Investing in Alternative Assets

Alternative Investment Strategies

Incorporating alternative assets into portfolios can be challenging even for the most experienced investor. It is important that investors consider their risk tolerance, how much illiquidity they are comfortable with, are prepared to invest over the medium to long term, and have a clear objective for investing — whether that be to mitigate against market volatility, portfolio diversification, or achieve higher returns, among others.

Investing over multiple years and diversifying across key areas such as geographies and sectors is important; helping reduce risk and potentially increase returns by capitalising on varying market conditions.

• Private Equity and Venture Capital typically involve direct equity investment in private companies. Investors have the potential to achieve significant returns due to operational improvements, strategic changes, and value creation opportunities. However, the illiquidity and, on occasions, high leverage associated with private equity can increase investment risk, making careful due diligence crucial.
• Real Estate Investments, whether commercial or residential, can offer stable income from rental yields and the potential for capital appreciation. However, market-specific risks like regulatory changes and economic downturns can affect returns.

Traditionally, exposure to private equity has been achieved through a fund structure, but investors are increasingly seeking to supplement this by also investing on a deal-by-deal basis (Source: FT). This provides investors with more flexibility in terms of the types of companies they back and the sort of deal structures they invest in. Deal-by-deal co-investment also enables investors to leverage the expertise and track record of a proven alternative asset manager, utilising its market knowledge and networks to source high-quality investment opportunities.

Publicly listed Real Estate Investment Trusts (REITs), Private Equity Investment Trusts (PEITs), and Venture Capital Trusts (VCTs) have provided a degree of access to all investors (including retail) who have looked for exposure to both of these asset classes, albeit with scaled-down diversification benefits. This is because both ‘products’ are effectively publicly traded companies, and therefore subject to the same economic and market risks as other publicly traded companies.

Alternative Investment Opportunities

There is a strong motivation from investors, private equity firms, and even many regulators to improve accessibility to alternatives, such as private equity. Recent shifts in retail investing, such as ELTIF 2.0, the revised European Long-Term Investment Fund, introduced by the EU, are helping to create a secular shift towards inclusivity and unlocking private markets for individual investors. Access to a wider investment universe helps with diversification and enables investors to mitigate risk by mixing investments and moving beyond traditional stocks and bonds.

Retail investors account for half of all wealth globally. The democratisation of private markets and lacklustre performance in the public markets will see more of them explore the full investable universe.

That said, alternative investments are complex and typically only suitable for experienced investors who can evaluate and understand the risks and merits of such investment and who have the resources to bear any loss that may result.

Why gain exposure to Alternative Assets?

Gaining exposure to alternative assets can offer significant benefits. The low correlation of alternatives with traditional markets provides valuable diversification, reducing portfolio volatility. A mix of asset classes is regarded as the optimum way to construct a robust and highly diversified portfolio.

Moreover, the illiquidity premiums and skilled management inherent in private markets offer higher return potential. Alternatives like private equity and real estate inherently diverge from the patterns of traditional listed markets, offering a potential buffer against negative market trends and tapping into opportunities absent in the traditional 60% equity vs. 40% bonds portfolio structure.

Private markets are uniquely positioned to capitalise on significant market trends and structural shifts, such as AI and the low-carbon transition. Private equity’s focus on longer-term investment horizons aligns well with the development cycles of AI and sustainability projects, which often require time to mature and achieve their transformative potential (Source: BlackRock). Investing directly in these emerging companies through a private equity co-investment structure can offer a way to tap into the expected growth of these high-growth sectors that may not be available in public markets.

The greatest pull for investors is the potential for higher returns, where many alternative assets have delivered impressive long-term performance. As an example, the U.S. Private Equity Index provided by Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20-year period to 2020, while during the same time frame the S&P 500 returned 5.91%. This superior performance is also reflected in the UK in the aforementioned analysis from the BVCA.

