Future of Alternatives 2025: Investors’ Inexorable Push to Alternatives

The investor universe is evolving, as pressure to find higher returns to meet liabilities drives increasing allocations and newcomers to alternatives

Near-zero interest rates are expected to prevail in many parts of the world from now until 2023, if not beyond. Oxford Economics forecasts have central bank policy rates below 0.5% in the US, Germany, France, UK, and Japan until 2023, and not rising above 1% in any of those countries until 2026 (Fig. 1). This will stoke asset price inflation while compressing fixed-income yields, forcing more investors to seek alternative investments to stocks and bonds. 

High valuations on blue-chip stocks will strengthen the case for investors to target private equity as a route to access the most promising start-ups and growth companies. Globally, 81% of investors polled by Preqin for Future of Alternatives 2025 said they expect their allocation to alternatives to increase by 2025 (Fig. 2). Just 3% expect allocations to decrease.

The composition of alternatives portfolios will also evolve, with 79% of investors saying that they expect to deploy a larger proportion of their funds into private equity by 2025 (Fig. 3). A majority (58%) of all investors polled expect their allocations to private debt to increase by 2025, while 56% plan to allocate more to infrastructure investments. 

Relative to these asset classes, hedge funds and natural resources will be less popular with investors over the next five years, with less than a quarter expecting to increase allocations. This is not particularly surprising: private equity has historically outperformed public market equivalents and has a track record as the best-returning asset class for pension funds over the long term. Preqin reports a 10-year horizon IRR for all private equity funds of 13.6%, with buyout the best performing strategy with a 14.4% horizon IRR over the period.

Investors’ Need for Higher Returns
Over the next five years, population aging in developed countries will exacerbate an increase in liabilities and funding gaps at pension funds. This is a massive fundraising opportunity for managers of alternative assets with a proven ability to generate steady returns in a maturing market. Indeed, public pension funds tracked by Preqin have been steadily increasing allocations to alternatives over the past decade, with the median allocation rising from 18.1% in 2010 to 30.3% in 2020 (Fig. 4).

However, as the pensions industry continues to shift from defined benefit (DB) plans to defined contribution (DC) plans, a key issue for managers to address is how to manage liquidity and provide daily valuations for DC pension fund investors without compromising on returns. Some gatekeepers have launched open-ended or ‘evergreen’ investment vehicles that allow DC plans to invest in private equity, such as Partners Group Generations Fund. More innovation in new investment structures can be expected over the next five years.

Investors Seek Multiple Routes to Private Equity
That said, the fund will remain the dominant vehicle. Almost half (49%) of investors in our survey expect to make greater use of pooled vehicles to invest in alternative assets over the next five years. This is especially so for investments in private equity, private debt, hedge funds, and infrastructure, whereas more investors still prefer to access real estate opportunities through co-investments or direct investments (Fig. 5).

In the private equity space, 61% of investors expect to do more co-investment deals by 2025, while 58% expect to make greater use of pooled vehicles. The market for co-investments and secondaries will grow, driven in part by rising allocations from pensions with a lower tolerance for pensioners’ savings being tied up as undeployed cash in a pooled fund. 

Another trend to watch is LPs buying minority equity stakes in private capital managers. After hitting a record of 10 in 2017, the number of such deals surged in 2018 to 28, with Preqin recording 23 in 2019. These transactions are attractive for LPs because having a direct equity stake in a fund manager gives them exposure to management fees and carried interest as an additional source of income, on top of individual fund returns.

Capital Will Concentrate and Bifurcate
The trend toward greater concentration of capital among fewer funds will continue into 2025. We expect a smaller number of large and well-known GPs to continue to dominate fundraising. Preqin data shows the number of private equity funds closed worldwide declining in recent years, from a high of 2,674 in 2017 to 1,776 in 2019, with just 846 funds closed by mid-October 2020. In tandem, average fund size has risen from $247mn in 2017 to $390mn in 2019 and $450mn in 2020 to October.

This trend does not mean smaller and newer funds will be completely squeezed from the market, however. A full 79% of investors in our survey expect to increase the number of fund manager relationships over the next five years. Among smaller GPs, LPs will continue to seek out those with more focused strategies that can offer a differentiated risk/return profile. More than a third (35%) of investors will look to invest more with specialist managers by 2025, while keeping some allocation with managers that offer a diverse range of strategies. Ten percent said they will target only specialist managers. 

Transparency Will Continue to Improve
As the alternative assets industry grows, rising allocations to private markets will no doubt renew calls for more transparency in how illiquid holdings should be valued and how rates of return should be reported. 

One particular issue is standardization. Nearly three-quarters (73%) of investors in our survey said that inconsistent reporting from their managers is a challenge they face when investing in alternative assets, with two-thirds saying that getting an insufficient level of detail from managers is also a challenge (Fig. 6). 

In the US, the Adopting Data Standards Initiative seeks to standardize how private equity firms report performance and fees, while larger LPs are pushing their GPs to report through a standard platform, giving an individual LP consistency across their own investments. We expect auditors, brokers, and regulators to come under more pressure from stakeholders to challenge the opacity of the alternatives industry over the next five years. And we believe that transparency between alternative assets stakeholders is good, and has improved further as a direct result of the COVID-19 pandemic. 

Encouragingly, 85% of fund managers polled by Preqin anticipate that they will disclose more information to investors over the next five years. Fund managers that make the commitment to deepen their relationships with investors through better guidance and sharing of information stand to benefit from having more high-conviction clients that will stay with them through multiple generations of funds.

But Greater Scrutiny Is Inevitable
Against a backdrop of rising wealth inequality, and with fewer companies deciding to go public or stay public, public scrutiny of private equity-owned firms will also intensify. Dividend recapitalizations have already come under fire as a tool used by managers to soup up private equity returns at the expense of a company’s financial health, thereby introducing more instability into the economy. Carried interest, which in most regimes is taxed at a capital gains rate rather than income rate, has also been identified by critics as a tax loophole. More lobbying on these fronts can be expected over the coming years.

Broadly, management fees for active equity managers are roughly 20% lower in 2018 than they were in 2008, in part because passive funds have become so cheap, according to the Harvard Business Review. Alternative asset managers will find it hard to escape this trend as the industry matures. The 2/20 fee structure traditionally associated with hedge funds and private equity funds is no longer the industry standard. A 2019 poll of hedge fund managers by the Alternative Investment Management Association (AIMA) found that the average management fee for the sector had fallen to 1.3% of AUM, with managers becoming increasingly responsive to investors’ desire for more equitable compensation arrangements. 

Looking ahead, funds that are responsive to changing investor demands are best positioned to find new growth areas. For example, more ‘bespoke’ client solutions such as customized investment mandates and value advisory services have been introduced into the market over the years. While the best performing fund managers may be in a strong position when it comes to negotiating fees, it will be vital for the long-term health of the industry that reward and incentivization structures properly align the interests of all stakeholders.

Download a data pack containing all the charts in our investor articles for Future of Alternatives 2025. For more predictions and projections on the future of the alternatives industry, visit Preqin's Future of Alternatives 2025 Content Hub.