In English, we use the term “when pigs fly” to denote something that will never happen. But did you know there is a mythical creature that in German is called an “eierlegende Wollmilchsau”, quite literally a pig that produces milk, wool and eggs? We have never seen one, but are sure you would agree it would be a lot more useful than its fabled aerial cousin.
Imagine the equivalent financial product: it would allow simultaneous exposure to debt/equity, long/short positions, public/private markets and with full liquidity available to the widest range of institutional and private investors. It might seem as far-fetched as our non-flying hybrid pig, but as you will discover in this series of articles, there is a trend of convergence towards such structures.
In this first article, we will explain what we mean by convergence, exploring the context and highlighting some key topics that we elaborate on in future articles.
Going up and down the liquidity spectrum
Asset management convergence adopts many guises. One of the most prominent trends has been the rotation by traditional asset managers and hedge funds into illiquids, namely private markets, a consequence of the asset class’ tantalising performance since the GFC. According to the American Investment Council, private equity firms have consistently outperformed public markets over the last decade.
McKinsey notes performance in private debt has also been strong with 2008-2018 vintages producing median internal rates of return (IRR) of 9.4%. This shift to illiquids comes as a number of long- only managers and hedge funds struggle to produce steady returns – owing to the low interest rates and market volatility.
The strong performance available in private markets is prompting more institutions – including pension funds – to pour vast sums of money into the asset class as they desperately hunt for yield in order to match their long-term liabilities. For example, private market fundraising reached almost USD 1.2 trillion in 2021 – a 20% year-on-year jump – with AuM (assets under management) now totalling USD 9.8 trillion.
The growth of private markets has also been driven by various government and regulatory policies. Most notably, governments are increasingly prioritising investment into infrastructure or projects designed to improve energy security or the transition to a low-carbon economy, which is creating opportunities for managers focused on the private markets.
Post-crisis regulation has also facilitated an opening for private debt managers notably in EU markets. The introduction of stronger capital and liquidity requirements for banks, together with the push to increase the depth and integration of European capital markets, is opening up a wider range of financing channels for large swathes of the EU economy. Private debt managers are stepping in to take advantage of this opportunity by providing more direct lending notably to SMEs that might previously have been reliant only on bank finance.
Many hedge funds always had small portions of their portfolio in illiquid positions as investment opportunities arose. Current market trends sees these hedge funds as well as long-only managers more strategically repositioning themselves into illiquids so as to maximise their capital-raising potential by appealing to a larger demographic of investors.
Although a lot of column inches have been devoted to stories about managers chasing illiquidity premia, there are a number of instances of private markets-focused firms launching liquid fund ranges or entering into more liquid positions in a hybrid style offering.
Not only does this help managers target investors with conservative risk profiles, but it enables firms to put unused capital to work more easily. Right now, private equity managers are sitting on USD 1.78 trillion of dry powder – or unspent committed cash – which needs to be deployed.
In the alternatives world more generally, managers are developing products aimed at retail – such as UCITS or 40 Act Funds. A number of these asset managers see retail money as a useful mechanism by which to diversify their businesses, especially given the sheer size of the retail market.
Although diversification can bring benefits, it is vital investment firms navigate some of the constraints they may face, especially around expertise, operating models, risk management and liquidity.
Steering clear of the convergence traps
Strategy convergence can open up a wealth of opportunities for managers – both in terms of performance and fundraising – but it is a process which needs to be undertaken carefully and thoughtfully. From an operations perspective, different strategies and financial instruments have their own unique requirements such as distinct settlement protocols, different valuation techniques or client/regulatory reporting obligations, which managers need to be on top of. In order to do this effectively, managers firstly must make sure that they have the right internal talent in place to handle these new assets or fund-types.
It is critical that managers are accessing the right technology and operating model for their new and perhaps more complex investment strategies and instruments. In addition, managers should think carefully about how they run their various strategies – especially if they are operating in business silos.
As such, firms need to ensure their front, middle and back offices function in a way that is synchronised and joined up. By doing so, COOs will have front- to back-end capabilities to handle their converging investment strategies. In addition to creating the right internal framework to support this, COOs must also work with providers who can help them simplify and automate their operations.
Effective data management is critical too. By having a single source of truth, managers can obtain a holistic overview of their entire business operations. Not only does this help managers scrutinise performance and risk more effectively but it can also facilitate economies of scale and provide cost synergies. With the investment industry becoming increasingly complicated through convergence and diversification, it is vital that managers ensure their operations are streamlined.
Convergence is also prompting managers to re-evaluate their service provider relationships. As some clients widen their distribution footprints by targeting new domiciles and investor bases (i.e. retail), whereas others turn to illiquid strategies, universal banks are in an excellent position to support them.
With managers requiring a much wider suite of services because of their various convergence initiatives, they need to engage with well-capitalised providers who have the expertise and capabilities to assist them in areas such as prime brokerage, custody, both traditional and alternatives administration, risk and regulatory reporting, depositary, financing, and access to global markets. By collaborating with the right third-party vendor, managers will be able to rationalise service provider relationships enabling them to reduce counterparty risk while obtaining cost optimisation and operational benefits.
Ultimately, integrated service providers such as BNP Paribas Securities Services are well placed to help clients achieve diversification in a way that is frictionless.
In the end, there is no chance to see a flying pig very soon, as they would serve no useful purpose. On the other hand, there is plenty of need for convergence and for hybrid fund structures. We will take a closer look at some hybrids in the next article in our series.
 New York Times (December 4, 2021): Is private equity over-rated?
 McKinsey (March 2022): Private markets rally to new heights
 McKinsey (March 2022): Private markets rally to new heights
 S&P Global Market Intelligence (February 11, 2022): Another PE dry powder record set