Private View Blog: Private markets are not a panacea for yield-starved investors
Interest among wealthy clients to invest in private markets is steadily increasing as they seek yield in an ever more starved world, but it is too early to say there is significant private banking capital moving into the asset class. There are several hurdles ahead, from product design, to clients’ actual ability or even willingness to lock-up their capital.
This surge in interest is understandable given the combination of a decade-long, ultra-low interest rate environment and fears that the bull run in listed securities may be peaking. The current environment, with private markets becoming more mainstream, has some similarities with hedge funds in the early 2000s – a new and exciting asset class that clients are increasingly curious about; but failing to understand all the complexities involved.
Private markets are inherently a long-term investment and while clients have been asking more questions recently to understand what their investment options are, the intricacies involved present substantial challenges that they need to be comfortable with. It is vital that advisers first create trust in the product and be transparent about some of the challenges involved in investing in this complex asset class. The educational process is of utmost importance given that clients will need to commit capital over an extended period.
The challenge of going private
One major challenge is how private markets are accessed and how illiquidity is being packaged. For example, there are investment managers investing in liquid assets using so-called private equity techniques, which then in turn offer very reduced liquidity terms to their own investors. This type of structure contains a significant asset liability mismatch and is skewed in favour of the investment manager. While it could work in very specific instances, such as activism with publicly listed companies, it is difficult to find clear benefits for the limited partnership (LP).
Furthermore, there are investment managers who have previously specialised in investing in semi-liquid assets moving their portfolios and strategies toward more illiquid assets. For example, some high yield credit managers have begun expanding their investment universe into more distressed credit opportunities. While such a strategy is likely to involve tougher lending terms to the borrowers, and therefore a higher degree of risk management; what is critical is to avoid any asset liability mismatch in which the liquidity offered to limited LPs is higher than the assets of the portfolio. In this particular case, the expansion into less liquid assets could be seen as a natural evolution of the strategy, should the expertise of the team grow in tandem.
Finally, there have been several reports recently of asset managers launching hybrid structures that promise a “private market premium” in a liquid format. Cautiousness is warranted about this type of ‘innovation’. During times of stress, there is a very real risk that the product will not behave as anticipated by the client, hence denting confidence. If an asset has a very limited amount of liquidity in normal market conditions, then any repackaging aimed at increasing this liquidity is artificial and should be viewed with extreme prudence.
Education is key
When a strategy or an asset class is relatively new, the exercise in convincing clients of the merits of doing so is a complex one and must be combined with an educational process to explain not only how the asset class works, but also best practice investment rules. During such an educational phase, it is imperative to avoid any shortcut that could lead to misaligned expectations.
Over the last couple of years, we have worked closely with clients to identify appropriate investment strategies that offer higher yields, with the required liquidity relative to the assets. This has concentrated predominantly around short duration strategies, credit-based strategies and real estate lending. For clients who are seeking a higher yield in alternative assets, there are pockets of opportunities in areas such as southern European non-performing loans and special situations, mezzanine and equity tranches in collateralised loan obligations, risk sharing transactions, and even bridge loans backed by real assets.
When it comes to more complex areas of the investment universe such as private equity, whether in venture capital or more stable instruments such as buyouts, clients should be cognisant of how this differs from traditional asset classes.
There can be a place for all asset classes, however esoteric; but they should only ever be approached with a client’s full understanding of the far stricter investment terms involved.
Nicolas Roth is head of alternatives at REYL & Cie
