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This podcast is only for the attention of professional investors in the financial industry. Outerblue by Amundi. Welcome to Outerblue Conversations.
- Sofia Santarsiero
Hi, hello everyone and welcome to our Amundi podcast, Outerblue. This is our second episode of the year and I'm Sofia Santarsiero. I'm the head of institutional solutions and innovation here at Amundi. and I'm very happy to be joined today by Amin Rajan, the CEO of CREATE Research. Hi Amin, we're so happy to have you on the podcast.
- Amin Rajan
Hello Sofia, good morning and great to be here and thank you for inviting me.
- Sofia Santarsiero
So Amundi every year publishes with the support of CREATE, so Amin and his teams, the Amundi CREATE Research on pension funds. So we think of innovative topics that will shape the pension fund ecosystems in the years to come. This year, we picked private assets and Asian emerging markets. In order to really understand what pension funds globally are thinking about these two main asset classes, Amin and his teams interviewed 157 pension plans in 13 key jurisdictions. And all these pension funds are collectively managing almost 2 trillion of assets, 1.9 trillion. Before we dive into the more specific question on each of the asset classes, can you tell us where are some of the most common denominators that you found between the attitudes towards these two broad asset classes? So private asset and Asian emerging markets.
- Amin Rajan
That's a great question to start with, Sofia. There were quite a few common denominators and the three that were, there were three that were most noteworthy. The first one was that both private markets, as well as emerging markets are very susceptible to changes in the interest rate cycle in the U.S. In private markets, for example, returns depend very much upon the amount of leverage that is available, and interest rates determine the cost of that leverage. Also, when it comes to emerging markets, what we find is that many companies in emerging markets rely on dollar-based borrowing in order to finance their business growth. And again, interest rates make a lot of difference to them. So in both cases, this exposure to the U.S. interest rate cycle has been a major factor. But that's not the only factor. There are two other factors as well. One of them is that in both cases, as a result of the last bear market, investors have become much more selective in terms of asset classes and also in terms of countries. For example, if we look at private markets, previously the emphasis was really very much on almost all five or six key asset classes. Now the emphasis has really sort of shifted, for example, from private equity to private debt, from real estate to infrastructure. And this kind of selectivity has become important as a result of the changing dynamics of the returns in these asset classes.
The same thing really applies to emerging markets. In the past, the tendency was to treat all Asian emerging markets almost as a block, had a blanket approach to these emerging markets. And now, what is really happening is that there is much greater selectivity by country. For example, in the past, the countries that received most attention were China and India and Taiwan and South Korea. Now, smaller countries are receiving much more attention. Also now India is receiving much more attention. So selectivity has really become a major factor, to the point where the emerging market label has been becoming redundant, because these countries are all at very different stages of economic development, political maturity and regulatory framework. So we are in a situation where all emerging markets are no longer created equal. They have to be treated on an individual basis.
The third and the final point about the common denominator is that private markets as well as emerging markets are now increasingly exposed to geopolitical risk. Now in the past geopolitical risk covered wars, now they cover a whole host of things like de-globalization, like climate change, like cyber security and most importantly the growing rivalry between US and China. And this rivalry is really having a major effect on the neighbouring countries in Southeast Asia now. To the point that these geopolitical risks are really forcing investors from going from managing risks, to managing uncertainty. Managing risk is about operating on the basis of non-probabilities of outcome, and managing uncertainty is all about a shot in the dark, as you know. So we are in a situation where there is extreme risks in both sets of markets. However, having said that, those markets still hold great promise, and investors have to strike a balance between the fear of missing out on good returns and capital conservation. And that's a delicate balancing task that they're trying to do at the moment.
- Sofia Santarsiero
Thank you very much Amin. So selectivity is key and managing uncertainty is also key for pension funds going forward. In terms of private markets allocation, so we know that the overall generally increased in the last years. Is this a trend that you expect to continue going forward? What are also the preferred asset classes in your view, and what pension funds have been sharing with you? So you started to mention it a little bit at the beginning with this, for example, with the shift from private equity to private debt. But I would like to go a little bit more in details on this. And maybe also if you can share what are the main drivers in your opinion of this increased allocation to private markets?
