Private clients in pole position to capture illiquidity premium
Alternatives are playing an increasingly important role in private client portfolios, offering impressive returns and diversification from traditional asset classes, with the long-term mindset of these investors allowing them to stomach the illiquidity.
Managers dealing in private equity and real estate have been among the biggest beneficiaries of the low interest rate environment since the 2008 financial crisis, says Dan O’Donnell, global head of Citi Investment Management Alternatives at Citi Private Bank, as both their businesses and assets have been able to borrow readily and cheaply in order to finance their acquisitions.
“We expect these conditions to persist for several years to come,” he says, with the lack of liquidity in private markets providing opportunities for those willing and able to take the risk.
Private equity makes good use of the type of capital that long-term investors have to offer, believes Charlotte Thorne, founding partner at investment office Capital Generation Partners. “Family office investors sometimes undervalue the illiquidity they can take. They often overvalue the idea of liquidity, and consequently undervalue the illiquidity they can offer to the market. Private equity is exactly the place where that particular type of capital is best suited.”
This is clearly not the case for all investors and some of those who are drawn to the asset class need to consider what would happen if the whole market “freezes” and their capital ends up being locked up for 10 years or more, she warns.
Private equity is very appealing in the current environment, says Ms Thorne, because of the low yield on offer from bonds and concerns over the future of stockmarkets. “So there is a bit of a feeling that private equity is the only game left in town.”
Yet those investors looking to the asset class for diversification are looking in the wrong place, she says.
“Those who think it will behave differently to the rest of their investments because it has the word ‘private’ on it, and therefore it is not equity, may be disappointed,” explains Ms Thorne. “Often we hear it described as a diversifier, but if you have a long-only portfolio then it really isn’t. It will behave slightly differently at the margins, but it will correlate. I think the veil of opaqueness over the pricing masks the truth of the matter.”
For diversification, investors are better off looking to hedge funds, she believes. These can play a part in constructing a “robust, diversified portfolio”, but many clients are wary of the high fees.
“It is a hard story to tell at the moment as equity markets seem to be doing fine and clients are rightly aggrieved at having to pay the fees hedge fund managers demand, particularly as over the last few years they do not seem to have earned them.”
Many investors are looking for strategies that are providing some convexity and which are not correlated to traditional equities or fixed income, says Patrick Ghali, managing partner of Sussex Partners.
“We have seen a significant increase in investor appetite for alternatives, especially strategies that should do well in more volatile markets, without acting as too much of a drag on performance should the rally continue a bit longer, and which are not overly reliant on leverage and liquidity,” he says.
Popular hedge fund strategies at the moment include global macro and CTAs, volatility strategies, plus sector or geography specific long shorts, while some investors are starting to look for specific event driven and distressed strategies, not for immediate investment, but to be ready once the cycle turns, he says.
“Being prepared is key as it will be too late to invest with the best managers, and many opportunities will be picked over already if one is too late,” adds Mr Ghali.
The desire for uncorrelated protection and diversification of returns has resulted in alternatives becoming “essential” in portfolios, reports Richard Klein, head of alternatives and distribution at Kingswood Group, with many asset managers suggesting up to a 25 per cent allocation.
“Investment strategies and managers that were previously only available to select areas of the market are becoming more accessible, with both liquid and illiquid alternative strategies now within reach of the broad private client market place,” he says.
Mr Klein sees demand for a multi-strategy absolute return defensive alpha Ucits vehicle investing in best of breed liquid alternatives managers and able to provide different returns streams from traditional equity and fixed income asset classes.
Alternative multi-manager funds and multi asset funds often disappointed investors in the past as they took in too much money and were forced to rely on more directional strategies, he claims, leading to correlated returns and an inability to be nimble during volatile events.
“Targeting niche, capacity-constrained strategies which are run by managers who understand their capacity limits and are focused on alpha generation is where we are convinced the opportunity presents itself,” says Mr Klein, adding that diversifying among alternatives is as important as diversification amongst conventional asset classes.
Private equity, he believes, will continue to create value and he points out that companies are staying private for longer.
