S. Korean institutions rediscover joys of home

Institutional investors in the Asia-Pacific region, a steady source of mandates for global private markets managers over the past decade, appear to be hitting the pause button against the backdrop of this year's capital markets pyrotechnics, market veterans say.

A long stretch of time which saw rock- bottom sovereign bond yields and narrow currency fluctuations facilitate a persistent flow of pension, insurance and sovereign wealth fund money into private overseas assets has given way to a more complex environment, with domestic assets back in the game of offering competitive returns.

South Korea's market is a case in point, with this year's dramatic rise in domestic rates leaving "risk-free paper" there offering higher yields in some cases than international illiquid asset classes, noted Simon England-Brammer, senior managing director and head of Europe, the Middle East and Africa and Asia-Pacific institutional, global client group with Nuveen LLC, the $1.1 trillion asset management arm of New York-based TIAA-CREF.

On a recent trip to Seoul, Mr. England-Brammer said he found insurers, a segment of the market keenly focused on asset-liability matching, making "significant shifts" in allocations back to domestic assets in the wake of hefty increases this year in both domestic yields, on the one hand, and the costs of hedging U.S. dollar exposures to won on the other.

The Korean won has weakened 13.9% vs. the dollar this year while the yield on the 10-year sovereign bond, coming off an Oct. 17 peak of 4.462%, stood at roughly 3.765% in trading Nov. 21, up more than 70% from the start of the year.

The increase in hedging costs has been dramatic enough to make "non-domestic investment considerably less attractive," Mr. England-Brammer said in an email.

By way of example, he pointed to the potential returns a South Korean investor could garner now from U.S. core/core-plus real estate.

A year ago, an insurer could have hoped for a 5% or 6% return from that asset class, but today — after a management fee of 50 basis points or so and hedging costs of 150 basis points or more — the net return would be closer to 2% or 3%, he said. That's less than the almost 4% yield on offer now from one-year government paper, up from roughly 1.4% a year ago.

Rising domestic rates in turn are "raising the bar" for making offshore investments, notably in markets such as South Korea and Taiwan where local insurers have been big buyers of overseas assets, said Trevor Persaud, Singapore-based group head of investment strategy and solutions with AIA Group Ltd., the largest listed insurance group in the Asia-Pacific region.

"Within our investment-grade portfolios, we are reducing our focus on offshore (U.S. dollar)" allocations where local rates are increasing and hedging is getting expensive, Mr. Persaud said.

Currency managers, meanwhile, say market volatility and rising hedging costs, as U.S. rates continue to lead global yields higher, are spawning growing interest in their services this year.

Currency hedging "was kind of a sleepy topic for many years because volatility was so low (and) interest rates were compressed" but that's all changed this year, said Joseph Hoffman, CEO of Chicago-based Mesirow Financial Holdings Inc.'s currency arm, Mesirow Currency Management, which manages roughly $120 billion in hedging strategies as well as some currency alpha offerings.

Mr. Hoffman said he hasn't seen his firm's clients, predominantly pension funds, shifting assets back home from abroad but on recent trips to South Korea and Japan he found a considerable pickup in interest among clients that historically deployed a passive hedge, for instance maintaining a 50% hedge ratio, to shift to more active hedging programs as a means of lowering costs.

And it's not just the country's insurers that are focusing more on their home markets. The broader universe of South Korean asset owners are looking more closely at domestic opportunities now amid dramatic changes in the attributes that made private market assets overseas relatively more attractive over the years, said Andrew Shin, Seoul-based head of investments, Korea with investment consulting firm Willis Towers Watson PLC. Preqin cited the country as a leading investor in private markets, predicting annualized growth in international private markets allocations of 15% in coming years, in a 2022 report, "Fundraising from South Korea: A guide to raising capital."

With the U.S. currency topping 1,400 won last month for only the third time on record, following the global financial crisis of 2008 and the Asian crisis of the late 1990s, "if you're a believer in mean reversion, you don't find this a very welcoming environment to buy assets denominated in dollars," Mr. Shin said.

"What one yen or one Korean won could buy you last year, you're only able to buy 70%" now, agreed Alex Kim, who joined Chicago-based Monroe Capital LLC in Seoul just over a year ago as the $14.1 billion private credit boutique's managing director and head of Asia.

In another hurdle for investors now, Korean insurers and mutual aid associations are finding themselves with less ample liquidity after government moves over the past year to limit real estate lending by banks left many aspiring home buyers turning instead to those asset owners as an alternative source for loans, he said.

The need to ensure adequate liquidity could find insurers, pension funds and mutual aid associations eyeing won-denominated corporate credit at some of the most attractive yields on offer since the Asian financial crisis — such as the billions of dollars of bonds issued this year by Korea Electric Power Corp., the country's top utility, with yields in recent months of well over 5% — rather than illiquid, long-term investments, said Dong Hun Jang, who joined Seoul-based international corporate law firm Yulchon LLC as a senior adviser in early 2022 after six years as chief investment officer of the Public Officials Benefit Association, a $14.8 billion Seoul-based mutual aid association.

Many Korean asset owners have allocated to overseas private market assets generating internal rates of return between 8% and 10% but it's becoming harder to justify when they can invest instead in very liquid KEPCO bonds with a AAA rating yielding 6%, with no need to worry about foreign-exchange moves or hedging costs, Mr. Shin noted.

The combination of less liquidity, pricey overseas assets and the recently attractive option of investing in risk-free 10-year Korean government bonds or near-sovereign bonds such as KEPCO at yields double or triple the less than 1.5% on offer two years ago will make asset owners much more selective in pursuing private markets opportunities overseas over the coming year or two, he said.

And indeed, South Korea, long a rich source of mandates for global private markets firms, has seen those allocations diminish over the past two or three quarters, market participants say.

Asset owners "have pretty much stopped investing in long-term illiquid investments this year" and they could remain conservative until U.S. rates peak sometime next year, Yulchon's Mr. Jang noted.

Many South Korean limited partners "are taking a wait-and-see stance on overseas real estate investing due to the perceived risk associated with rising interest rates and Korean won depreciation," said Chiang Ling Ng, Singapore-based chief investment officer, Asia, with Houston-based real estate firm Hines.

Some are looking to resume real estate investments during the coming year but others predict current sentiment could prevail through the second half of 2023 or beyond, Ms. Ng said.

"The pace of Korean institutional investors' interest in offshore opportunities has slowed significantly," with smaller LPs lacking capital to deploy while large pension schemes and sovereign wealth funds are waiting for a better time to deploy, agreed Pamela Ambler, Singapore-based head of investor intelligence and strategy, Asia-Pacific, with Jones Lang LaSalle Inc.

If there's broad agreement that the competitive landscape has become considerably tougher, some managers insist there will continue to be opportunities to serve asset owners in Korea and the broader region this year.

While a U.S. core or core-plus real estate strategy may no longer meet the needs of some clients, after hedging costs, some are responding by considering higher risk value-added strategies or niche areas offering higher returns, said Kamal Bhatia, New York-based chief operating officer with Principal Asset Management.

The punchline, Mr. Bhatia said, "is that you need to have a much more diverse set of offerings and you need to be able to do both debt and equity to be actively engaged right now." Managers singularly focused on core U.S. real estate will find the going tough, he said.

"It's going to be a more challenging year ahead, given the volatility," Nuveen's Mr. England-Brammer said. "I still believe Asia will be a positive market for Nuveen but it will be far more targeted opportunities that will win investor confidence," he said, adding that "private credit and private equity look to be the most attractive right now."