Of the few things that asset managers, government and pension funds can agree on, is the reality that equities, fixed income and property have proved inadequate in so far as providing risk adjusted returns. The three asset classes have been the mainstay of pension and institutional investing for decades in Zimbabwe. The anxieties of 2008 that have ignited a vigorous search for alpha (Excess returns of a fund relative to the return of a benchmark index) and need for diversification have been a key motive for a growing interest in alternative investments by Zimbabwean institutional investors. The trend is the same world over, where a recent global alternatives survey revealed that alternative assets under management globally stood at USD6.2 trillion in 2016, growing from USD1 trillion in 1999 – an 11% annual growth.
As the Insurance & Pension Commission (IPEC) reports reveal; private equity and infrastructure investments are becoming more embedded in the portfolios of pension funds. This may well be the new normal in asset allocation. Recent successful infrastructure investment activity and private equity transactions have helped to profile alternatives as the new destination for institutional funds.
Alternatives vs traditional assets
In general, Alternatives are investments in assets other than stocks and bonds which are uncorrelated to the broader market. Because Alternatives tend to behave differently than typical stock and bond investments, adding them to a portfolio provides broader diversification, reduces risk, and often enhances returns.
A 2015 World Economic Forum report on Alternatives, suggests that a useful way to think about alternatives is to differentiate between their “contents” – the assets or strategies that determine how individual investments might be expected to perform and their “containers,” the fund or investment structure that will determine transparency and access to capital. For example, an infrastructure bond has an underlying asset in the form of infrastructure (content) but is housed in fixed income vehicle (container).
Most popular Alternatives include: Hedge funds, Venture Capital, Private Equity, Infrastructure, Illiquid credit, Real Estate, and Fund of funds. Despite record defaults, high vacancies and dear prices, ‘property’ remains the largest asset class and alternative investment by value. As private equity and infrastructure asset classes demonstrate downside protection and all weather returns, the notion of property as principal ‘refugee of value’ for pension funds is now being challenged.
Infrastructure – now what matters is the vehicle
The last three years have been the most active in the infrastructure asset class in Zimbabwe. A flurry of infrastructure fixed income assets have and are still coming on the market. By the end of the year, total infrastructure related fixed income assets could well be more than USD3 billion. CBZ’s tertiary education infrastructure bonds, IPEC’s agriculture infrastructure bond and IDBZ’s are all in a capital raise mode.
But despite the underlying asset being robust (infrastructure) the vehicles that have been used thus far in Zimbabwe are beginning to show structural challenges for long term investors. Fixed income instruments, historically averaging 9% per annum coupon, used to be one of the best places to park funds in the deflationary era of 2011-2016. But with rising inflation, investors are beginning to fret about holding bonds. Forced by illiquidity investors may end up holding, until maturity, instruments that lose their buying power. But that should not discredit infrastructure as an “asset”.
Listing the infrastructure vehicle protects the instrument from the devaluing effect of inflation. In addition to income from the underlying infrastructure asset being inflation sensitive, the share price of the listed vehicle would also capture inflation as all listed equities do. In South Africa, Infrastructure Special Purpose Asset Companies (SPACs) aka Cash Companies have become popular as a way to house infrastructure projects on stock exchanges thereby providing pension funds with three key investment requirements: income, downside protection and duration.
World over, Australia is regarded best case study of how a government can stimulate growth in infrastructure assets. Simply, the state has stripped off most red tape and regulations that hampered transfer of public infrastructure assets into private hands. In addition, each time an asset is sold to an investor or fund, the money received by government has been recycled into building additional infrastructure assets by the state.
In a country with a sector wide backlog in infrastructure, much can be accomplished if both our national and local governments open up to working with private sector investors. This may require flexibility in the ownership and management of infrastructure assets.
Private Credit – underserved alternative
As banks curtail lending to businesses due to deteriorating economic prospects and central bank’s cap on lending rates, immediate casualties are medium sized companies. Already, non-performing loan (NPL) figures for first half of 2017 have been reported to reverse the declining trend. This adds pressure on banks to apply more scrutiny on lending, further worsening financing of businesses. To be fair, with a cash crisis that is aiding non-funded income, banks may not be in any rush to lend funds.
