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3 Reasons Advisors Shouldn’t Recommend Alternative Investments to Their Clients (And 3 Reasons Why They Should)

Post on: March 8, 2018 | Kyle Engelken | 0

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Broadly speaking, alternative assets include interests in direct participation programs, venture capital, private equity, hedge funds, REITs, commodities, and other real assets such as oil and gas interests, precious metals, art, and even fine wine. More recently, this asset class has expanded to include positions in investment opportunities utilizing Regulation CF (crowdfunding) and Regulation A exemptions. This is significant because now unaccredited investors have access to previously inaccessible private investments, effectively expanding the universe of investment product.

However, alternatives aren’t for everybody. Here are a few reasons you may want to avoid recommending alternatives to your clients:

 

Illiquidity

During a period of market correction or a recession, liquid assets are likely to lose value. In extreme scenarios, like we saw in the Great Recession, credit markets can dry up almost entirely. A diversified portfolio of private equity and other illiquid alternatives may require periodic capital calls to fund new investment opportunities. This requires access to readily available funding sources like short-term fixed income, cash, or liquid equities. If markets are depressed, this may force an investor to unwillingly sell marketable assets at unattractive prices in order to fund an illiquid position. Investors without a solid base of diversified, liquid investments should consider the risks of an allocation to illiquid alternatives that may require periodic funding. In addition, a properly diversified allocation to alternatives would include commitments to investment opportunities across multiple vintage years, strategies, and managers. Building a mature allocation to alternatives would require liquid sources of cash to handle capital calls throughout the year, at any time. In general, investors that don't have a solid base to his or her financial pyramid (i.e. reasonable debt service, short-term savings, insurance, college savings, retirement, etc.) should strongly consider other areas for diversification potential beyond illiquid alternatives.

 

Risk

Investing in a private security is inherently risky. Investors should be prepared for the possibility of their investment being written off completely - in other words, "going to zero". A typical venture capital manager's portfolio may have 15 to 20 positions in various early stage companies. A handful of these companies may become "home runs" with a high return on capital while the vast majority get written off as unsuccessful ventures. The handful of successful investments need to outweigh the failed investments to ultimately generate a reasonable portfolio return. Investors that commit to individual investment opportunities on a deal by deal basis lack the diversification of a professionally managed fund. Private investments are usually made into highly speculative ventures with a measurable probability of failure. The required potential return for an investment is therefore quite high. This underscores the importance of doing proper operational and investment due diligence on an offering, its sponsor, manager, and all parties involved.

 

Fees 

Sponsors and managers that invest private capital on your behalf usually charge hefty fees for their efforts. Asset management fees, advisory fees, fund administration fees, professional consulting fees, and broker dealer commissions are just a few examples that may be disclosed in an offering memorandum. The structure of return distributions may also favor the manager or sponsor that attempts to compensate them for their efforts of managing the investment. A typical return of capital waterfall in a limited partner, general partner arrangement is 100% of distributions to the limited partner until return of capital plus some preferred return hurdle (usually 6% to 8%), then 80% of returns thereafter. This means that 20% of additional returns beyond the preferred return hurdle go straight to the general partner. This "carried interest" compensation is on top of the fees listed previously.

To cut to the chase, it’s not uncommon for over 10% of an investor's principal to be allocated toward the payment of fees and commissions from the onset of an offering - before any carried interest. Investors should understand this dynamic and be comfortable with the fee structure of an offering they are considering committing funds to. Reading and understanding fee disclosures in an offering memorandum or prospectus is always a good idea before signing a subscription.

Achieving vintage year and sector diversification in private investments takes time and patience. Illiquidity risk is high, but illiquidity does not equate to market risk. For those willing to stomach the ‘J’ curve, properly diligenced private investments offer an alternative to niche asset class exposure in public markets such as technology, real estate or natural resources. Skilled private managers can showcase expertise in niche-markets, like distressed credit and specialty natural resource funds, to build portfolios of attractively priced assets that are not followed by the broader investing public.

 

Long-term investors with a solid financial base, tolerance for risk, and a firm understanding of fee structures may be especially interested in alternatives for the following reasons:

Attractive Risk-Return Profile

Diversification properties within alternative investments are well documented. While alternative investments alone add significant risk to a portfolio, a properly sized allocation can expand a portfolio’s efficient frontier and provide uncorrelated sources of investment return.

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Return Profile

It’s no surprise that fixed income yields are near all-time lows and the dividend yield on the S&P 500 is below 2%. Bonds have essentially been in a bull market for over 30 years and current yields in the domestic fixed income market are not a significant contributor to a diversified portfolio’s return. Today, where do advisors turn to generate uncorrelated return? Dividend stocks, active bond funds employing leverage, and Public REITs are options, however common portfolio risk factors across these asset classes compound one another and can lead to unforeseen downside risk.

Investors are demanding creative solutions and private alternative investments can offer a differentiated source of potential return. There is substantial risk associated with investing in private securities and as with any other investment opportunity, investors should understand the risk and return trade off.

 

Institutional Success

Institutional capital including large pensions, endowments, high net worth family offices, and foundations have sizeable allocations to alternative investments and have outperformed traditional portfolios consistently.

Indeed, both Harvard and Yale endowments now have over 60% allocated to alternative investments. When asked how they were able to consistently outperform their peers, their answer mentioned the sizable allocation to alternatives and access to top performing managers in the space.

Global buyout firm KKR recently conducted a survey of over 50 ultra high net worth and high net worth investors. The survey concluded that alternative allocations averaged between 22% and 45% in those types of investor portfolios. Institutional beneficiaries are entrusting their capital allocators to sacrifice liquidity for return potential.

 

DRIVING COMPETITIVE ADVANTAGE: 
Alternative Investments and Technology Adoption for RIAs

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Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice. Private securities offerings may have a long holding period, be illiquid, and contain a high degree of risk. Investors must be able to afford the loss of all of their principal. Illustrative proforma results may significantly differ from actual outcomes. Past performance does not indicate future results. 

 

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About author

Kyle Engelken

Kyle brings a deep understanding of portfolio management and private investments to WealthForge from his tenure at Cambridge Associates. Kyle received his bachelor's at University of Richmond and MBA from the College of William and Mary. Prior to joining WealthForge, Kyle managed a portfolio of microloans in Nicaragua for a US-based non-profit.
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