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The rapid rise in popularity of private markets has been matched only by industry innovation and the enthusiastic adoption of new technologies. Nowhere is this more apparent than when it comes to risk transparency.
This involves the disclosure, estimation and timing of prospective cashflows, drivers of returns and valuation, along with other asset-specific information, such as the location of physical assets or inventory.
Previously, private markets tended to account for a fraction of institutional investment allocations and where the investment viewed as a simple ‘black box’ that quietly paid out money. Since then, however, allocations have grown – to as much as 25% in some cases. This has led to the requirement for far more detailed information on numerous factors, to ensure investors can have confidence in the reliability of the returns they receive.
However, due to the opaque nature of private markets, investment information is typically limited. Indeed, while statutory information is made available (annual accounts, etc.) detailed information on the prospective cashflows, drivers of returns and valuations are hard to come by.
Given that private markets are not traded via listed exchanges, there are also a number of risks associated with the asset class that can affect the sustainability of returns. These include a number of risks, including around liquidity, cashflow, market and idiosyncratic risk.
Liquidity risk – private markets are traded directly between counterparties, therefore there is no readymade market. As such, the risk is a potential paucity of liquidity to sell an asset. Alternatively, there could be a market but with only a limited number of buyers, resulting in the asset being sold at a discount.
Cashflow risk – many private market investments have unpredictable cashflows, in respect to both timing of drawdowns (i.e. when managers call capital) and distributions (i.e. timing of proceeds of disposals). Therefore, the investor needs to have capital available to meet funding obligations, with the variable timing and quantum of receipts posing reinvestment risk for investors.
Market Risk – like all investments, private markets are influenced by changes in the investment environment, including risks around demand, interest rates, currencies, countries, monetary policy and politics. These risks can markedly influence the valuation of an investment.
Idiosyncratic risk – private market assets are typically undergoing some form of transformative activity, be it a company restructuring, a building renovation or new infrastructure project. Normally, this risk can be mitigated by experienced management teams with the specialist skills in their selective fields. However, not every manager is successful, and poor decision-making may lead to corporate insolvency or project failure. There is also a range of risks that are out of the control of management, such as natural disasters or acts of terrorism – many of which are uninsurable.
With great risk transparency, asset owners are able to form a more complete view on these risks. To achieve this, information must be captured at the granular level, allowing asset managers to disaggregate potential performance drivers. Each investment can then be broken down into a ‘value bridge’ format in order to show the key drivers of returns. These components of returns can then be used to test a portfolio’s resistance to different market events.
This type of approach is not readily available to investors. However, at Aberdeen Standard Investments, we have developed a platform (enabled by Microsoft technology) to bring a range of private market investments together in a single portfolio.
The framework involves taking individual transaction underwriting models across asset classes that are deal-specific and translating them in a common framework. Here, the revenue and costs are linked to country, market and sector growth, with idiosyncratic growth included in order to reconcile the company’s business plans. Balance sheets are simplified to accommodate capital structure nuances. In order to create proxy valuations, resulting net income streams are linked to transaction multiples. We have also created framework models for direct investments and indirect fund investments. All calculations are translated and combined so that investors can visualise the portfolio in a dynamic way.
By taking a granular view of assets, risk transparency offers a number of benefits, including insolvency detection and valuation measurement.
Detailed financial disclosure can alert the investor to possible signs of stress, which may lead to insolvency or default resulting in loss of capital. Should the warning signs be detected early, then remedial action can be taken.
Linking cashflows to key drivers allows investors to assess sensitivity to market factors, such as GDP, interest rates, FX changes, along with variability of exit multiples and timing. Private markets investment is principally cashflow driven and valuations are typically derived from discounted cashflow analysis. Therefore, risk transparency can supply the necessary information – on forward earnings, costs, balance sheets, etc. – that aid in the formulation of a more accurate exit valuation.
As we have shown, the rise in popularity of private markets has been accompanied with increased demand for clarity and reliability around cashflows and returns. However, given the nature of private markets, information around these factors has historically been challenging to ascertain. Nonetheless, the industry has responded, by taking innovative approaches to identifying, analysing and presenting information. Our own approach to risk transparency is a case in point. Going forward, we believe asset owners will grow ever-more sophisticated in their approach to identifying performance drivers and risks – allowing investors to have increasing confidence in the reliability of the returns they receive.