It is now possible for investors to gain access to the top performing and consistent private equity funds, he says. “The Luxembourg SICAV offers a robust vehicle, regulated at fund and manager level and this offers the access required for the private client market place. This has helped place private and Illiquid markets very much on to the mass-affluent client radar.”
Go large
For those investors with a long-term investment horizon who can tolerate parts of their portfolio in less-liquid investments, UBS suggests investing between 20 and 40 per cent of their portfolios across various alternative investments.
“Demand for alternatives is strong,” says Karim Cherif, head of hedge funds and private markets at UBS Global Wealth Management, with the sector attracting fresh capital from new and existing investors. “According to our Global Family Office report, over 40 per cent of the average family office portfolio is now invested in alternative investments.”
Valuations may be high in private equity, but these are supported by positive macro fundamentals, easy access to financing, competition for assets and demand for the asset class, and in general the asset class is not overvalued, he believes. Meanwhile, when viewed over the long-term, returns should remain attractive from an absolute and relative perspective when compared to public markets.
But Mr Cherif warns that the private equity universe has grown and there have never been as many funds as there are today, which presents challenges to investors unable to carry out proper due diligence, while access to the most sought after areas of the market is difficult to those without existing relationships.
Like Ms Thorne at Capgen, Mr Cherif highlights the important role of hedge funds as a diversifier.
“They are well equipped to navigate the current environment of slowing growth and can find opportunities around geopolitical events. We recommend avoiding exposure to single strategies and encourage diversifying across strategies and drivers of returns.”
Alternative investments, and in particular, private investments, form a core part client portfolios at recently launched London-based private investment office Eighteen48.
“We are not overweight alternatives in model allocations, but we do expect our alternative exposures to produce a somewhat greater contribution to returns overall, as the expected returns on traditional asset classes fall,” says chief investment officer Edward Clive.
Indeed, he believes that many private clients are underinvesting in alternatives given the illiquidity they are able to stomach.
Alternatives perform various different roles in portfolios for the firm, with, for example, private equity and directional hedge funds sitting alongside long equity exposure as growth assets, while private credit and low-correlation hedge fund strategies act as diversifiers.
One area where Mr Clive reports broad interest in is direct private investments, with many clients receiving significant co-investment deal flow, both from private equity funds they are invested in and from their personal networks more broadly.
“Often they lack the resources to screen and diligence these ideas effectively on their own. We act as their ‘home team’, pooling their deal flow with that of other clients, carrying out thorough due diligence, and executing on the opportunities which we judge to be the most interesting.”
Returns from private investments over the last 10 years have had a clear tailwind from buoyant equity markets and ultra-cheap debt, he says, leaving aggregate valuations and levels of leverage in private investments elevated. But Mr Clive points out that commitments to private funds are generally deployed three to five years into the future.
“In our experience, investors do best in the private funds space by following a disciplined commitment programme and deploying a similar amount of capital year after year. Excellent returns can be generated from funds launched in expensive markets, which are able to take advantage of opportunities thrown up by weakness in subsequent years.”
Alternative strategies can allow investors to earn a liquidity premium in exchange for the illiquidity of the investment, which is not something available on public markets, says Norman Villamin, CIO Wealth Management at Union Bancaire Privée, yet he reports that, given their experiences in the financial crisis, clients are understandably cautious.
“However, as return generation is increasingly challenging and new risks are emerging globally, clients are opening up to the value of alternative strategies in the current market environment,” he says.
But he warns that valuations in the private equity space appear to have “got ahead of themselves” in the past year, increasing the importance of deal and manager selection and risk management at this stage of the economic cycle.
As with all investments, lower inflation, slower growth, weaker productivity gains and higher initial valuations probably mean that expected returns for investors over the next decade will be lower in aggregate than those realised by private equity over the past decade, cautions Mr Villamin.
“However, given the pace of innovation and the access that private markets are providing for new, emerging and even long-cycle segments of the global economy, investors can seek to mitigate some of this cyclical compression through higher returns,” he adds.
Bricks and mortar
The current economic environment makes real assets very appealing, says Rogier Quirijns, head of European real estate at Cohen & Steers, but despite this he believes the listed side of the market in which he operates is “under appreciated” by investors.
