Lonsec and SQM have highlighted manager selection as a crucial risk for financial advisers when it comes to private market investments.
Unlisted markets are becoming increasingly integral in the Australian wealth management landscape, with local portfolios relying on a mix of 88 per cent allocated to public assets and 12 per cent to private assets, according to Natixis Investment Managers. However, this spread is set to narrow as the focus on private assets intensifies.
Speaking on Netwealth’s portfolio construction podcast, Lonsec Investment Solutions’ chief investment officer, Nathan Lim, emphasised private asset manager selection as a key consideration for financial advisers to be aware of.
“I’d really be calling out manager selection as another critical risk when considering private assets because the dispersion in returns between the highest and lowest quartile managers is much wider than in public markets,” he explained.
“We recently have seen a study that estimates that the performance between the average top quartile and bottom quartile US private equity manager was nearly 20 per cent.”
Referencing research from Blackstone and Morningstar, top quartile private equity managers in the US delivered returns of 29.6 per cent over the past five years. Meanwhile, bottom quartile private equity managers saw returns of 14.6 per cent – demonstrating a performance dispersion of 15 percentage points.
In comparison, the gap between top quartile and bottom quartile managers in public asset classes was less than 2 per cent.
Blackstone stated the significant dispersion in private assets underscored that the rewards to effective manager selection were higher in private markets.
Elaborating on this research, Lonsec’s CIO said: “So that means the best manager and the worst manager there was like a 20 per cent difference between the returns that they produced – that is about 10 times the dispersion you find with public market global equity fund managers where the difference between the best and worst manager was only about 2 per cent.”
“I think it’s really important that when you’re looking at private markets, manager selection is really important. It’s very crucial.”
Paul O’Connor, head of investment management and research at Netwealth, also said the notable dispersion of investment returns is an idiosyncratic risk specific to private market investing. This risk, he added, underscores why it is critical for advisers to do their due diligence before selecting a certain alternative strategy for clients.
He unpacked: “There should be a real focus on looking and understanding each private equity strategy and potentially looking at what sort of research and potentially even a Lonsec research rating on a product to give you a better understanding about what actually lies within that product.”
Moreover, Lim encouraged advisers to evaluate a manager’s track record, scale and size, operating platform, ability to source deals and opportunities, and use of high-quality external resources, such as third-party valuations.
SQM Research managing director, Louis Christopher, also urged advisers to be cautious of managers’ potentially conflicted interests and related party lending in private credit.
“We think it’s important that you get down to the individual borrower details when you’re looking at a private credit fund. You want to know who they are, you want to know the strengths of that borrower,” he said on a recent Ensombl podcast episode.
“We want to know who they are so we can rule off that they are not a related party. This is important because we have been seeing certain instances where there’s been related party lending. As a research house, we are not comfortable with that.”
Last month, Lonsec said the rise of private credit funds had forced it to change its research process, having rated 28 private credit funds including 20 which are domestically focused. In addition to the growth it has observed over the past three years, Lonsec said it has declined to initiate coverage on a “meaningful number” of funds.
Examples of problems with private credit funds which could see a fund rejected by Lonsec included a business in its infancy, a clear equity-debt conflict, small team with lack of resources, a complex asset-based financing structure, or a subscale number of loans.
SQM Research also put the private credit space on alert in March in light of increased issues affecting wholesale funds and newer launches. The alert means SQM is increasing its active monitoring of the sector and placing a greater emphasis on governance and increased due diligence screening of the funds.
This came amid ASIC’s scrutiny on the asset class earlier this year, after it enacted a private markets review that flagged concerns about the rise of private credit funds. Product failures are likely, the corporate regulator said, and it is increasing its focus on the assets and their risk for retail investors.
