Institutional investors should be adopting innovative thematic approaches to derive more value from private markets, according to Nelson Lam, senior vice-president of equity and alternative investments at Trans-Canada Capital Inc., during a session at the Canadian Investment Review‘s 2022 Investment Innovation Conference.

“Why private markets? There’s at least 10-times as many private companies as public companies worldwide — just think of all the small startups, local businesses, and innovative technologies you can find in the private markets’ area.”

The key benefits that private markets offer institutional investors include higher returns and increased portfolio diversification, he said, noting both benefits can be improved through the adoption of opportunistic investing and several niche strategies. “Think about thematic investing approaches targeting different areas, like property technologies in China, U.S. digital infrastructure and emerging market infrastructure. Those strategies have relatively low correlation among each other and even lower correlation to public markets, generally speaking.”

Read: Using renewable energy assets to manage risk in private markets

Lam argued that these benefits can be amplified by adopting niche strategies in specific areas. For example, the private credit space such as litigation finance and lending to high net-worth individuals. “These strategies offer attractive expected returns — in the area of 10 to 14 per cent.”

He also suggested that investors can protect their portfolios against inflation through other thematic private market strategies. “In real assets, for example, there are toll roads, bridges and hospitals that are only investable through private markets. Also, quarterly valuations help to damper the day-to-day volatility investors have to endure in public markets.”

Lam also identified several challenges facing institutional investors that are seeking to construct these thematic strategies in private markets. “We’re going to tackle them one by one.”

The first hurdle is how to identify the right asset classes to target, said Lam, sharing a chart that lists yearly returns by private market asset class. “Dispersion between asset class returns can be significant on a yearly basis, so building a diversified portfolio is essential. The point being that a good private assets program should be built with many private market asset classes, not only with one or two asset class or strategies.”

Next, Lam recommended how institutional investors can ensure these thematic strategies are properly diversified through different regions and sectors. “You want to make sure that your portfolio is not over saturated — in a region, asset class or strategy. . .  It requires rigorous work. Appropriate resources and time, combined with a decent program size, in terms of assets under management, is required to achieve such level of diversification.

Read: A look at the practical challenges of meeting target allocations in private markets

The third major challenge facing investors is related to selecting asset managers, he said, noting the performance dispersion among private equity managers is far more significant than among public equity managers. “These notable dispersions [in terms of asset manager performance] on the private markets side mean that the selection of the right private market manager or specialist is very crucial to the success of the program.”

A fourth major challenge facing thematic investors in private markets relates to governance”, said Lam. While investment boards approve investment policies that include asset allocation guidelines per asset class, more sophisticated or thematic strategies are harder to classify and have the potential to cause misalignment.

He suggested this outcome can be avoided by adopting broader mandates. An alternative approach in constructing a private market program is to eliminate fixed target weights within sub asset classes and adopt a wider range to allow sufficient flexibility for opportunistic investing. “An example of this concept is found in global equity mandates. When you hire a global equity manager, would you set fixed targets for regions, countries, market caps? No, right? You would provide a benchmark with guidelines around which the manager will look to add value. In this instance, the manager is responsible for the overall allocation of the portfolio, not the investor’s investment board.

“Selecting a manager that employs a holistic approach is preferable when investing in private assets. While this approach is feasible internally, the internal investment team will need to have strong expertise in private markets while making the right investment decisions and the appropriate portfolio shifts to be opportunistic.”

Read more coverage of the 2022 Investment Innovation Conference.