- Amin Rajan
Now, growth in private markets, will continue. As you mentioned, there has been very rapid growth in the past, and the growth is likely to continue, but with one big proviso, that growth is likely to slow down as well. The private markets have definitely entered an era of slow growth after the banner year of 2021, when they attracted huge sums of money. Since then, the deal flow has slowed down very considerably. And the main reason is that the previous wall of money that came into private markets have severely reduced the opportunity set to the point where the dry powder now stands at its record high. For example, if you look at the data on on dry powder, it's grown at the rate of 11 over the past 10 years, ending in 2023 with an all-time high of 3.9 trillion which is equal to just under a third of the private market universe. About a third of the universe at the moment has got capital which has been allocated, but has not been invested. So this is one key reason. So the asset growth will continue, but it will continue at a slower rate. Now there have been constraints in the past and these constraints have become even more relevant now. Some of the constraints were really about the transparency, the lack of liquidity, high fees, high charges. All those factors were previously not so relevant, have suddenly become very relevant, because the growth expectations are likely to be very limited. Indeed, there have been forecasts put out by Peachbook, which said that in 2024, the expectations of return on private equity were likely to fall from something like 20% per annum to something like 10% per annum. So this halving of return expectations is really having a major effect.
Having said that, there are some growth drivers which are likely to be in play. The key driver is really the rate reduction cycle in the US. And that cycle at the moment is continuing, but maybe won't continue as far as we were expecting in the light of the agenda of the new administration. But the debt rate reduction cycle is going to have a major effect in terms of enabling more deal flows and also enabling the distribution of cash back to the investors on the maturity of funds. There is another driver as well which is worth bearing in mind, which is that more and more growth companies are going into private markets rather than coming into public markets. By the time they come to public markets the best upsides are usually gone. Not only that, these companies are preferring to remain in private markets for much longer, and this is really having a major effect. Apart from that, also on the regulatory side, in the defined contribution pension plans in Europe in general and in the UK in particular, new regulations are lifting restrictions about liquidity, and lifting restrictions about the fee caps and so on. So, you know, there are some growth drivers in play at the moment. which are likely to have quite a big effect. And as a result of that, investors are continuing to show interest in private markets and particularly interest in ESG-based assets, because they have got ESG commitments, many of them have got fiduciary responsibilities to deliver on the ESG agenda, and private markets are seen as the best avenue for engaging in ESG investing, because ESG metrics can then be hardwired into the mandates of the private market assets.
So as a result of that, what we're going to see is some continuing growth in the private market asset classes. The key asset classes that are likely to benefit are private debt, where the amount of interest that is being shown in that is absolutely huge. Default rate has been low, and returns have remained consistently good, even during the difficult turbulent period of the last two years and so on. The second asset class which is likely to do well is private equity. There's still a lot of interest in growth equity. and in buyout activities. But the interest will be much lower in the light of lower return expectations. Infrastructure is another one which is likely to do really well because there is growing interest in what is now called the 4D revolution. And the 4D is about decarbonization moves. It is about trends in demographics. It's about trends towards deglobalization. And it's about trends towards digitalization. And the idea is really that investors now that they're so concerned about capital conservation, they want to invest in asset classes which have got predictable sources of returns. And this 4D revolution is seen as predictable sources of asset classes, which can override the market cycles, such that, you know, the fear of missing out is then very much limited by the kind of asset that they're investing in. So infrastructure is likely to do particularly well as a result of the 4D revolution. Infrastructure is also going to be very much favoured by pension plans who have got indexation in their pension payouts. Because, as you know, infrastructure has got inflation protection links in the mandate and so on.
