIFID II. Managers will need back office platforms and data-management capabilities that can adapt to evolving regulatory requirements without incurring significant additional costs.
More liquidity, please—Inflows from a wider range of institutional investors lead quickly to new expectations, especially when those investors are used to greater liquidity from equity and bond funds. Notwithstanding the challenges of wrapping traditionally illiquid assets into more flexible fund structures, it is clear that investors are increasingly demanding liquidity, guaranteed through open-ended and quasi-open-ended structures. Such evolution is inevitable—and often positive—when a product achieves investor popularity. With back offices initially established to meet more limited needs, the demand for liquidity requires managers to reassess operating infrastructures, staff expertise and technology requirements while ensuring transparency.
Alternative managers need to manage their business capabilities just as carefully as their clients’ assets to thrive in today’s increasingly competitive environment. Business may be good, with assets continuing to flow in, but squeezed margins and heightened regulatory costs mean managers must give greater thought to the operating framework within which they deliver value to clients.
In a market where valuations and transparency is being nudged higher by heightened demand, focus should be on matching investment to opportunity. Rightly, managers wish to remain light on their feet, directing their attention and resources to where they can add most value, rather than build up fixed-cost overhead. Today it is possible to access the robust operational capabilities required to handle growth, while retaining cost flexibility, through partnerships with expert and experienced service providers, such as BNY Mellon.
When the alternative becomes the mainstream, it is time to think big. That means acquiring scale without reducing your room to maneuver.
2 Preqin, Private Equity Real Estate Deals Rebound in Q2 2017, July 19, 2017
Global Head of Private Markets Solutions, Alternative Investment Services
Alan Flanagan is responsible for driving the Private Markets Solutions business globally. Alan has gained substantial expertise in the hedge fund, private equity and real estate servicing markets, where he previously ran the product management and strategy group for Alternative Investment Services business globally.