Alternative investment strategies may help improve risk-adjusted returns in a typical 60/40 portfolio. A multi-strategy approach provides the potential to diversify across a range of strategies and managers, which have lower correlations to traditional asset classes as well as to one another. So, when one strategy does poorly, another may do well. Employing a balanced and active approach to investing can better offset risk to provide more stable risk-adjusted returns over time.

Suitability of Alternative Assets

Institutional investors and high-net-worth individuals (HNWIs) have historically found alternative assets suitable due to their higher risk tolerance, longer-term investment horizon, and ability to afford the historically high investment minimums.

However, retail investors are gaining increasing access to private markets through regulatory changes, such as ELTIF 2, and technology-driven platforms making the process easier and more transparent. Despite this, careful assessment of risk tolerance and investment goals is critical, given the risks and complexities involved.

Many private investors tend to have a shorter investment horizon than institutional investors, so investing in long-term illiquid assets that could lock up capital for several years may not suit them. Investors should always determine their level of liquidity reserves necessary to meet their short-term cash flow needs.

Wealth managers typically limit the market and funding liquidity risk for their clients, ensuring they maintain sufficient exposure to liquid assets that can be accessed if required. This is typically 10% to 20% total exposure to private markets.

Not all options in the marketplace are suitable for every investor, and many firms offering these types of investments have strict protocols to ensure investor suitability.

Advantages and Disadvantages of Alternative Investments

While alternative investments offer significant potential benefits, investors must also understand the associated risks. This section explores the advantages and disadvantages; highlighting their unique risk-return profiles and evolving landscape.

The illiquidity premiums and active management of alternative assets often result in higher returns compared to traditional markets. Additionally, the low correlation with public equities and bonds offers valuable diversification benefits. Real estate and private debt also provide the potential for stable income streams that can enhance overall portfolio returns.

True diversification in the public markets is becoming harder to achieve over time. A declining number of publicly listed companies is reducing the ability for investors to diversify their portfolios across sectors, regions, and sizes. Major stock markets like the FTSE in the UK and Dow Jones in the US are experiencing a reduction in listed companies, and IPOs are becoming more infrequent. High-quality companies are also staying private for longer, and the number of businesses backed by private equity is growing (Source: Hamilton Lane). This is leaving many investors, who solely invest in the public markets, closed off from large parts of the global economy. Mixing in private assets provides new options for building portfolios that pair attractive returns with new forms of diversification.

Liquidity will always be the biggest hurdle for individual investors and the greatest challenge for private equity firms targeting individual wealth for further growth. Liquidity expectations of a typical private investor are very different from those of a large institution. Individual investors are used to getting money out when they require it, but a private equity investment model is geared towards a patient approach where money is typically locked in for a longer period before any distributions are made, limiting investors' ability to access their capital quickly.

Management and performance fees are typically higher than those of traditional assets, potentially eroding net returns. Moreover, valuation complexity requires specialised due diligence and robust valuation models, adding to the investment's resource intensity.

Assessing Risks and Returns in Alternative Assets

Less transparent assets, such as private equity, real estate, and hedge funds, along with the limited available information compared to public markets, can make it difficult to fully understand the risks associated with these investments.

For most private investors, alternative investments will not be suitable due to the higher risk profile, but for those who do qualify, it is important to evaluate and understand the risks and merits of such investments. Education around alternatives is often cited as one of the biggest challenges for the restricted distribution of this asset class. A large segment of qualified financial advisers and wealth managers do not advise on alternatives as they themselves struggle to communicate the value proposition and how certain strategies will impact their clients’ investment portfolios. Alternatives are complex and require additional knowledge and tools of assessment outside of the standard approaches to the public markets.

That said, advisers are set to significantly grow their allocation to private assets in the coming years as their knowledge and understanding around regulatory aspects and the risk/reward profile of alternatives increases (Source: FT Adviser). As more alternative investment platforms and products come to market, the increased requirement for appropriate guidance and advice is even more imperative.

