Gandy Gandidzanwa & Itai Mukadira
If there is one thing that has been proven over and over again in the last two decades, it is that the ZSE alone cannot be relied on for value preservation.
Some investment management pundits are though quick to counter this by demonstrating that it has beaten official price inflation over the period.
A deeper analysis, however, shows how dismally it has fared against the rate of currency depreciation – and that, is the true benchmark for any value preservation assessments.
A new industry order demands that pension funds diversify their investments beyond just the ZSE and property exposures.
While it may not be clear why pension funds continue to mostly limit their investments to only these two traditional asset classes, the regulatory constraints argument cannot continue to be used. Neither can the loose argument on lack of viable alternatives.
With those two off the table, the one argument that probably remains is that the mainstream asset managers, entrusted with managing millions of dollars of pension funds money, just lack the required expertise to confidently deploy funds into the alternatives space. Alternatives investment management requires a special skillset not akin to that required for managing traditional assets. The absence of an eco-system that facilitates easy deployment of funds into the alternatives space further compounds the challenges.
But what are alternatives, and how best can trustees engage with these for enhanced portfolio value preservation, capital growth, and income generation, while preferably, simultaneously impacting society at the same time. Some scholars have highlighted the nomenclature of categorising the assets into “mainstream” and “alternatives” as a key culprit for the low uptake of the alternatives.
They thus advocate for the use of “private capital investments” as opposed to “alternatives”, a reference now widely adopted in most developed markets. Private equity, private debt, commodities, precious metals, derivatives, hedge funds, structured products, infrastructure, and farmland are just some of the more common asset classes in the private capital investments family.
By their nature, of course, it is important to note that there is not a single listing of them that could ever be exhaustive.
Clarity of Objectives is Supreme
With anything investments, trustees need to be precise on what they are looking for in their asset allocation decisions. Contrary to common thinking, investing for “highest returns possible” alone is not only such a vague objective, but one that is incomplete and risky.
A well-crafted strategic asset allocation starts with placing clarity on the nature, term, currency, timing, quantum and degree of variability of the liabilities that the pension fund is investing to support.
In the case of defined contribution funds, the liabilities are more commonly defined in terms of target net replacement ratios. With that clarity of intention, the contribution that each asset class brings to the strategy, in terms of expected returns, risk exposure, diversification, and correlation can be a lot more easily pinned down on. That then informs the trustees on how much exposure to private capital investments the pension fund requires.
Due Diligence is Key
The primary purpose of due diligence for any investment is to minimise risks while simultaneously maximising value for the investor.
In private capital investments, the need for painstaking due diligence is acute. Private capital investments typically involve medium- to long-term investments in illiquid assets. That the valuations are subjective and prices negotiated further compounds the complexity of investing into these assets.
Because every investment opportunity in the private capital market is unique, due diligence in the space requires an investigative approach.
Asymmetry of information stacks the trading negotiations heavily against the buyer.
It is an extremely cumbersome process only best left for professionals. From industry-specific research to company financial due diligence, and from commercial to operational, to technological and legal, due diligence in private capital markets is a multi-disciplinary process only for experienced experts.
Manager Selection is a Differentiator
Randomly select an asset manager for a money market investment mandate, and the difference with the best performing manager over any given period will, in all likelihood, be just a shallow margin. Do the same in the private capital investment market with your own money and that’s negligence, do it with other people’s money and that is tantamount to criminality.
Manager selection in the private capital markets is a huge factor to the success equation. That the terrain is wide, deep and rough, means there are no substitutes for thorough manager selection. Each manager is very different in their strategy definition, deal sourcing process, economic sector specialisation, portfolio company value creation capabilities, and investment team expertise.
For instance, in private equity space only, some fund managers specialise in venture capital deals, some are specialists in equity growth investment opportunities, while others focus just on management buy-out opportunities.
Deal sourcing capabilities deserve a special mention here. This is the place where a private equity fund manager’s skill, or none thereof, is first exhibited. Managers vary in their deal-sourcing approaches – immediately separating those that will ultimately win from the rest.
A structured approach that allows a manager to continuously source opportunistic targets is critical to repeatable success. It is an invaluable part of the investment management process in which managers build strong deal flow pipelines, setting their firms up to close quality deals.
Patient Investors
There are very clear and compelling reasons why pension funds should have an exposure to the private capital investments markets. While the need for higher returns immediately comes to mind, the need for diversification is usually an overlooked one.
Private capital investments provide access to a broader range of industries and sectors that are otherwise not readily available on either the ZSE or the VFEX. These are also less correlated with the sectors accessible on the two exchanges, providing a hedge against market volatility.
The long-term nature of private capital investments aligns well with the long-term liabilities of pension funds. Pension funds are, by design, patient investors, thus most suited to benefit from the extended investment horizons of private capital investments.
Importantly, private capital investments in sectors like real estate, infrastructure, and natural resources can provide an effective hedge against inflation. Value creation and growth strategies of a well-developed private capital market helps preserve value in inflationary environments.
The potential for investment customisation and specialisation is much easier in the private capital space. The expanded breadth of opportunities means pension funds can craft tailor-made strategies that match their specific risk-return profile and investment objectives.
Not Just an Act of Capital Deployment
Core to private capital markets investment success is the ability of a fund manager to contribute to, and provide, strategic direction to the portfolio companies they invest in. Trustees that invest directly in private capital opportunities without using the expertise of private capital asset managers are having it all wrong.
In-built into any private capital asset manager’s investment strategy is a clear process for growing their portfolio companies over the period of ownership.
Private capital investment strategies are not mere capital deployment exercises. Instead, they are repeatable structured processes of capital deployment, capital restructuring with financial leverage, strategic direction provision, execution, monitoring, evaluating, and exiting.
If not properly managed, the risk of complete capital loss in the private capital investment markets is real. That they are illiquid in nature with long lock-up periods means investors cannot immediately disinvest even when they are sure something is certainly not going well with their investments. There are no readily available secondary markets to use for exit routes.
Conclusion
Private capital investment strategies offer real, unique, and compelling performance-enhancing opportunities. Pension funds need to strategically incorporate these investments into their portfolios if they are to meaningfully turn around their members’ financial fortunes in retirement.
Trustees are best advised though not to go it alone but instead to leverage on the expertise of specialist private capital fund managers. Even traditional asset managers, without specialist private capital investment management teams, lack the required expertise to excel in this space.