Alternative facts 

As alternative allocations increase, the specific challenges posed by transitioning them are coming sharply into focus.  

In search of greater diversification and better yields, pension funds and other asset owners have been expanding allocations into alternative assets classes in recent years. The trend is set to accelerate: led by flows into private debt and private equity, total global AUM in private assets grew from $10.7 trillion in 2020 to $11.8 trillion in 2021, and will reach $17.2 trillion by 2025, according to Preqin.

In the UK, LGPS schemes have been active players driving the growth in demand for alternatives. As open schemes, whose extended liabilities deliver a funding challenge, this asset class is particularly valuable. “They are in a situation where they are constantly thinking about long-term returns and are turning more to illiquidity premium to achieve this,” says Steve Webster, direct of transitions  and trading solutions at MJ Hudson. Platforms, too, are entering the sector. “Retail platforms have a number of considerations that can often lead to the restructure of assets such as: is their customer proposition competitive, does it provide something unique, is this being offered in an efficient way and is the best way to provide this proposition by outsourcing mandates or manage them in-house,” says Andy Gilbert, EMEA head of transition client strategy at BlackRock.

The growth of secondary issuance, private debt and private equity has shifted the liquidity profile of many asset owner portfolios. “The shift to real assets has expanded the complexity and number of asset classes within the scope of a transition, moving these beyond the traditional equity and fixed income landscape. This brings a new complexity to the question of how you manage the risk during the transition,” says Chris Adolph, director of implementation services, EMEA, at Russell Investments.

Growing allocations to alternatives have focused the attention of clients and transition managers on interim management. The large spreads and higher volatility of alternatives portfolios make the cost of being out of the market much higher than for more traditional mandates.

“Clients may need interim solutions to bridge the timing gap between moving funds away from a legacy portfolio and toward an alternative investment,” says Amanda Williams, regional practice lead for the Americas at Northern Trust in Chicago.

Savings of a well-executed transition, meanwhile, including transitioning in specie rather than via cash, may be several per cent. For those shifting as part of pooling they may be equivalent to multiple years of cheaper management fees achieved by shifting the alternatives mandate to a pooled vehicle (see page 14 Alternatives and pooling).

Launches grow

As the demand for alternatives mandates increases, managers are being recruited to facilitate a growing number of fund launches in private equity or multi-asset strategies, compounding a similar trend for ESG funds. This is adding workload and challenges specific to these sectors. 

Paul McGee, head of Macquarie Capital’s transition management and portfolio solutions group in London says niche sector requirements are coming from a range of participants. “As well as a raft of fund launches by the local government pooling entities, you also have the regular fund management community launching a wide range of new funds, for example Paris-aligned benchmarks and climate transition benchmarks,” he says.

A launch requires a time-intensive planning process. There are a host of legal hoops to jump through and regulatory approval is needed before the fund is ready to launch. Operational requirements – involving fund accountants and custodians – are also more onerous. “Then there are questions of how and when seed money will be committed, how many managers are involved with a launch and who gets which allocation. It all results in significant transition lead times,” says McGee. “And for every fund that is launched there are probably five that should be shut – either they are tracking yesterday’s benchmark or they have a tenth the AUM they once had. We’re seeing a lot more that,” says Graham Dixon of Inalytics.

Advice regarding alternatives transitions has become an increasing part of the work of consultants.

But when it comes to more complex transitions the structure of private markets imposes limits to what transition managers can offer. For fixed income securities there may be dark pools where transition managers can find liquidity, but for less liquid assets like property establishing an accurate price is much harder.

Structural limits

“Certainly, there is a role for the industry to play to help those investors but structural factors make it challenging – assets that price only on a quarterly or even an annual basis, for example,” says Craig Blackbourn, EMEA head of transition management at Northern Trust. 

“Transitions are efficient on two-sided trades within the same asset class – or at least related assets – where a manager can gain better access to liquidity. But where assets are illiquid, such as bank loans, it is very hard to transfer from one entity to another,” says Cyril Vidal, head of portfolio transition solutions at Goldman Sachs.

Transition managers unable to buy assets like bank loans on behalf of customers, may need to reach beyond their usual skill set to find proxies to manage the risk, helping clients shift up the liquidity spectrum as the cash call approaches, such as by providing beta exposure to the target portfolio using synthetic products.

“You can look at the transition as a whole, undertake the risk management and the cash flow management, but when there are asset classes where you cannot implement, like bank loans, transition managers will have to develop systems to accommodate that,” says Dixon of Inalytics.

A degree of flexibility will be familiar to pension funds, who face a similar requirement in meeting payment obligations to their members at stipulated, predictable times reaching far into the future. They prepare for these events by cycling through different assets with differing liquidity, return and risk profiles. “Clients who pay pensions working on reducing the cost of raising that cash,” says Adolph of Russell Investments.

The issues will also be familiar to those who have handled the growing allocations to emerging markets in recent years, where transition managers must wrestle with local regulations limited by regulation about what they can own on behalf of the client.

Mandate terms from alternatives managers add to the challenges, with infrequent opportunities to purchase or redeem. “There are operational challenges to the process of purchase and redemption, which are controlled by the governance document, so it’s hard for transition managers to time the clients in and out. A fund might open their buy in period for a week a year; the GP might be required to approve all redemptions,” says Williams.

