Posted by Macquarie Asset Management
May 27, 2020
Scale wins (mostly). Prior to the COVID-19 downturn the asset management industry was grappling with weak profitability due to oversupply, increased regulatory requirements, and fee pressure from technology. The current downturn may intensify these pressures, accelerating consolidation. The winners are likely to be the big players with scale, due to both their cost advantage and their broader product offering. In alternatives, the leading small players may also benefit if they can maintain top tier performance and have an attractive, differentiated, or niche strategy.
While some funds and strategies could experience challenges, the Federal Reserve’s decision to buy non-investment grade bonds, and the extensive central bank and government support and guarantee mechanisms put in place in most countries could mean the worst outcomes are avoided, and alternatives emerge from the downturn in relatively good shape.
The COVID-19 downturn could induce crises in EMs, either from the direct economic and social impact of the virus and lockdown measures, or from capital flight as investors lose confidence. Any cooling of relations between the west and China could make this worse, given many are commodity exporters. The capital that shifts out of EMs is likely to go into investments with similar risk-return characteristics in the Developed World.
We believe that there is a structural trend underway here, driven in part by demographics as younger cohorts tend to be more environmentally and socially conscious. The virus experience may also add to investors growing sense that businesses should have sustainable business models that are built to handle not just known unknowns but also unknown unknowns. ESG fund flows should continue to expand rapidly and the pressure on corporates to adopt effective ESG strategies may intensify.
The profitability pressure in many listed markets may see many asset managers try to move into the higher fee alternatives universe. Many may struggle though, if they overpay for platforms or underestimate the difficulty of organic growth in the face of incumbents with scale, large balance sheets, and a long track record. In terms of fund flows, the volatility of listed markets and any poor performance in EMs could cause money to flow out of both, with alternatives a possible beneficiary. As interest rates plumb new lows, and the expectation that they are likely to remain very low for a very long time solidifies further, investors with long-dated liabilities they need to match (pension funds and life insurers) could be forced out the risk spectrum even faster. Private credit, real assets, and other alternatives could be beneficiaries of this trend.
Daniel McCormack, Macquarie Infrastructure and Real Assets Economist
Those active managers that perform well during the downturn and prove their ability to add alpha in challenging times are likely to be rewarded with increased inflows. But outside of those top players the rest could find it increasingly challenging to justify their high fee levels and passive strategies may continue to grow in popularity.
Although some business models may be challenged by COVID-19 related disruption, and valuations could fall due to the market disruption and the removal of the Softbank tailwind, the large amount of dry powder means that good businesses should continue to attract capital. Tech is likely to remain popular with investors. That said, there could be an increased focus on cash generation by investors. The idea that cash generation is ‘irrelevant’ (as it seemed to be when Softbank was such a major player in the sector) may be consigned to the dustbin of questionable investment ideas.
Investors become more comfortable with online services and virtual meetings, while the preference amongst staff for working from home could increase. These trends could serve to accelerate the digitalisation of the industry. The importance of an effective online service offering could grow and the need for top drawer technology systems and cyber security may become even greater.
Partly as a result of the digitalisation trend, but also due to the increased focus on ESG, corporate brand and customer service may become more important. Offering more than just a competitive risk-adjusted return could become a larger part of the equation for managers trying to attract and retain investors and talented staff.
The regulatory environment is not likely to change as much as it did in the post-GFC period as the current crisis is not a financially driven one (for now), but certain non-regulated asset classes like US mid-market private credit (where there has been large flows post-GFC as banks retreated) could come into focus if there is material loss of investor capital. Regulators may consider including those credit managers as financial institutions, or at least regulating them in similar ways.
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