Authors: Ric van Weelden and Richard Bruyère
The Covid-19 pandemic has left its mark on asset management, accelerating some themes that were already developing, and shining a spotlight on others, say Ric van Weelden and Richard Bruyère
Prior to the current health crisis, the asset management industry was already moving away from its relatively inefficient past. Historically, change was held back through market fragmentation, opacity and high margins, which in turn encouraged complacency.
However, powerful forces of change have been at play throughout the last decade: regulation, technology and low yields, to name but a few. The climate crisis was an additional driver. Now, Covid-19 will further speed up change. The global pandemic also reveals who is adjusting to the new reality, and who still has ground to cover.
Covid-19 has put asset managers to an unprecedented test. Once the dust settles, the question will remain around their ability to cope with - and in some cases benefit from - the disruption this health crisis has brought. Based on our ongoing dialogue with asset managers and the many in-depth discussions we have held with investors over the past few months, several key themes emerge that will shape the industry in the near future.
Below we cover some of the key trends which we discern for the decade to come.
Sustainability takes centre stage
While ESG has been a buzzword nearly a decade, the crisis has brought it to centre stage. The probable short and long term causes of the health crisis and its direct consequence on our economies lay bare some of the fault lines running through the world today. Globalisation, coupled with eroding world governance, climate change and the seemingly inexorable growth in inequality have been warning signal for years, made worse through the impact of and the reaction to the Great Financial Crisis.
What is new is the broader focus on E, S and G. The long-neglected “S”, in particular, will be put under the spotlight.
- Environment – Environmental considerations will widen to include a biodiversity angle, as the health crisis lays bare the increasing risks that our way of life has brought to bear.
- Social – The aftermath of the pandemic will bring about an increased focus on issues such as employee treatment, paid leave, healthcare arrangements and supply chain management. This will shift the focus away from simply global warming impactors - fossil fuels, utilities, airlines and carmakers - to the services, financial and healthcare sectors.
- Governance – New themes will emerge, in relation to the likely de-globalisation trend (e.g. aggressive tax avoidance by global corporates).
The new ‘normal’ in private assets
The current Covid-19 pandemic is unlikely to derail private assets from their unabated growth course over the medium term. This growth is primarily driven by yield generation imperatives and regulatory/ accounting-friendly diversification benefits.
The future scenario is nevertheless one of enhanced discrimination among these asset classes. This will hinge on an increased focus on relative value (as illustrated by the comeback of liquid credit to the detriment of private debt in investors’ favour) and a long term resiliency analysis.
Private assets are likely to remain the most powerful profitability growth engine for the industry.
Without a doubt, infrastructure is bound to emerge as the big winner of this crisis, crowned for its unrivalled resilience to economic shocks. Short-term profitability issues, prevalent among private asset managers, will be toned down for infrastructure managers by the long life-cycles of assets. In the longer run, massive government stimuli will fuel growth, focusing on sectors in which the crisis has revealed the need for transformational investments: renewable energy, utilities, vertical infrastructure, and digital infrastructure.
The same rings true in real estate, albeit with a greater sense of urgency. The short-term return issues caused by rent payment delays granted to tenants have revealed the risks of an asset class that had come to be considered as a suitable replacement for fixed income products in investors’ portfolios.
Additionally, the Covid-19 crisis has highlighted and accelerated trends which are transforming the real estate investing landscape. Changing consumer behavior and work practice, translating into a likely decline in the demand for office space and the rise of online consumption will reshuffle opportunities and force asset managers to rethink their approach. In this new world, generic strategies, such as commercial real estate, may no longer make the cut.
In private equity, the picture may appear bleak, as most funds will likely be impacted by the global economic shock. Although the deal machine still appears to be running, it is largely fueled by large volumes of dry powder and the power of inertia. Valuations at the end of Q2 will be depressed. Exit strategies will be frozen. Heightened secondary market activity is to be expected as forced sellers scramble for liquidity.
Over the mid-run, a new line of differentiation will crystallise. The ability to identify the sectors and business models that can weather economic shocks; to operate in a virtual environment at full efficiency; to adapt to changes in global trade patterns, travel and logistics will spell the difference between winners and losers. Those private equity firms with strong resources in operational excellence and in-depth ESG analysis credentials will press their advantage by supporting and transforming their portfolio companies through the post-Covid-19 world.
Private debt is likely to suffer the toughest blow from the crisis (direct corporate lending, including uni-tranche strategies). Across the board, credit repricing has already led investors to arbitrage away from the asset class towards public markets, that have become more attractive on a relative value basis. Issues that were already raising eyebrows pre-crisis – weak covenants, over-concentrated portfolios, copious rounds of leverage – will likely concentrate investor focus. Against this backdrop, opportunities are fast arising for asset managers nimble enough to seize the moment and able to marshal the right skillsets and resources to target distressed opportunities or special situations.
In the mid-run, the private debt market is betting on the ongoing bank disintermediation trend to act as the rising tide that will lift all boats. This is by no means a done deal. Traditional lenders may find themselves revived by private lenders’ failure to support their portfolio companies, and in a strong position to hold their ground. They will be bolstered by replenished amounts of capital and vocal public authority support. Private debt managers may well find the crisis to have a deeper effect on their business than they had initially reckoned, and will need to demonstrate their value-add in times of turmoil.