There is typically a higher dispersion in performance based on factors such as strategy, manager skill, and market conditions. Venture capital has one of the highest dispersions among the asset classes due to its higher-risk strategy of investing in earlier-stage businesses. This variability makes rigorous manager selection and due diligence crucial.

Investment manager selection will centre around their reach and ability to source, evaluate, and execute deals, which will help investors to construct a highly diversified portfolio of private companies. Strong value creation capabilities can also be a real differentiator, as the ability to build efficient, high-growth businesses through substantive operational and productivity improvements is required to achieve the multiples to which private equity firms aspire.

Current market pricing is usually not readily available for many illiquid assets, posing a challenge for investors to assess value and risk. Alternative methods to determine the valuation of such assets are required, as only when a company is sold can true market values be observed in the case of private equity.

Just like investments in liquid assets, fewer liquid assets offer an array of opportunities but have different investment characteristics and risks that need to be considered on their individual merits.

Trends in Alternative Investments

A shift in mindset is beginning to be seen in wealth management as alternative investments are increasingly being viewed as a core holding within a portfolio, with a spread of allocations across both public and private assets being favoured, rather than merely as a bolt-on exposure.

Traditionally, private equity investments have been accessed through funds requiring investors to commit capital to a pre-defined strategy. However, the trend towards co-investment on a deal-by-deal basis is gaining traction, offering a more transparent and controlled way for investors to steer their investment choices, aligning more closely with their risk tolerance and investment objectives (Source: FT). This strategy facilitates direct exposure to high-quality investments, often alongside seasoned private equity firms. Investors can decide on their level of participation based on the specifics of each deal and their current investment strategy or liquidity situation.

For many investors, the greater selectivity and control is the appeal, allowing them to seek out the most robust businesses at the right valuations. It also enables them to diversify their portfolios across sectors, geographies, and development stages to help mitigate the impact of industry-specific shocks and macroeconomic variances. Not to forget the higher return potential. Unlike fund investing where the manager is paid a performance fee on the overall total return of the fund, a performance fee is only earned by the manager on the positive performance of the specific stand-alone investment for a deal-by-deal investment.

There has also been an explosion in private market capital, resulting in more companies turning to private markets to fund their growth. The steady decline in publicly listed companies has been well-documented, leaving investors with less choice and therefore a greater challenge to achieve diversification within what has become a more concentrated and correlated market. As a result, private equity is playing an increasing role in driving growth, innovation, and skilled employment across global economies.

The landscape of alternative assets is continually evolving, influenced by trends such as environmental, social, and governance (ESG) factors, technological advances, and changing investor preferences. ESG considerations have grown in importance, with private equity and venture capital funds increasingly incorporating them into investment strategies (Source: EY).

Technological advances like artificial intelligence (AI) and big data have improved due diligence, portfolio monitoring, and risk assessment. The fintech ecosystem is also fast developing tools and solutions that can streamline distribution and make it more affordable to individual investors, rather than being the preserve for large institutions.

Accessibility of Alternative Assets

Historically, institutional investors have dominated private equity due to high minimum investments, long lock-up periods, and complex due diligence requirements. Technological advancements and increased transparency, along with new entrants and innovative fund structures, are democratising access. Today, alternative funds and direct investment opportunities are more accessible to experienced investors and family offices, prompting significant capital inflows and fuelling growth in the alternatives sector.

Traditional wealth advisers like private banks and registered investment advisers are setting themselves up to distribute alternative investments (Source: Mercer). This not only gives them a broader menu of diversification options for their clients, which is increasingly being demanded, but also a substantial new stream of fee income.

As mentioned in our guide to alternative investments, by carefully considering investment goals and horizons, investors can leverage the unique advantages of alternative assets to achieve their financial objectives, ultimately constructing a robust and diversified portfolio that has the potential to withstand the volatility of traditional markets.