This may be the dawn of a golden age for high net-worth investors. Our clients participate in opportunities previously reserved for sophisticated endowments, pension funds, and large family offices. The minimum required to invest in many institutional-caliber funds is now as low as $50,000 (versus $10,000,000 or higher). Opportunities that would have required 7-10 year capital commitments are now available in more familiar structures with greater liquidity.Investment types include the “major food groups” of private markets (equity, credit, real estate, infrastructure), specialized asset classes like energy, reinsurance, litigation finance, and fine art, and a wide range of hedge fund strategies.
But caution is warranted. No investment idea is too good to be ruined by poor design, more capital than a strategy can handle, high fees, or the wrong investor base. A velvet rope outside the club provides no guarantee the drinks and music inside are any good. Some sales pitches promise exclusivity, whereas others proclaim democratization as their mission. Limited familiarity with private and alternative investments will lead many advisors to chase the shiny object and risk unhappy outcomes for their clients. Confusion reigns about the appropriate size and place of these assets in a portfolio. We do not share this confusion: our team has extensive experience in due diligence and allocating to private and alternative assets. We are acutely aware of their history, the value they offer investors, the pitfalls, and how to separate the wheat from the chaff. Our team’s background with private and alternative investments is unusually deep within the advisor community. Here are some principles that guide us:
- The case for privates: the case for private relative to public assets varies depending on the asset class. The banking system’s diminished role in capital formation since the Great Financial Crisis of 2008-09 has created the clearest advantage to private issuers of credit over corporate bonds. Private equity offers investors diversification by offering access to parts of the economy that are less well represented in the stock market: from the most prosaic of industries to the high-growth companies that stay private longer or avoid going public entirely. The alignment of incentives also attracts some of the best management talent in finance. Public real estate investment trusts own assets similar to those held by private vehicles, but the publicREIT market is both much smaller and different in composition than the private commercial real estate market. Regardless of the asset class, the case for any private investment is that it must enhance potential returns and/or provide a diversification benefit to a portfolio.
- The case for hedge funds: in the modern era, a hedge fund is more of a compensation structure than an asset class. In fact, some categories of institutional hedge fund strategies are better accessed through public funds, where they are both well-managed and carry reasonable fees. It is often easier to make a broad case against hedge funds than for them, but they remain a source of potential innovation and (used selectively) can provide unique forms of return enhancement and portfolio diversification.
- Illiquidity: according to academic finance, the “illiquidity premium” is an added level of return an investor should earn for being allowed to withdraw their capital only quarterly, annually, or less frequently. We have seen some fund sponsors invert this idea, proposing that investors should happily pay more for the behavioral discipline imposed by a longer hold period (and less frequent marking of share price). We do not share this view. 📌 More on Illiquidity
- Stranded at sea: when liquidity is limited by fund prospectus, it is expressed in time; in practice it can be limited in amount. A strategy that is aggressively marketed, poorly understood by its distribution partners and end investors, and ultimately disappoints can lead to limited redemptions and a long runway for the full return of investor capital. Proper diligence is like embarking on an ocean cruise: we need to vet the sturdiness of the vessel and the experience of the crew, but to also take the measure of the other passengers and consider how they ended up on the dock.
- Know your sponsor: we have found value partnering with a wide range of firms–from the very largest private equity sponsors (exceeding $1T in assets!) to much smaller funds with unique strategies that exploit defensible niches. Regardless of size, we invest time and travel engaging with the organizations we consider partnering with–to gauge the caliber of their people and the importance of our clients’ capital to their corporate strategy.
- Fees and leverage: outside the protections of the Investment Company Act of 1940, which governs the public funds that most investors own, live a looser set of constraints on fees (including incentive fees) and risks (such as leverage) that lack uniform reporting standards but are essential to evaluating an investment opportunity.Here, experience matters. We consider all investments on a level playing field in terms of their return potential, risk-adjusted and net of fees and expenses.
- Imitation: in finance, success breeds imitation and often disappointing results. Among many examples:the extraordinary achievement of the late David Swensen managing the Yale Endowment spawned both a handful of successful university endowments run by his disciples and a wave of failed copycat strategies foisted on the public–despite his meticulous account of the unique organizational advantages essential to his track record and a second book which could have been titled “Don’t Try this at Home.”(1)
- Replication: lower fees are the most reliable form of investment “alpha” and a key driver of the fee compression achieved by public funds over the past decades has been the replacement of active discretionary managers by algorithms, including various forms of indexation. To accomplish what Vanguard and others have for public equities, but for portions of the private and alternative asset market, would be an unqualified win for investors. Many such efforts have failed, some have at least partly succeeded, and we watch this space very closely.
- Shiny objects: despite the usual disclaimer that past performance is no guarantee of future performance, investors–amateur and professional alike–are vulnerable to compelling narratives and impressive track records. Experience and informed skepticism are essential. Bernie Madoff’s reported returns were instantly (albeit privately) identified as a likely fraud by the famous polymath Ed Thorp(2), but it doesn’t require a brilliant mathematician to distinguish between plausible and implausible results–only a modicum of quantitative finance.
- Volatility laundering:(3) the fact that private assets are traded less frequently and often valued by third-party appraisal has not escaped the attention of managers (like the one who coined this phrase) whose performance is tracked moment-to-moment in the more volatile public markets, as well as some serious research efforts. While we find merit on both sides of what can sometimes be a contentious debate, we use simple principles as a guide: a) we believe every investment should be additive to a portfolio and that investors should be compensated for illiquidity; b) the appropriate amount and type of illiquidity is unique to each investor; c) statistical measures of asset and portfolio risk and risk-adjusted returns require fair adjustments to return streams that are marked-to-market via different conventions.
If you would like to learn more about how private and alternative investments can improve your portfolio, or about our process and experience, we welcome your thoughts and questions.
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