- Sofia Santarsiero
So what I hear is that overall growth and interest in private markets is going to continue to increase, actually, whether in a slightly different shape. And also that somehow investors, and particularly pension plans, are getting a little bit more selective. They look at the constraints with definitely a bit more attention than used to be in the past. So I wanted to ask you, what are the factors that limited partners, the so-called LPs, use to select the general partner, the GPs, when they need to allocate to private markets. And if you have any view on whether this criteria could change going forward as well. Thank you.
- Amin Rajan
Another great question. Before 2021, which was a banner year for private markets, the choice, the selection criteria was very much guided by the return expectations that were going to be delivered by General Partners. However, since 2021, that has been expanded to include another set of factors. And the other set of factors is, yes, we want to have high returns, but we also want to have assurance that the General Partners have the capabilities to deliver on high returns, or to deliver on the targeted or expected returns, and so on. So basically, they're very much now interested in what capabilities do General Partners have. And in particular, they want much greater exposure or much greater transparency around the investment process because at the moment they get very little. They have very little idea about what the investment process is that is used by General Partners. They also want to have transparency around performance attribution analysis because they want to see what kind of performance attribution analysis is being done. They also want to see transparency around who the all the investors are in a particular fund because at the moment if I'm investing in a fund I don't know who the other investors are. So by having this sort of transparency, they feel that they will be able to have a better measure of the kind of capabilities that General Partners have. So what they are basically doing is adopting a two-stage approach. In the first stage, they're really interested in what the track record of General Partners is in terms of delivering their clients' financial and ESG goals. Also, what kind of fee structures they're charging. Are they really charging a fee structure which is consistent with value for money? And they also want to know if the General Partners have the deal teams, which really stay with a particular mandate from start to finish, from origination to the maturity of the fund, because they really want to see the stability of the teams there, because without the stability of the teams, they reckon on the management of the fund.
- Sofia Santarsiero
Thank you very much, Amin. So now we're moving a little bit more towards the other part of the of the survey, of the research, which is Asian emerging markets. Can you give us a little bit of an idea of how pension plans are allocating to this asset class, so Asian emerging markets? And also, if you can give us an idea of what are the preferred region and countries, and potentially also the types of strategies that pension plans use to access this asset class.
- Amin Rajan
• As far as the allocations are concerned, and currently, something like 62% of our survey respondents are already invested in Asian emerging markets, but only 11% have allocations in excess of 10%. So the point is, you know, assets are very thinly spread across the pension universe. And these numbers were higher before the Russian invasion of Ukraine. But when that invasion occurred, as we know, Russia was taken out of all the key emerging market indices. And as a result of that, Russian assets become worthless. And that sent some sobering messages to pension investors, because they thought that if there are tensions between China and Taiwan, that China would suffer a similar fate. So as a result of that, many pension plans reduced their allocations to China, simply because they're worried that China could lose a place in the emerging market indices. And that fear is not unwarranted because at the moment there is a bill going through US Congress which is seeking to exclude China from all main emerging market indices. So this could cause a huge havoc, huge dislocation. So this fear has really sort of kept the allocation levels lower. However, over the next three years or so, we expect the allocations to rise and something like 76% of investors from 62% now to 76% in three years' time expect to be in emerging markets. Selectivity is going to be a major factor as far as investing in Asian emerging markets is concerned. That is because in the past, these markets had high growth rates, but high economic growth has not converted or has not translated into high earnings per share. Indeed, there were only two countries where this has happened. One of them was India and the other one was Singapore. And it's not a matter of surprise that it was in both these countries that investors think that they've done, their assets have done, particularly well. In both cases, the return expectations have been met and in some cases they have been exceeded. And so one factor in the past which has really limited the allocation to emerging markets was really about these issues around governance, issues around transparency, issues around liquidity and so on. Now if you look at the future, things are getting better because countries are improving their governance structures. There's a huge effort going on, for example, in South Korea. South Korea has always had what is called the Korean discount, because although it had world-class companies, their share prices languished, has languished over the years. And that is because of the governance systems in South Korea. Now these are being reformed. And as a result, South Korea is becoming very attractive. Taiwan is becoming very attractive. India is becoming very attractive as a result of governance. Philippines is becoming attractive. Vietnam is becoming very attractive in view of its strategic partnerships with the major economic powers and so on. So things are beginning to look good for emerging markets. And as a result of that, we expect new flows into emerging markets. And as far as asset classes are concerned, the flows are likely to be in thematic funds. particularly themes which are related to the 4D revolution that I referred to earlier on. There is also going to be greater flows into emerging market debt, both hard currency and local currency. China will attract funds, but these were mainly speculative investment. Either contrarian investors who think that China's story is very real and is going to deliver good returns, or investors who think that the China fear is overdone and very soon there may be a market correction and we'll have some reversion to towards the mean.