New themes in traditional assets
While we do not see a trend break in the move towards passive and the continued erosion of the overpriced ‘centre stage’ of classic active, the pandemic has inserted some trends, not least in the reappraisal of risk. Several opportunities are coming to the fore for asset managers:
- Short-term resurgence of left-behind asset classes (investment grade fixed income) in allocations driven by relative value opportunities;
- Playing the “national card” either in the form of riding the government intervention wave (managing asset purchase programmes) or devising new products that will thrive in a de-globalisation trend and/or contribute to national economic rebound;
- Continuous rise of thematic equity strategies (sustainability, resiliency, turnaround…);
- Renewed investor interest in asymmetric strategies helping circumvent excessive equity market volatility (convertible bonds, risk premia).
Technology and the client experience
The remarkably high tolerance for a poor client experience will be truly a thing of the past. Reliable and repeatable performance against a reasonable fee cannot be brought to bear with subpar client service. For most asset managers this will require increasing outsourcing or cooperation with third party providers, to keep pace with client demand and the standard delivered by best of breed, in many cases the largest scale asset managers.
There is nothing new or different to the increasing role of technology in the investment process and the complex ecosystem of in-house functions (investment management, data control & operations, trade execution, portfolio administration, risk management and compliance) and intermediaries, including broker-dealers, custodians, fund administrators, electronic trading platforms. What is different is the glaring need for the processing, transmission and communication of information in the client interaction to work flawlessly, clearly and rapidly. Virtual communication has taken the place of physical interaction, leaving little room for error and requiring an easily understandable and digestible format and narrative.
The result may well be a step-up in outsourcing to external vendors, as many asset managers find the cost of a complete, internally built and maintained system prohibitive. Time has run out on the ability to contemplate different solutions and recruiting in-house resource, resource which may be a lot more difficult to come by in the wake of the health crisis.
Investments in digital solutions also provide differentiation opportunities for asset managers towards their distribution clients who, increasingly, expect them to support their core business.
Finally, asset managers are reconsidering their investment processes, to better cope with abrupt and unanticipated spikes in volatility. Traditional risk management may be enhanced through the use of technology integrating artificial intelligence to improve the ability to predict and manage market anomalies. This integration should allow for securities analysis and portfolio construction to incorporate forward looking analysis, built on deep learning, which improves resilience in the occurrence of similar crises in the future. The disruption that Covid-19 has caused paves the way for an accelerated adoption of deep learning technology and an investment approach with an improved ‘black swan’ scenario analysis or other break-down in asset class and securities correlation.
Specific post-Covid-19 regulation may focus on business continuity, operational risk and liquidity management.
In the wake of some recent scandals, liquidity management, otherwise referred to as restrictions on redemptions, has taken on a rather toxic meaning. However, an easily overlooked aspect is its ability to mitigate systemic risks and stabilise markets. While this cannot be a justification for what happened, even less why it happened, a rethink may be called for. Too much rigidity around liquidity management can only be brought about by exposing us all to heightened systemic risk. On top, an accurate valuation of assets in the case of a redemption may be difficult in the case of an across-the-board market disruption of the magnitude we have just witnessed.
Change in capital markets
The massive government and central bank stimulus may well create a new lease of life for traditional banks and stimulate the increasing importance of shadow banks in equal measure. The latter emerged in the wake of the Great Financial Crisis and are now well placed to benefit. It is too early to assume that the arch of bank disintermediation has come to a halt or will resume once the dust settles. The scale and complexity of the demand for financing, the need for risk capital and the size of the challenge of rebuilding and transforming Europe’s economy may well point to the latter, in the longer run. For now, the monetary and fiscal stimulus places the banking system at the heart of the effort to keep businesses afloat. In the meantime, regulators have already loosened rules to allow banks to cut back on their capital requirements, as they acknowledge the crucial role of banks as a channel of credit provision. A potential revival of securitisation would be an additional vindication of the key role and sustainability of a traditional intermediated financing model.
At the same time, shadow banks or non-bank financial intermediaries have the scale and ability to analyse complex financing needs, act with the agility and speed (especially given the amount of dry powder at their disposal) and assume risk in a way most banks cannot match.
They have different roles to play. The community of shadow banks clearly contains asset managers, some of whom (in particular, diversified platforms operating at scale across markets and product segments) will end up being as major beneficiaries of the health crisis.
What will the future bring?
Against this background of opportunities, a divide is emerging between operationally agile, long-term strategic planners and the rest, who are waiting for clarity to emerge. Asset managers have the opportunity to take advantage of current uncertainties and prepare for the next growth cycle by detecting the “weak signals” of future competitiveness. Business mix, product innovation, enhanced client engagement and non-organic strategies will pave the road to success for those who will take bold action.
Current times could also reshuffle the pecking order, and present an opportunity for long-term established players, some of which are late to the third-party development game, to make a big leap forward.
Ric van Weelden is a Senior Partner at INDEFI, the asset management strategic consultancy..
Richard Bruyère is managing partner at INDEFI, the asset management strategic consultancy.