“No one really knows what the long-term returns are of this asset class. The last 30 years’ returns are higher than equities and bonds, higher than the Dow. The risk/return profile is very favourable, even as interest rates go up and down.”
And there is more upside to come, insists Mr Quirijns. “Our product has higher yield than bonds at a lower risk and I can get growth despite the global slowdown.”
In the UK, many investors experience of real estate has been in poorly managed open ended funds which have given poor returns, he claims. But he says investors must treat his product, which buys real estate listed equities from a bottom-up perspective, as a long-term investment with at least a three-year time horizon.
“Some people are afraid of the volatility of the listed market, but I think it’s great. Because I have a non-volatile underlying asset class, I have strong cash flows, I know what I am buying, so if there is sentiment in the market that creates volatility, then that is an opportunity to create alpha.”
Invesco Real Estate offers both listed and direct investments in the commercial space, and while its client base has traditionally been institutional, the firm recognises that in the future the fastest growing sources will be from private investors and defined contribution pension funds.
“That is a tremendous source of capital and we decided a year or so ago that it was a route we wanted to be able to target specifically,” says Simon Redman, managing director, client portfolio management at Invesco Real Estate. The direct side of the market should be more attractive to this cohort, he believes.
“A lot of retail investors have put money into Reits in the past and they have a good role, but today people are looking for stable income and investments which diversify away from traditional equities and bonds. You can get that in the listed part of the market but over the short term Reits are very highly correlated with equities with the same volatility whereas direct global real estate tends to very stable.”
Investors want to be able to access the underlying direct assets, and what that provides in terms of long-term, direct income, but they have not been able to in the past, says Mr Redman, though this is now changing.
“Real estate has very bond-like characteristics, with a bit of an equity kick,” he says. An office building, for example, sees its rent go up every few years, while there is also room for asset growth.
“And unlike listed assets where you are trying to buy well and sell well, part of our job is to do things to property once we own it. We can change the tenant profile, do work on the building. It is very much an active investment.”
Moreover, it is a simple asset class to understand, insists Mr Redman, though it can be harder to execute as you really need a local presence. “We look for supply and demand. In around 90 per cent of markets we look at there is no oversupply. And there is demand. So most markets look pretty compelling.”
VIEW FROM MORNINGSTAR: Uncorrelated funds continue to struggle
The nature of alternative funds is that they do not typically correlate strongly with equity or bond markets.
This does not mean, however, that market returns are irrelevant to them all, or that they would all be totally uncorrelated. Some funds include a fair amount of market risk that they adjust through time and combine with alternative trades and in 2019 markets have helped some of Europe’s largest liquid alternative funds to strong returns, while several of the more uncorrelated funds have continued to struggle.
It has been a particularly difficult year for Merian Global Equity Absolute Returns fund, which had lost 7.7 per cent in the trailing 12 months through 30 November in US dollar terms. This market neutral equity fund has typically no correlation with the global equity market. Year-to-date 2019 the quantitatively-oriented strategy has been hurt by rising correlations between different equity characteristics as well as some technical reasons related to its trading patterns. Investors have grown wary, leading the fund to lose around 70 per cent of its assets from its high in mid-2018.
Times have also been difficult for another quantitatively-driven fund, BlackRock Style Advantage, that also has a low equity-market correlation.
But as noted, 2019 has been a fortunate year especially for funds that have ridden the strong risk-on mood of the market, both on the equity and bond sides. The top performer has been Legg Mason Macro Opportunities Bond, managed by Western Asset Management. It has shot out the lights with its 18.1 per cent return over the last 12 months, especially on the back of its emerging markets bond positions. The fund has also profited from US government bonds’ falling yields.
Some of the better performers also include three funds that invest a moderate share of their assets in equities: BNY Global Real Return, DWS Concept Kaldemorgen, and Insight Broad Opportunities.
At DWS, German veteran Klaus Kaldemorgen has profited not only from equity bets, but also from his positions in gold, Japanese yen, and US long bonds, and the fund has drawn assets to grow above €10bn ($11bn).
Matias Möttölä, CFA, Associate Director, Manager Research, Morningstar
