Investors ready to stomach illiquidity in search for returns

With falling risk-adjusted returns from traditional sources, alternative assets are playing an increasingly important role in private client portfolios, offering higher return prospects and lower volatility, albeit at the cost of greater illiquidity.

“Investors have to learn to live with illiquidity, if it matches their goals and if they want to continue to generate returns with the most appropriate risk return ratio,” says Christophe Donay, head of macro research and asset allocation at Pictet Wealth Management.

Because core sovereign bonds no longer offer a true alternative to equities, late last year the Swiss bank switched its traditional 60/40 strategic asset allocation for private clients to an ‘endowment style’ system. 

This approach aims at better safeguarding wealth and producing real returns by allocating a third of the portfolio to alternatives, the remainder equally split between equities and bonds.

This system, embraced nine years ago by Pictet’s pension fund, has produced since then an outperformance of 250 basis points over the traditional balanced allocation, explains Mr Donay, who chairs it, with private equity generating 16 per cent returns a year on average.

While expected returns from all asset classes have been downgraded, private equity remains the bank’s “most favoured asset class” for returns, forecast at 10 per cent per annum over the next decade. This compares to the 5 to 6 per cent anticipated from developed markets equities.

With a 25-year alternatives track record, Pictet’s partnership with heavyweights such as Blackstone and KKR enables the bank to gain access to “high quality deals” and funds. “Illiquidity means that not only does it take time to get out, but also it is very difficult to get in,” explains Mr Donay.

Going private

While fear of illiquidity remains, investors are increasing allocations to alternatives, shifting money from fixed income to private debt and from public to private equity, notes Lukas Erard, COO and head of sales and client services for the private equity group at Credit Suisse.  “Investors are realising that, after the longest equity bull market, the ‘music is going to stop’ while allocation to illiquids will continue to generate returns,” he says.

To meet client demand and enhance returns, private banks have been launching new programmes of diversified, real asset portfolios, promising cheaper and more tangible solutions than traditional funds of funds.

These structures may include underlying private equity managers with access to credit lines, enabling them to buy companies before finishing their fund raising, or secondary portfolios where investments for the most part have already been made. These solutions offer more frequent cash flow, reducing illiquidity. 

Two years ago, Credit Suisse included private equity in its strategic asset allocation for advisory portfolios with at least $5m. The bank is now trying to “democratise” the space, offering “vintage” multi-manager programmes to less wealthy clients. 

“We are taking a lot of time to explain to clients not to time the private equity market, but continuously invest every year, so they have enough distribution which can be used for future capital calls, and their portfolio becomes self-funding over time,” says Mr Erard.

Today there is a lot of “dry powder”, or huge amounts of money not yet deployed and sometimes chasing the same deals, which can drive multiples higher. Despite this, multiples in private equity are often still lower than in public markets, he adds. 

Credit Suisse likes to work with managers that have a specific industry expertise and an established network, allowing them to identify interesting mid-sized firms with more exit options than just the public market. As a result, it is currently less engaged with large buyout firms.

HSBC expects 9 per cent returns from private equity, versus public equity at 6 per cent, but manager selection adds at least 300 basis points to the performance, says Henry Lee, global head of managed investment solutions at HSBC Private Banking. “There is probably a 600 plus basis point illiquidity premium, if we pick the right private equity managers,” he adds. 

HSBC uses a mix of big brand and smaller private equity and private lending firms. “Big brand names are becoming increasingly better at what they do,” says Mr Lee, targeting deal sizes much bigger than in the past, including public to private deals. Barriers to entry are huge, as is the expertise required, meaning only a handful of firms can compete for such deals. 

While there is much more money chasing the same investment opportunities, driving prices up, it is also true that, due to regulatory constraints, the ability of larger institutions or banks to lend to smaller companies is reducing. 

Listing is becoming less frequent and the average age of listed companies is much older than it once was. Abundance of private capital gives firms the option to fund themselves without going to public markets. 

In 2018, HSBC Private Banking launched a private equity programme, which is managed on a discretionary basis, giving clients access to diversified solutions.

The programme includes buyouts, thematic funds – such as medium sized, niche, special situations type of private equity funds – as well as co-investments and direct secondaries, which are already invested for the most part in live companies. This gives investors something tangible to analyse and a better chance of determining a more realistic projected return, as they can analyse underlying companies.

“The advantage is clients have the option to commit every year, rather than having a committed period of five years. In addition the divestment period is technically more front-end loaded and shorter than the usual 10 to 15 years of a primary private equity fund  - at least for the large allocation to secondary and co-investments,” says Mr Lee. 

