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27 September 2019

Investors want alternative assets, but can you cope?

By Roger Woolman

The phrase “alternative assets” has become something of a misnomer. Asset classes such as private equity, private debt, real estate and infrastructure have become so popular among investors they are now almost mainstream.

This creates a challenge. Clearly there are opportunities for asset managers (and their service providers) to profit from the investor trends by moving into different asset classes … but only if you have the skills and operational support infrastructure to do it well.

Alternatives on the rise

Projections from the PwC Asset and Wealth Management Research Centre suggest allocations to alternatives will almost double from US$11.2tn in 2017 to an estimated US$21.1tn in 2025.

Given alternatives’ potential to spike returns, generate reliable income streams and provide valuable diversification and risk reduction benefits, it’s easy to see why investor interest around the world is riding so high.

But while the investment rationale for shifting into new asset classes may be strong, the operational and system demands that come with supporting multiple—especially alternative—asset classes shouldn’t be underestimated.

Accurately allocating profits, losses, expenses and tax impacts among every investor is a challenge, demanding specialised administrative expertise and system functionality. Meanwhile, heightened investor and regulatory scrutiny call for greater transparency and better reporting.

What is the operational ask?

Coping with complexity and diversity is a major factor. The alternative asset label incorporates a wide variety of asset types, investment strategies and fund structures, each with specific processing requirements.

Common operational pain points though include:

- Data sources

Data sources differ from one asset class to another. And the information is often delivered in varying (and various) formats.

Private capital markets-related data doesn’t always come from a standardised data feed. Notices may be sent as a PDF or fax. Image-type data may be used to notify investors of a capital call or distribution.

That creates a handling consideration. Can you parse those non-flat file data types? Can the information be collected through email?

- Accounting treatment

Modern private equity funds and newer hybrid funds, for example, require complex investment accounting that feeds into investor accounting to provide investors with detailed look-through to the underlying assets—allowing them to see their portfolio constituents and the XIRR by investor and investment. Detailed look-through from an investor to the investments is also needed to generate accurate fee calculations.

Private equity funds typically engage in multiple investment rounds too. Whenever new investors come in, the fund must rebalance its profit and loss since inception, and the capital calls and distributions to investors.

Distribution waterfalls add further complexity, especially where distributions are heavily customized. Calculating and allocating the different tiers in the fund’s distribution schedule can be a real headache without a sophisticated waterfall calculator.

In the case of private debt nuances can occur—for instance, interest accruals may be left as payables, with loans only repaid at the end or with ad hoc repayments. Such treatments contrast with those for bank debt or syndicated loans.

- Data migration

Adding new assets to a portfolio management system typically requires a point-in-time conversion of whatever positions the fund holds at that moment. Certain asset types though require migration of the full back history, to accurately track all the capital commitments and drawdowns, allocate management fees and generate waterfall calculations.

Transferring that data involves significant work, with a risk of ending up with inaccurate or missing data.

Are your people and processes up to the task?

Many investment firms still rely on a mix of spreadsheets, in-house built technology and legacy vendor systems. Can these existing infrastructures and workflows cope with adding new asset classes, especially alternatives?

There is little room for errors or failures. Regulatory and reputational risks will hound any firms found making mistakes or falling short of best practices.

And with investors expecting high-quality servicing—and employing stringent due diligence checks to ensure fund managers can deliver it—a controlled, auditable operating environment is becoming a prerequisite for attracting allocations.

Tactical vs. strategic solutions

Accommodating new asset classes requires the right systems, workflows and expertise. There are two ways to get there:

1. Big bang strategic implementation

Replacing a legacy system environment with a sophisticated portfolio management and accounting solution with built-in, multi-asset class functionality can provide firms with all the capabilities they need out-of-the-box. An integrated, automated environment allows for consolidation of systems and can deliver meaningful internal efficiencies, while satisfying investors’ due diligence demands.

Upfront system costs and the transition time to switch to a new platform need to be borne in mind, but these can be alleviated by opting for cloud-based system delivery. Outsourcing certain middle- and back-office functions can also help fill any gaps in processing expertise.

2. Phased approach

The alternative is a tactical rollout—to take the immediate asset class functionality you need from a new system, perhaps through a restricted license, without ripping out and replacing your entire existing infrastructure. Managed service outsourcing of some tasks can again offer supplementary processing expertise until you’re up to speed.

Such an approach may save some big upfront decisions, disruption and initial outlay. Adding further asset class functionality and consolidating systems onto a more strategic platform can then be tackled at a later stage.

With investors keen to diversify into different asset classes, what you can’t do is nothing. If you want to take advantage of the trend, make sure you have the capabilities to cope.