Myths & Misconceptions: "Alternative" Investments
By: Brian Seay, CFA
What are alternative investments? Are private – or alternative – assets just for the ultra-wealthy? What is (or is not) the secret sauce of private managers that drives the high returns you see in the media? How should you think about private assets in your portfolio? In our latest podcast episode, I dive into some popular myths about alternative investments so that you can think rationally about whether they make sense in your portfolio. Watch the video below, listen to the episode on the podcast feed or read the transcript below.
Transcript:
Hello and welcome to the capital stewards podcast. This episode is all about alternative and private investments. I wanted to cover some common myths and misconceptions I hear frequently about alternatives. The first is that they really aren’t all that “alternative” or different from other investments in your portfolio. Most involve either buying the equity – or stock – of a company or lending money to a company. Just like publically traded stocks and bonds. The difference is usually that alternative investment funds are private. They don’t trade on an exchange and information about them is often hard to get. That adds to the mystique – and perhaps mythology – the alternative investment universe. So we are going to talk about how private – or alternative – assets aren’t just for the wealthy, the existence or nonexistence of the private managers secret sauce that drives the high returns you see in the media – and how you should think about private assets in your portfolio.
Myth 1: Private Assets are only for the very wealthy and not for me.
While investors do need to meet government minimums for personal wealth, income and liquidity, fund structures have been evolving over the past decade to be more accessible. Originally, investors often needed to commit $1MM or more to access private investment funds. Fund minimums now can be between $50 and 100k, making private funds a real option for more investors. So if you have at least $1MM in liquid assets, you should at least be considering private investments to supplement your portfolio.
Myth 2: All of these new fund structure innovations means that I don’t really have to give up access to my cash for 8-10 years.
For investors new to private assets, most funds require that you commit a minimum amount of capital upfront, which they will call or draw down to make investments. Private funds generally expect to make investments over 8-12 years. Historically, investors needed to wait until the latter half of the funds life to begin receiving distributions. New innovations like interval funds suggest that some liquidity may be available for investors on a quarterly basis. Some traditional funds also promise faster liquidity. However, I caution investors here. The reality is that all of those promises of early liquidity are dependent on the supply of cash in a fund and number of investors asking for distributions. Everyone tends to want their money back at the same time when things are going poorly. In those cases, there is likely not going to be enough liquidity for everyone. This was in the news a lot last year when BREIT, a Blackstone real estate fund, was not able to meet the demand for quarterly withdrawals. Investors had to wait their turn. So, despite the innovations in the space, all of which are helpful for investors, I suggest not planning or expecting to receive your capital back until the end of the fund. Make alternative investments with a long-term perspective and plan on sticking it out until the end.
Myth 3: Private managers have a secret and that allows them to drive special, secret returns that everyone must access!
Private equity can be split into two categories, venture capital and traditional buy-out funds. Preqin is a data firm that tracks the private investment space. Over the past 10 years, traditional private equity buyout funds generated average returns of 28.3%. Venture capital funds, which invest in start-ups, usually in the technology space, averaged 19.97%. The S&P 500 split the difference, with a 10 year average return of 20.97%. Those are returns from Q1 of 2014 through Q1 of 2024. Stephen Kaplan is an academic thought leader on private equity at the Booth School of Business in Chicago. His work suggests that Private Equity outperforms the S&P 500 by about 5% per year. So do private equity funds produce outperformance? Yes. But is that so significant it overcomes the requirement for locking up capital without liquidity for a decade? Each investor has to make that decision. In my view, for investors with plenty of liquidity, the extra return can be worthwhile, but it is not a panacea of wealth building. Investors can choose to stay in public markets and do just fine.
Where there is “special sauce,” it is generally linked to the deal flow that Private equity and venture capital firms have access to. Buy-out funds spend vast amounts of time and resources looking for companies that are available for sale at perhaps a below market price due to one issue or another. Venture capital funds build relationships with company founders over the years and try to get the first cut so to speak at investing in new companies. The new firm may only need a few million dollars at first, so they don’t need that many investors. Sourcing and accessing opportunities becomes key.
Myth 4: Private Equity Funds borrow a ton and lay-off lots of workers. They are just corporate raiders.
Private equity funds, both buy-out and venture funds do push their portfolio companies to create strong operating performance. In recent years, this has led to a single digit reduction in employment, but far for the mass layoffs and other results you might expect. They generally make existing operations more efficient with lay-offs and then hire in areas that can expand or grow the business. Gone are the days of pure “financial engineering,” where PE funds bought a company, laid off lots of workers, borrowed money, and reaped all the profits. Generally, modern PE funds invest to restructure and grow a business. Steven Kaplan’s work shows that, By wide margin, PE firms are looking to grow the revenue of the business as primary source of value creation. Reducing cost is a distance second and leverage is even further down the list. They also tend to work closely with management teams. Management teams now own 15% of the company on average, the CEO owns 5% on average. That’s significantly more than most publicly traded companies and serves to align management with the ownership group more effectively than in a public company. So this is far from investors who swoop in from afar, restructure the financials of a company and then leave.
Myth 5: Private Debt has grown too fast and is the next Financial Crisis waiting to happen.
Private debt is the other side of the private equity equation. Instead of owning shares in a private company that benefits from its performance, investors are making loans to that company. These are typically private equity backed companies and the loans from private credit funds are used by the PE fund to buy the company. Because of the leverage involved, these are riskier deals than Banks will lend on in the post-GFC world – and as you would expect – the interest rates can be 9-13% - which is higher than both investment grade commercial credit and publicly traded high yield bonds. This market has grown substantially since 2008 as banks have pulled back and credit funds and institutional investors have stepped in to provide financing. Assets have been growing double digits for the last decade. I don’t view the rapid growth in and of itself as a huge problem. The issue with rapid growth is that fund managers start chasing bad deals because there aren’t enough good deals for funds to invest in. In reality, the total AUM for the private debt space stands at less than 10% of the AUM of private equity. PE firms have more than $1 Trillion in “dry powder” i.e. cash from investors to invest. So I think private debt can continue to grow without much of an issue.
