The Restless Hunt for Yield


mitchell palmer is a research intern at the Milken Institute’s Asia Center in Singapore. erin cher iis a business and program development associate at the Asia Center.

illustrations by hylton warburton

Published January 24, 2022


For many workers, the bulk of their retirement savings is invested for them by large institutional investors, like the California Public Employees’ Retirement System (CalPERS) and Singapore’s sovereign wealth fund, GIC. Traditionally, these institutional investors have kept workers’ money in publicmarket assets (e.g., stocks and bonds), where prices are transparently available and assets are usually easy to buy or sell at low transaction costs.

Over the past two decades, however, the sustained fall in interest rates has made those public-market assets less attractive. Indeed, since the new millennium, the annual return that institutions can earn by making long-term loans to the U.S. federal government (10-year Treasury bonds, which are traded freely on public markets) has fallen from around 6.6 percent annually to approximately 1.5 percent. At the same time, the expected cost of meeting obligations to a typical pensioner is growing increasingly burdensome. With populations shrinking (or soon to shrink) and lives lengthening in much of the rich world, fewer workers will be available to support more retirees for longer.

Caught between rising anticipated retirement burdens and lower yields on safe, fixedincome securities, institutional investors have been forced to look elsewhere to ensure their continued ability to deliver satisfactory returns to their stakeholders, notably pensioners and taxpayers. And that largely explains the growing interest in nontraditional investments, generally lumped together as “alternative” investments.

The Restless Hunt for Yield

Most investors in alternative investment assets are large institutions or accredited, highnet- worth individuals. And for good reason: The investments often require a very substantial buy-in, demand technical knowledge of specific industries for sound investment assessment, and are not regulated by watchdog authorities such as the SEC. As a result, they pose considerable risks.

These factors create daunting barriers to entry for retail investors, who tend to be nonprofessionals without access to the deep pockets and technical knowledge that institutional investors enjoy. But for institutional investors guided by qualified managers, alternative assets are alluring given the high potential for returns — provided they are willing and able to lock up large amounts of capital for long periods. Asset classes within alternative investments include commodities, real estate, venture capital and private equity and debt.

In the private-equity asset class, for instance, institutional investors entrust their money to fund managers, who use it to buy companies that are not listed on stock exchanges and thus less subject to regulation. Those companies are then eventually sold or otherwise converted to liquid assets, hopefully returning a healthy profit to investors — even after adjusting for higher risk.

As noted previously, this requires investment managers with strong technical understanding about specific industries in addition to a broad understanding of how good companies are run. And this expertise doesn’t come cheap: institutional investors have to pay high fees to obtain competent guidance. As a matter of convention, managers take 2 percent of the value of the assets entrusted to them each year in management fees, along with 20 percent of any realized profit above a contractual benchmark. Hence the shorthand “two-and-twenty” arrangement, which dates back to the earliest days of the industry.

Yet in spite of stiff fees (not to mention ongoing academic debate about whether private equity is, in fact, a superior risk-adjusted asset compared to more conventional investment vehicles, such as index funds that track the performance of whole asset markets), many institutional investors have been increasing the private-equity allocations in their portfolios. According to PwC, the consulting giant, the amount of money allocated to private equity increased from $1 trillion in 2004 to $4.7 trillion in 2016 — and that despite the intervening global financial crisis.

What We Found

To offer some insight into the role of privatemarket investments in an institutional investor’s portfolio, the authors and a team of collaborators from the Milken Institute’s Asia Center in Singapore interviewed nine highprofile institutional investors. They included principals in sovereign wealth funds, pension funds and university endowments in Canada, Hong Kong, Singapore, Taiwan and the United States.

All who participated cited a common set of advantages for committing money to the alternative sector:

• It may allow investors to earn extra profit from their ability to lock up capital in assets not readily convertible to cash — the illiquidity premium.
• It may bring corporate governance advantages. One investor called it “the best way to own corporate equity” because private ownership removes the distraction of quarterly results reporting and allows executives to focus on creating long-term value.
• Private markets are subject to more frictions and higher transaction costs than the public markets, which makes it more difficult for the market to price-in new information or insights. But this downside can be an opportunity, since investors may gain advantage from their informational and skill advantages.

At the heart of this influx of money into alternative investments is a key relationship: the one between investors and the managers hired to invest their money. Understanding how institutional investors approach this core relationship can shed light on whether some of the advantages could also be enjoyed by retail investors.

The Case for Retail Private Equity — Or Not

Traditionally, retail investors have been barred from investing directly in private markets for both commercial and regulatory reasons.