- Sofia Santarsiero
So thank you so much Amin and we're reaching now the almost the end of our discussion but I have one last question for you so you started mentioning it a little bit in your in your previous answer in for example in terms of the improving improving governance structuring in Korea, but do you have in mind other drivers and inhibitors to the growth of investing in Asian emerging markets by pension funds?
- Amin Rajan
One of the key messages from the survey is really that the emerging markets of the future are going to be very different from the emerging markets of the past. First of all, that label is going to become redundant. Secondly, it's going to become redundant because they are making progress in a number of areas. For example, if you look at regulation. You know, there is much greater regulation. If you look at India, for example, the top thousand listed companies have to report on their ESG credentials every year and the progress they are making on their ESG credentials. If you look at the three main stock exchanges in China, ESG disclosure is compulsory, as is engagement with investors. So they're making a lot of progress in not only in the area of ESG, in the area of regulation, but also in the area of corporate governance and so on. And as a result of that, they feel that they would be in a better position to attract huge foreign capital, which they need to decarbonize their economies, because there is ample recognition in India, and indeed right across Asia, that the war against global warming is going to be won or lost in Asia. So Asian countries are very aware of the fact that they have a very critical role to play in terms of fighting the climate change. And as a result, they need to attract a huge amount of foreign investment. China, for example, needs to invest something like $15 to $20 trillion on its green agenda. And they're not going to be able to raise that money by themselves. And they expect foreign capital to help them out in that particular process.
So we're going to see some convergence in certain areas, like governance, corporate governance, and also in the area of regulation, as these countries begin to emulate the investment practices that now prevail in the West. They very much want to make sure that they are really modelling the capital markets on the Western style, such that they are deep, they are more liquid, there is transparency, no front-end running or anything like that. And as a result of that, we will see convergence in certain areas. But there is also going to be divergence in two notable areas. One of them is returns and the other one is correlation. Emerging markets in Asia are going to retain their uniqueness because they are now equipping themselves to convert the high growth dynamics into high returns. And as a result of that, their returns are going to remain higher than the returns in the developed markets. And also they are going to have a lower correlation than the market, than the assets in the developed markets, so there will be convergence in some respects like governance, like regulatory framework, but there will also be divergence in terms of returns, and in terms of correlations. And that really argues for investing in emerging markets because they still offer a good diversification opportunity with good income and return upside.
- Sofia Santarsiero
Thank you very much Amin. So as a conclusion, definitely continue to invest in emerging markets with selectivity and in those countries that really showed some improvement in terms of regulation and corporate governance.
I really enjoyed our conversation today. I hope our listeners did too. So thank you very much, and of course stay tuned for the next Amundi Create Pension Fund research towards the end of the year. Amin, it was a pleasure to have you.
- Amin Rajan
Thank you very much indeed for having me.
- Disclaimer
This podcast is only for the attention of professional investors, as defined in Directive 2004-39-EC, dated 21st of April 2004, on markets and financial instruments called MIFID, investment services providers, and any other professional of the financial industry. Views are subject to change and should not be relied upon as investment advice on behalf of Amundi.