The problem is not the pace of growth, it’s the rapid rise in interest rates. If interest rates remain high, and the economy continues to slow down, the companies that were lent money may have trouble making their interest payments. Many of these loans were done in 2019, 2020 and 2021 when interest rates were much lower. Now debt payments for companies have gone up 3x in some cases. The longer we remain in a high-rate environment – the more likely we are to see defaults in private debt. Because of the growth in the industry, many newer funds likely lent to companies with fewer protections than the more established players. We won’t know until the tide goes out, but when it does, I would expect some of the funds in the private debt space to be wishing they made smarter deals.
Despite what may develop into an issue in the asset class, it’s important to distinguish that from a contagion debt crisis that spills over into other areas of the economy. The owners of private debt are large institutional investors. They would have to take losses on their positions and their endowments or pensions would suffer. However, because banks are less involved in the space, my view is that the losses would be more isolated to the owners of private debt and not impact lending broadly in the economy. So Private Debt may have looming issues, but I don’t see that as a major risk for the U.S. economy.
Myth 6: Some real estate developers and owners are struggling, now is a great time to try to get a deal by investing in a privately held REIT or fund.
The real estate market is a tail of two halves. Commercial office properties continue to struggle as demand for office space was dramatically reduced post Covid. Despite what you see in the news about return to office programs, offices are operating at about 60% of their occupancy levels according to Kastle systems, which tracks card swipe data for office workers. Occupancy went down to 55% during 2022 and has ticked up only slightly since. The result is that companies are reducing their space when leases come up for renewal and office properties are struggling. Other parts of the real estate market, retail, industrial, multi-family apartment housing are doing ok. IF you could buy a newly launched fund that was buying properties valued based on today’s interest rates, with today’s debt levels, and with today’s occupancy levels, that maty represent an attractive opportunity to buy properties at relatively low values. The challenge is that many REITS, public and private, are perpetual in nature. So in addition to their ability to acquire properties at today’s good values, you are also buying shares in their prior holdings which may drag on performance for a while. So I think there may be a buying opportunity emerging in some spaces, but I wouldn’t blindly assume all real estate funds will benefit equally. You need to find a fund that is raising fresh capital and buying at today’s good prices. Also, if you can stick several hundred thousand into a private real estate fund, you can likely buy a small local property on your own. You may be better off buying your own properties – in your local community – than investing through a larger fund.
Myth 7: All alternatives are designed to provide higher returns than public securities.
Remember, as an investor, your goal is to give yourself the higher probability of accomplishing your goals. That usually means earning consistent, compound returns over time with the lowest risk possible. Some alternatives, like some Hedge Funds and Infrastructure Funds aren’t designed to produce eye popping returns, they are designed to produce mid-single digit returns consistently across all kinds of environments. In 2022, Many investors learned the hard way that In a world where inflation is higher and interest rates are more volatile, bonds may not provide the best diversification. Both bonds and equities declined in 2022. However, strategies like absolute return hedge funds and infrastructure continues to produce those steady eddy returns despite the environment. So it may make sense to have some alternatives in your portfolio that don’t drive returns, but they reduce risk and volatility over time.
Myth 8: Alternatives are all the rage, so the fund I’m being sold should work out ok.
There is a reason the government has net worth minimums for certain kinds of alternative investments. They do not have the disclosure and investor protections that ETFs and mutual funds have. Investors are essentially entering into a private business contract with an investment manager and the assumption is that both parties are sophisticated enough to understand the risks they are taking. So due diligence is very, very important in the alternative investment arena. That involves everything from reviewing the prior performance of a potential investment, to looking at the financials of the fund and the fund’s sponsor, to understanding the background and experience of the managers. It is vital that you ensure someone is doing the leg work on potential alternative investments on your behalf if you are not doing it yourself. So don’t be lulled into a false sense of confidence because everyone is talking about alternatives. The most important thing in the alternative investment space is that you do your homework to prevent a total loss of your capital.
Myth 9: All private fund managers are created the same.
This is related to the point about due diligence, but I wanted to highlight it more. There is much more dispersion between the returns of private investments than there is between mutual funds and ETFs with similar mandates. If you pick the wrong mutual fund, you may underperform the market by a few percentage points, but your performance is likely to be close that of the broader public market. Managers herd and tend to produce similar results. In private markets the ability to pick a manager than will be in the top quartile of returns is usually critical to your private market success. The best performing private equity funds may produce average annual returns in excess of 20% per year, but the worst performing funds may bring only single digit returns over a decade. That difference is hugely significant. That new shiny “private equity or debt” fund someone is selling to you will not produce the returns you expect just because it is labeled as private equity or debt. Choosing the right fund structure and manager are paramount to success and you need a framework for evaluating the potential success of a fund manager. So make sure you spend the time to understand why the particular manager you are investing in is the right manager for your portfolio.
I hope you found this discussion helpful as you consider your own portfolio. My view is that for the right investor, alternatives can be a very important building block of your portfolio. Generally, you need to be able to commit significant capital to these strategies for years or even a decade for it to pay off. As I mentioned earlier, alternatives can enhance returns, but they are not a panacea and you shouldn’t feel pressured into using alternatives, there are lots of ways to achieve your investment goals, and alternatives, while popular, are only one of those strategies. If you have questions about existing private investment holdings or are thinking about whether you should have exposure to alternative investments, reach out any time, I’m happy to discuss your specific situation further.