Gaining exposure to private equity through a fund, rather than direct deals, enables clients to leverage economies of scale from an organisation and gain access to a structured diversified portfolio. “Big families or family offices tend to prefer direct deals,” he says. 

“They behave more strategically in sectors and industries they are very familiar with but find it harder to execute in other sectors.” 

Time to hedge?

While private markets appeal to advisers and clients for the illiquidity premium, there seems to be a renewed interest for hedge funds as well, badly battered over the past few years around poor performance and high fees. 

“We have seen a pick-up in client interest in hedge fund investing in the last year,” states Nancy Fahmy, head of alternative investing, Merrill Lynch and Bank of America Private Bank. The US bank has $50bn of assets under management across private equity, hedge funds and real assets, and around 60 open hedge funds, all sourced through third-party managers.

“A lot of investors are looking to hedge funds as an alternative source of return, because investing in a long only portfolio will not protect them in the next phase of the cycle.” Many clients have questioned the value of investing in hedge funds over the last decade, but this may be due to the lack of education or understanding about the different strategies and how they perform in different market environment, explains Ms Fahmy. 

“In a 10-year bull market, you should not expect [all hedge funds] to outperform the S&P 500. We focus very heavily on educating our investors around the different types of sub-strategies and how they perform in different market environments.” 

In the current environment, equity long/short is important, while some global macro strategies are also performing well. “What is very important for us is the quality of managers and how they perform over time and how we position client portfolios for a variety of market cycles,” she says. 

Reviewing, replacing and adding new managers is a key part of the service offering. Rather than timing the market, clients are recommended a consistent, well diversified portfolio, including alternative investments. These have been proven to provide diversification benefits and enhance returns, versus a traditional portfolio not including alternatives, she explains. 

The issue with hedge funds is that they require “sophisticated understanding”, says HSBC’s Mr Lee. Pre-crisis, people were buying the track record, rather than appreciating real risk being taken. Now investors are more aware, and the most sophisticated still invest in these vehicles. HSBC’s hedge fund business is still growing, albeit at a lower pace than its private equity business.

Out of fashion

Other private banks are not so convinced and no longer invest in these products.  

“Hedge funds have been a big problem, fashionable in the 2000s but, as a category, they have had negative performance for a long time, and today the alpha they produce, on average, is limited,” says Gianluca La Calce, CEO and general director at Fideuram Investimenti, asset management arm of financial advisory network Fideuram and Intesa Sanpaolo Private Banking, which together run €220bn ($247bn) in client assets. 

The Italian asset management firm created an alternative investments platform four years ago, launching three funds, which gathered almost €1bn in client assets. 

The most recent launch, investing in global multi-asset private markets, has raised more than €500m, “one of the highest” levels ever reached in Italy with this type of investment for the retail market. The fund, managed in partnership with Partners Group, invests globally in private equity, debt, infrastructure and real estate, allowing the manager to access opportunities across asset classes, and has a minimum investment of €100,000. 

It is also cheaper if compared to an equivalent fund of funds, by at least a percentage point, he states. “The objective was to bring the largest number of clients to private markets, creating core alternative solutions, to enhance clients’ portfolios and offer new revenue sources.” 

The fund, which has a duration of 10 to 13 years, promises to start distributing revenues to investors at the end of the fourth year. Clients often do not want to give up liquidity, even when they do not need it, reports Mr La Calce. 

The bank is looking to launch another alternative fund later in the year, believing in the enormous growth potential within the private bank, where only a very small percentage of client assets are invested this way. “A client with €5m in assets, who has no particular liquidity requirements, can have a target allocation of 20 to 30 per cent to alternatives.” 

Private investors also need to understand that these illiquid, private market investments are cyclical, and while on average they generate higher returns than liquid assets, this result is not guaranteed every year. 

UK bank Coutts however, derives “nearly all” portfolio returns from bonds and equities. “Overwhelming data shows that over 10-15-20 years, in the stress periods of the market, hedge funds and private equity, in aggregate, do not exhibit strong enough lack of correlation,” says Mo Syed, managing director and head of global markets, Coutts. He concedes there are “some great hedge funds and private equity funds”, but most of them are closed to private investors. 

The bank offers its most sophisticated clients an introduction-only service to companies looking to raise assets, where the decision is ultimately that of the client to invest or not. “Every investment decision is a balance between pain and reward, and considering fees, the liquidity of the investment and the alpha generated over sustainable time frames, we don’t think alternatives are relevant to our clients,” he says.