In USA where regulation has forced banks to pull back from lending, private debt providers in the form of middle market lenders have filled the gap. Private market debt has taken the form of opportunities in asset-backed investments, direct lending, distressed investments and bank portfolio liquidations. With a more hands-on approach to managing credit, private debt lenders are able to optimise company operations and earn high risk-adjusted returns.
Investec Asset Management’s USD5 million convertible loan investment in OK Zimbabwe post 2009 and Imara Group’s debenture instruments are examples of private debt lending that have set stage for dis-intermediation of banks with time. This asset class provides less correlation to equities, fixed income and property asset class – an important trait for pension funds.
Perhaps the greatest opportunity in this asset class will come when ZAMCO sells its book of NPLs taken off bank books. But this chunk of US$830million credit assets will not be investable to mere financial investors. Instead, credit investors need to do more including sitting on boards, monitoring operations and instituting changes in the running of businesses. Not surprisingly, for businesses that require semi-permanent non-dilutive capital, private debt market is the mirror image of private equity.
Private Equity – where will returns come from?
In the Western economies, private equity returns have been experiencing consistent downward pressure in the last two decades. Entry of new players and competition for the few available deals have compressed returns from mid-20’s to mid-teens in the same period. The trend is catching up in developing world as witnessed by South African market performance data.
To produce alpha, private equity managers now need to go beyond just levering portfolio companies and mastering allocation and timing (buy low and sell high), but are now required to roll up their sleeves and help optimise operations of the businesses they control.
There may be just a handful household private equity names in Zimbabwe including Takura and Brainworks, but there are several boutiques, most which hover below the radar of Securities and Exchanges Commission of Zimbabwe (SECZ) regulation- as they can argue that they are managing private funds. The majority of these are ‘specialists’ focussing on mining and agriculture spaces where returns are high but the need for capital is obvious. By introducing some level of governance, aggregating small players and plugging them to markets, these private equity managers are unlocking value in these portfolio businesses.
The future of the local industry is likely to follow the global path. Growing sophistication of institutional investors including pension funds and pressure on fees and returns will reward scale leading to consolidation among private equity managers.
Acceleration in adoption of Alternatives?
Three trends in particular will shape the growth and size of alternative investments in Zimbabwe
Regulation – the success and proliferation of alternatives investing will mostly be determined by regulation, which will affect how alternative investment firms invest and the way they engage with the broader financial industry. The regulatory authorities namely SECZ are treading a fine line between opening up the asset management sector while safeguarding institutional and retail investors. The tighter the rules and capital requirements for asset managers, the less players and liquidity in the sector. Conversely, the looser the rules, the more the unintended consequences of misconduct and capital losses to innocent investors. As witnessed at the turn of the 21st century and in 2008, loss of trust in capital markets has the ability of pulling back the development of financial markets.
Institutionalisation of Alternatives
In this current and inception stage of most alternative investments, institutionalisation of alternatives will shape the size and value of asset classes. Education about the alternative investments has to be intensified among pension funds, insurance companies, corporates and fund managers to dispel reservations and uncertainties around such asset classes. The quicker institutional investors embrace adoption of alternatives the faster the growth of the assets.
The growth of retail investors as a source of capital, known as retailisation, is a strong trend expected to define alternative investments. Until now, weak household incomes and a shared scepticism for third party money management by asset managers and banks has dampened the size of retail funds. But if and when the economy formalises, inefficiencies will get eroded and arbitrage opportunities in the informal market will disappear as is the case with all structured economies.
With formalisation of the economy, excess household incomes are expected to move into asset managers as most investments will require scale and expertise to be executed. Such fund managers will require multi-asset allocation capability to invest across alternatives to provide retail investors with high risk adjusted returns and less volatility. Such a capability is likely to pave way for fund of funds who can guarantee daily liquidity and pricing to accommodate short term investors.