Improving timing

Despite the restrictions imposed by the types of assets that alternatives mandates contain, and the conditions imposed by those who manage them, transition managers still have plenty to offer. Timing the shift of assets to best benefit the client is one area of focus.

“We have the means to ensure the rotation is as clean as it can be, managing the exposure risk as far as is possible and ensuring the cash is ready on the day that it is called for. The client will have to decide which mandates to reduce, but the transition manager can run appraisals and monitor the liquidity of those portfolios, weighting execution as close as possible to the call date and employing futures to sell forward,” says Blackbourn.

In theory, transition managers can help position client portfolios for allocation to alternative mandates by replicating target exposure.

However, in practice Artour Samsonov, head of transition management and investment solutions at Citi in London, says he has few requests to conduct this type of exposure management. “Hypothetically, clients would want to be in target exposure right anyway, but many clients I talk to are typically happy to remain invested in legacy mandates until they are ready to allocate to alternative mandates. They choose to liquidate legacy exposure in stages to fund target alternative mandates directly.”

He still believes transition managers can help clients remain invested as much as possible in cases where the legacy portfolio is illiquid and will take many weeks or months to liquidate. “Where a client is liquidating legacy assets and raising cash steadily at a rate of $2m per day to meet a total allocation of $30m for example, the transition manager could reinvest cash in more liquid securities like ETFs, futures or other passive instruments to maintain exposure before funding the alternatives mandate,” he says.

In general, then, as clients look increasingly to transition managers for support with alternatives portfolios, the latter are shifting their service. Increasingly, clients are looking beyond pure trading capabilities, which many not be their only – or even their main – focus in selecting a transition manager. Rather, as transition managers become more active partners for clients to manage the liquid assets in a client’s portfolio they are also being asked to project-manage the assets that don’t trade on exchange.

With alternatives’ higher volatility, increasing the penalties associated with being uninvested in these transitions, the associated high costs are likely to continue to focus the minds of both clients and managers here. The alternatives stage is one on which transition managers will increasingly be required to distinguish themselves." 

Alternatives and pooling

Alternatives are a particularly important target for pooling because, with fund fees higher in this sector than traditional strategies, pension funds stand to gain more in cost savings by collecting together.

While these allocations are increasing in size, they still sit at the margins of many pension portfolios. Running small portfolios via segregated accounts creates a lot of work for investment managers, especially since many have been used to running larger segregated portfolios prior to the current vogue for alternatives began. Much of this work is administrative: handling assets that are often challenging to custody or administrate, such as such as emerging market credit or private equity, in remote and unfamiliar markets.

Relatively high management fees, which reflect in part this more complex burden placed on the investment managers, are all the more corrosive of asset owners’ returns given long lock-up periods. The long investment horizon necessary for illiquid strategies like private equity, mean investors may not be able to get their money out for 10 or 12 years after they put it in, with fees accumulating all the while.

It likely is that the growth of pooling will increase asset owners’ focus on what transition managers can offer, and how each offering distinguishes itself, evaluating how far the transition manager’s experience fits the specific needs of the portfolio in question.

“It’s about the depth of capabilities – having capacity in trading but also understanding liquidity in those asset classes. The transition managers might be great at trading equities but 40% of a portfolio might be in fixed income,” says Gilbert of BlackRock.

Transition managers have performed an important function transitioning LGPS assets into pooled management. However, there is a sizeable remaining alternatives portion of LGPS partner funds yet to be transitioned which may provide an important role for transition managers. Whereas a large part of the LGPS pooling transition activity has required little in the way of new innovation or solutions, the pooling of alternatives presents a potential opportunity to excel, according to Steve Webster, director of transitions and trading solutions at MJ Hudson.

“The next stage will allow people to see the best of transition managers,” he says. “For some, transition management might be seen as operational nice-to-have, but there is potential for it to deliver significant cost and risk reduction. After all, the proposals submitted by pool operators at the outset of pooling, to the Department for Work and Pensions, identified the biggest single expense increasing the penalties associated with being uninvested in these transitions, the associated high costs are likely to continue to focus the minds of both clients and managers here. The alternatives stage is one on which transition managers will increasingly be required to distinguish themselves as transitioning the assets.”

Alternatives pooling also provides complex operational challenges for pooling operators. Consider the case of a local government pension fund with a 10% stake in an early vintage private equity fund. From the local authority’s point of view, the ideal solution may be to combine that share of the fund into a single co-mingled vehicle where it is joined by all the other assets managed by that fund manager. In theory co-mingling existing stakes is possible; in practice the challenges are extensive, requiring gradual transition from maturing LP stakes into newly launched alternative co-mingled vehicles provided by pooling operators.

The timing of cashflows between old and new funds rarely match since allocations to alternatives are growing faster than any other asset class, which in turn slows deployment. This creates an increasing overhang of alternatives allocation waiting to be drawn. In many ways this money is in transition, raising issues familiar to those providing interim investment solutions, such as managing exposure risk, hedging, liquidity and cashflows. 

Consider a client invested in a range of listed asset classes that are destined for deployment into a number of alternative investment vehicles. When the call comes for funding, how does the client determine what balance of assets to liquidate verses what to retain?

“Clients need help to understand what to liquidate and when. How much should you take from the global equities portfolio, how much from your global credit? All the time you are trying to balance the residual risk in your listed assets with that of your outstanding private asset commitments,” says Webster.