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Benefits and Pensions MonitorThe Good, The Bad, And The Ugly
Non-traditional assets, from private equity and real estate through to venture capital financing and infrastructure funding, are the hot topic for plan sponsors who are tired of anaemic returns from stocks and bonds. Recent research shows that these assets have come of age, which leads to both good and bad results for the institutional investor. The Good One of the characteristics that the above assets have in common is the difficulty of valuing such unique investments. As one industry veteran noted, speaking of commercial real estate valuations in the 1980s, “appraisals were all about who could yell the loudest in the room.” Any asset that could be subject to that much subjectivity is bound to create some problems later on. But there are signs that valuations, at least in the real estate field, are getting a whole lot more rigorous. In a piece in the Journal of Property Research (Volume 20, #4), entitled ‘Does Assessed Value Influence Market Value Judgement?’ two U.S. researchers found that while “non-professionals” were biased in their perception of the value of a piece of real estate, professional appraisers were not. Previous studies in the real estate field had shown that even “expert appraisers” were biased in that they would base or frame their decisions on any standard that is easy to apply (in this case, assessed values). This finding is similar to the numerous studies in behavioural investing where investors will “irrationally” be biased in their understanding of value depending on everything from the price they paid for a stock to the actions of others in the crowd. Yet this study suggests that value judgments made by some real estate professionals were less intuitive and, therefore, more accurate. While the usual disclaimers apply, the good news here is that (maybe) some of us are getting more rigorous in being able to properly value what was previously thought of as a highly subjective asset class.
The Bad However, some bad news about alternative assets comes courtesy of the August 2004 McKinsey Quarterly. Speaking of the private equity marketplace, the authors speculated that there might be fewer deals around in the future in which to apply our growing sophistication in market valuation. In other words, the low hanging fruit may have already been picked. It is estimated that about US$90 billion and EUR$39 billion in Europe has been committed to this asset class by institutional investors, but is yet to be invested due to the paucity of good deals. There appears to be more competition for each investment, which can only lead to lower median returns for anybody newly entering this arena. The Ugly Finally, Standard and Spoor’s weighs in with a paper titled ‘When Projects Fail – 10 Years of Rated Project Finance Debt At Standard and Poor’s’ (August 2004). The analysis of project financing – which can include everything from power generation and petroleum refining to mining operations and transportation infrastructure – shows that no matter what the project, the reasons for some deals to get hit with huge losses are similar – technical risks of the project (such as construction and operations) and weakened financial performance both accounted for only five per cent of defaults or downgrades. On the other hand, counter-party and sovereign-related risks – where changes in government policies, the failure of business and legal institutions in a country to remedy disputes, and poorly enforceable property or contractual rights – were the risks that really affected investments. Another report from S&P in August 2004 has a title that makes the point abundantly clear, ‘How Much Is A Guarantee Worth In The Public Sector?’ The ratings agency concludes that, “The willingness to pay on a guarantee may vary significantly according to entity, country, and the instrument.” So just when an investor may have thought that he had a difficult deal properly structured, the last line of defence in making a project feasible, a government guarantee, may turn out to be easily breeched. The result is a bigger downside risk than many investors may have bargained for. There you have it. Things are maturing in the world of alternative assets, which has both positive and negative consequences for investors as such markets become more efficient. Yet risks, and I assume some profit potential, still remain, all of which makes for more interesting investing than could be had through stocks and bonds. Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto. |
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