To meet their return targets in the coming years, nonprofits are turning to the private markets.
In Mercer’s global not-for-profit investment survey released Monday, 65 percent of investor respondents said that over the next three years, diversifying away from traditional asset classes would be their greatest opportunity. To do so, many of them have begun moving toward the private markets: Sixty-three percent of survey respondents said that they’re either currently investing in the private markets or plan to do so over the next 12 months.
“Historically, almost all private markets have provided a return premium, or the advantage of [outperforming the] public markets,” Texas Hemmaplardh, Mercer’s not-for-profit commercial leader, told Institutional Investor. Private markets provide investors with an illiquidity premium: Because private assets tend to be illiquid, investors interested in allocating capital to them expect to eventually be paid for taking on that risk. For institutional investors with long-term investment horizons, however, that kind of illiquidity isn’t much of a concern, Hemmaplardh said.
The survey included responses from 133 global participants at a diverse range of institutions, including hospitals, endowments, foundations, and religious nonprofits. Most of the allocations to the private markets are going into private equity, primarily because the private equity market is much bigger than other private asset classes and the expected returns are “materially higher,” Hemmaplardh said. According to the survey, 61 percent of respondents intend to increase allocations to private equity over the next two years, 53 percent plan to do the same with private real assets, and 48 percent expect to allocate to private debt.
The move away from traditional assets and into the private markets can be traced to a widely held fear that returns will be trending downward in the coming years. In the first half of 2022, equity markets experienced their biggest drop in 50 years. Amid an onslaught of inflationary pressures, rising interest rates, and geopolitical tension, the S&P 500 fell nearly 20 percent, while MSCI’s global stock index experienced its biggest first-half drop ever.
Not surprisingly, institutional portfolios suffered as a result. Institutional assets in Wilshire Trust’s comparison service — a benchmark for U.S. institutional plan assets performance and allocation — posted an all-plan median loss of 9.63 percent in the second quarter, marking it the worst quarter since the initial Covid-19 shutdown in early 2020.
While the market picked up again in July, not-for-profit investors remain skittish about the prospect of future downturns, which pose a threat to their ability to generate adequate returns for their institutions. When asked to name the two biggest investment challenges that their organizations will face over the next three years, 59 percent of survey respondents cited low expected investment returns, while 50 percent said higher inflation.
Perhaps even more telling, only 61 percent of respondents felt that their portfolio was well positioned for another extreme market drawdown or volatility event. Thirty-five percent said they don’t know whether their portfolios will meet their intended financial goals over the next three years. “The macro concern is what the future of investment returns looks like for these portfolios,” Hemmaplardh said.
Shifting the bulk of a portfolio into the private markets isn’t easy, however. When Mercer asked respondents to name the biggest barriers to investing in the private markets, 57 percent said that they lack the resources to assess investment opportunities, 43 percent said it’s because the investment instruments are too complex and the fees are too high, and 41 percent said that the manager selection process is too complex.
In the public markets, managers are more susceptible to the concept of returning to the mean: At some point, outperforming managers will underperform and return to the average performance of the asset class. In the private markets, however, performance is more consistent. “The best managers yesterday tend to be the best managers today and tomorrow,” Hemmaplardh said. Picking the wrong managers, therefore, can be a huge risk for investors dabbling in the private markets, on top of the higher fees and the overall complexity of the private markets.
To navigate these obstacles, investors often choose to outsource various functions to third-party providers. In fact, 55 percent of respondents said that they’re outsourcing services to a third-party provider to help address the increased complexity of their portfolios.
And while small institutions have long relied on outside help, particularly with manager selection in the private markets, Hemmaplardh said that even larger institutions have begun to outsource as the private markets grow. “Big and small institutions face the same problem,” Hemmaplardh said.