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Wednesday, November 24, 2021
Investing | Private Equity | Alternative Investments | Portfolio
Alternative investments have become increasingly popular in investment portfolios and have rapidly grown over the last 20 years.
According to the Chartered Alternative Investment Analyst (CAIA) Association, alternative investments accounted for approximately 12% of the global investable market in 2018 but is expected to grow to as high as 24% by 2025.
In a world with near-zero interest rates, the quest for higher returns is pushing more investors into the alternative investments universe.
Why invest in alternative investments?
Most investors are aware of the traditional investment classes; equities, fixed income and cash, but may not be as familiar with alternative investments.
Alternative investments can be defined as anything that is not a traditional asset class. This broad definition of alternative assets includes but is not limited to: real estate, private equity, hedge funds, cryptocurrency, commodities, derivatives, fine wine and art.
Alternative investments are generally considered to have a low correlation with traditional assets which provides diversification and increases the risk/reward ratio within an investor’s portfolio. The assets tend to be less regulated and transparent than traditional investments, whilst also being less liquid or completely illiquid. This added risk historically meant that they were primarily reserved for ultra-wealthy and sophisticated investors. To compensate investors for the added risk involved, alternative investments offer higher significantly potential returns compared to traditional investments.
Due to the large minimum investment requirements and complexity, alternative investments have generally been seen as the purview of institutional investors, wealthy, and sophisticated investors and family offices. However, this is rapidly changing. There is now an increasing number of avenues for less affluent investors to invest in alternative assets. As the industry grows, investment minimums and complexities have been reduced to entice more investors. As a result, more investors are seeing the benefits of having a portion of their portfolio in alternative investments.
The main types of alternative assets
Whilst real estate is considered to provide a low correlation with stocks and fixed income, it also provides stable income and can be a hedge against inflation. There are numerous ways that an investor can gain exposure to the asset class including investing directly, through real estate operating companies, or through real estate investment trusts (“REITs”). Each approach has different characteristics and as such should be explored to decide which best one suits your investment strategy.
Private equity might not be as well-known an asset class as real estate but is now becoming more accessible. Private equity is an investment into companies that are not listed on a stock exchange, hence not publicly available. Historically, companies tried to become public quickly but the number of publicly listed companies in the United States has nearly halved between 1996 and 2018. Companies are going public at a later stage and at larger market capitalisations. Over the last 15 years, private equity capital has grown, and interest rates have reduced, allowing private companies to access capital cheaper without having to deal with the added scrutiny.
Ways to gain private equity exposure
There are many ways to gain exposure to private equity. The primary paths include investing directly, through a private fund, a listed fund, a syndicate, or crowdfunding.
Investing directly in private companies can be complicated. It requires significant capital and several investments in companies to reduce risk through diversification. Liquidity is also an issue for direct investments as capital is often tied up for 4-7 years.
Investing in private equity funds (“PE funds”) helps tackle the lack of diversification issue. When investors commit to a PE fund, fund managers research and build a portfolio of companies. One downside of PE funds is the fee structures. The industry standard is a 2% annual management fee and a 20% performance fee over a certain hurdle rate. Like direct investments, PE funds have long investment periods, typically up to ten years.
If both PE funds and direct investing contains too much illiquidity, a third option is to invest in publicly listed PE funds. Similar in structure to PE funds, shares in publicly listed PE funds trade on stock exchanges. The shares can be bought and sold easily, although the companies only get valued quarterly. The quarterly valuation process can cause listed PE funds shares to trade at a discount or premium to the net asset value of the underlying investments. Publicly listed PE funds should not be confused with public stock of private equity firms.
Private equity investment strategies
There are several private equity strategies including venture capital, buyout, and special situations investing. Each strategy has different characteristics, but all have historically provided outsized returns.
The main difference between venture capital, buyout, and special situations is the type of company that each strategy focuses on. Venture capital (“VC”) invests in startups and small companies. For a slice of equity in a company, VC investors provide capital. With a VC strategy, a minority stake in a company is usually acquired. As the companies that VC funds focus on are generally young the chances of the business succeeding are low. However, the tradeoff is that if the company is successful then the VC firm earns above-average returns.
A buyout private equity strategy focuses on mature companies acquiring the majority, or the whole company. Unlike most VC investments, buyout deals allow investors to make all the decisions and as a result, the company's perceived inefficiencies are targeted. Compared to VC investments, the risk of total failure is less for a buyout - so transactions are larger. However, the total return potential is generally not as significant.
A third strategy is special situations private equity. There is a range of special situations strategies, but they all aim to take advantage of crises’ within companies. These crises include among other things, issues surrounding mergers, bankruptcy and litigation. Special situations investors generally focus on companies that are in a difficult situation and have limited options, allowing significant holdings to be purchased cheaply. There are significant risks to this type of strategy. If the investor underestimates the size of the issues, significant losses can incur.
The future of alternative assets
As mentioned previously, alternative assets are expected to grow to 24% of the investible universe by 2025. This growth will increase competition forcing downward pressure on fees and entry requirements which will allow more investors to access this space. Technology will also have a big effect on the industry. Companies are increasingly developing online platforms that purchase alternative assets and split them into investment amounts of as little as USD 1,000. This gives investors the ability to add assets such as farmland, wine and art to their portfolios that would otherwise be out of reach. Like other asset classes, environmental and other ESG issues will affect the industry. Investors are becoming more vocal regarding how their values should be reflected in their investment philosophy and the industry will have to adapt.
Our alternatives offerings
We provide our clients access to a wide range of asset classes, both traditional and alternatives. We can help you incorporate equities, bonds, real estate, private equity and more into your portfolio in a manner that suits you best. Our model portfolios give you exposure to listed PE funds. Through our connections, we provide high-net-worth investors access to large private equity funds. Perhaps the most exciting aspect of our offering is we employ our expertise to originate deals, working with founders to invest in companies that have great future growth potential. These deals are available exclusively to our clients, ranging from early venture capital through to the private equity stage.
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