As noted above, private-market investments lack the inherent transparency of the public markets and require longer investment horizons. Thus, regulators, notably the SEC, have typically considered them too risky for lay investors.

Moreover, it is at times simply too costly for asset managers to devote teams to building one-on-one relationships, educating and hand-holding retail investors — even when retail translates as high-net-worth individuals or family offices capable of writing sizable checks. One of the interviewees shared that it can take roughly as much time to receive a $500,000 commitment from an entrepreneur who just sold his business as a $50 million commitment from a sovereign wealth fund. It is thus only reasonable for asset managers to prioritize their time and energy toward institutional investors who are lower maintenance and capable of larger capital commitments.

To some extent, though, recent technological and business innovations have leveled the playing field between institutional and retail investors. For instance, Temasek, an investment vehicle owned by the Singapore government, has begun issuing Astrea PE bonds through its subsidiary, Azalea Asset Management. These bonds allow non-accredited retail investors to invest in bonds backed by cash flows from private-equity investments, thus gaining exposure to the asset class.

Similarly, apps like Germany’s Moonfare and Singapore’s XEN allow investors who meet minimum wealth and income requirements to invest directly in private-equity funds. In many cases, they even provide a secondary market in which investors can buy and sell stakes in private-equity funds after they have been raised.

Having It Both Ways

One possible way to permit retail investors to gain direct exposure to alternative investments while also allowing particularly forwardthinking institutional investors to profit is for institutional investors to welcome retail investors as partners. Retail investors’ funds would be commingled with institutional investors’ big pool of capital when making commitments to private-equity managers and conducting co-investment deals alongside those managers. In exchange, institutions could levy a management fee on their retail partners.

The retail investor would (for a management fee) gain access to the significant market knowledge and influence of the much-larger institution. Crucially, they would also gain access to co-investments from which retail investors are usually excluded. And they would share in the benefits of the deep relationships that institutions build with their managers. These relationships can manifest themselves through better customer service, freer knowledge-sharing, sometimes better prices, and ultimately better investment outcomes.

This would allow institutional investors to substantially increase their capital without increasing leverage. As investors almost unanimously told us, in private equity, size matters. For starters, it allows institutions to defray the fixed costs of a large in-house professional team over a larger pool of assets and thus make it possible to compete on fees with peer institutions.

Bigger institutions are offered more deals because they are able to offer more cash for the same effort from fund managers. Similarly, bigger institutions find themselves in a much stronger bargaining position with fund managers because their commitment alone could determine whether a particular manager meets their fundraising goal for that round. These scale economies would benefit the institution’s other investors as well as retail participants.

Large public pension funds are in a particularly good position to begin such programs. Many workers save for retirement independent of their defined benefit pensions (e.g., through vehicles like IRAs in the U.S.), and might appreciate access to private equity and other alternatives. Moreover, their relatively long investment horizons are similar to those of their pension funds, making them natural co-investors.

Consider, too, that the development of private-equity expertise is a fixed cost. Thus, if public pensions were to offer co-investment opportunities to members, they could offer significantly more value to their members for little increased cost.

In order for this approach to work, pension funds and other institutional investors that wish to allow members to co-invest would need to convince regulators that their members are sufficiently well protected against the inherent risks of investing in largely unregulated private markets. This could be done, first, by allowing only a limited proportion of members’ portfolios to be invested in these vehicles. Second, institutions would need to be transparent and explain to investors the true risks of the private markets. Third, co-investment would likely have to start with only the largest and most reputable institutions with the longest private-equity track records so that regulators can grow comfortable with the model before smaller institutions are allowed to enter the market.

All this presumes, of course, that savers are ready for the change. And given the private nature of these assets, it may require some marketing to explain why they offer opportunities otherwise not available. For better or worse, though, the pitifully low interest (often negative in real terms) that savers can garner in safe, fixed-term securities and bank deposits is likely to persuade the skeptics.

* * *

It’s widely acknowledged that retail investors’ current reach for higher returns in an era of low (or even negative) interest rates creates troubling risks for both the investors and the broader financial system. But if done right, retail investors could be given access to a far wider landscape of investments that promise increased returns at acceptable levels of risk. A win-win may yet be in the offing.

This could significantly alter the current investment landscape, allowing the average Jane and Joe to build wealth through vehicles other than owner-occupied housing. And it may have positive ancillary consequences, from easing problems in funding longer retirements to dulling the edge of resentment toward those who have amassed great fortunes in a period of rising inequality.