Alternative assets – including private equity and debt, real estate, infrastructure and hedge funds – are fast joining the mainstream. Low expected returns on once-popular fixed income assets, now atthe mercy of cash-strapped central banks, are putting a dent into the balanced private portfolios of yesteryear.
As a result of these trends, the institutional model, popular with endowments and major pension plans, enthusiastic about significant allocations to private assets, is increasingly being adapted to the needs of wealthy private clients.
Ten years ago, alternatives, real assets and real estate were responsible for just 1 per cent of assets serviced by Universal-Investment, one of Europe’s leading fund platforms. Today, that figure exceeds 15 per cent, with particular bias to private debt.
“Key drivers behind the boom in private market opportunities are the low interest environment and the loose monetary policy,” reveals Julian Mayo, head of business development at Universal-Investment Ireland.
“Many investors have in one way or another a kind of minimum return they have to achieve. As they can’t achieve it with classical bond investments and also have reached in many cases the limits for equities set by their regulators, they diversify their assets into the illiquid space.” The Covid-19 pandemic, he believes, has acted as another catalyst strengthening these long-term drivers.
Bigger piece of the pie
“Alternatives are becoming a broader part of investors’ portfolios,” confirms Todd Myers, chief operating officer at Blackstone Private Wealth Solutions in New York, with private banks among the biggest drivers of increasing allocations.
“If you are a client of HSBC, Credit Suisse or most wealth management organisations around the world, the chief investment officer is suggesting an alternatives allocation to clients of 10 to 15 per cent. Today, across the individual wealth market, allocations to alternatives are probably in the 5 per cent range on average.”
Blackstone believes private banks must go “off piste” because they can no longer meet client expectations by deploying a traditional 60/40 stock/bond portfolio in today’s environment, with old-school fixed income positions in high yield or municipal bonds now shifting to modern day alternatives. The firm’s US private credit business – providing “lending solutions” to middle-market companies – has been one particular beneficiary and is soon to be rolled out globally.
“It gives an investor ability to access alternative credit, which is often seen as a substitute for the traditional public markets of fixed income,” says Mr Myers.
This notion of fixed income failing to fulfil its traditional role of stabilising portfolios is a key influencing factor at leading private banks. Geneva-based Union Bancaire Privee (UBP) draws attention to two significant trends.
“Those investors looking for yield are stepping away from the public bond market,” confirms Colin Greene, head of private debt at UBP. “This is a trend that has been happening for 10 years or more, but has been accelerated by what is happening in today’s bond markets.”
Private debt is now a $1tn asset class, according to consultancy Prequin. Flows into this sector have been fuelled by high levels of negative yielding debt in public bond markets, currently valued at $12tn. And even much of the debt that is positive yielding, is not generating sufficient returns after inflation.
The second trend is increasing appetite for thematic investments, particularly those linked to environmental, social and governance (ESG) dynamics, which have moved well beyond niche status and are expected to be the mainstay of portfolio allocations for the next 30 years.
This has been slow to take off but now seems to have gathered a loyal following. “Private equity did a pretty good job of ignoring ESG for the last 15 years, with a few notable exceptions and nothing happened for a long period of time,” says Justin Partington, group head of funds business for IQ-EQ in Luxembourg. “But critical mass kicked in after the ‘Greta effect’. Now ESG is the single biggest topic discussed by investors. It is number one on everyone’s wish list.”
Thematic investment is also coming to the fore because the pandemic has accentuated some themes and de-emphasised others.
“One of the things which Covid has demonstrated is this huge disparity,” says Mr Greene. “Some segments are unaffected by it, some have accelerated and others have been hit hard. So my recommendation is for investors to say: ‘Yes, I am in private debt for yield, but within this asset class, which segments and themes am I looking for?’ My focus is in finding the right themes and stories within private debt, the best risk/reward opportunities, particularly relating to ESG.”
One of these “alternatives” highlighted by UBP is the “highly scalable” 10-year theme of investing in funding and construction of affordable housing.
“What we will see over the next 10 years in the UK will be a huge drive to deliver more housing in general, mass market residential housing and also more regulated social and affordable housing. This need has been further accelerated by Covid,” adds Mr Greene.
Housing associations are also facing huge costs to retrofit buildings for fire safety, as a result of the Grenfell Tower tragedy in 2017 which killed 72 residents, diverting valuable resources from house building. With 22 per cent of carbon emissions emanating from housing in the UK, there is an urgent need for all future house building to be more carbon efficient in order to meet climate change targets.
“All of these things are sucking money out of the system, which would otherwise go to generating the financing of new home construction,” says Mr Greene. “As private debt investors, we are needed to provide this financing to generate new housing, to allow for costs of fire safety and retro fitting properties.”
Not only is the strategy provided by UBP in huge demand as a source of finance, but it is highly defensive and has huge impact in society, typifying the social pillar of the ESG formula, according to Mr Greene.
The 8 per cent return in UBP’s sights may not be as high as some other alternative options, but it looks attractive compared to other income-yielding assets. “We are not at 15 per cent private equity levels,” says Mr Greene. “But we are targeting an attractive return for the risk we take on our assets.”
These private assets, moreover, appear to make a “good fit” for private clients, believes Didier Duret, Geneva-based independent adviser to family offices on asset allocation. “Private assets are better understood by high net worth individuals, even more so when end clients are coming from an entrepreneurial background,” he says.
The approach to investing in these assets has moved away from deal-by-deal reviews and decisions towards professional platforms. “Family offices are now using sophisticated databases and tapping on independent due diligence to fashion an integrated risk approach,” he says.
According to Mr Duret, economic forces are currently aligned in such a way for these private assets to shine.
“The dislocation created by the acceleration of change and the real economic disruptions will spread a long shadow of disruptions and adaptations changing the structure of labour, goods and service markets, well beyond the pure post-Covid cyclical recovery,” predicts Mr Duret. “The high valuation of listed equities is also tempting family shareholders to buy and privatise assets when they can materially do it. Laggards in the changes could fall prey to private equity shareholder activists.”
But there are also many challenges for family offices keen to profit from the alternatives space. Getting to the highest level managers in private equity, for instance, can be a tall order for those with limited contacts. “Queuing is part of the game, illustrating that the private market is bent in favour of the managers,” says Mr Duret. “More sophisticated clients tend to be focused on small deals that require specific due diligence and capacity to understand the business, for instance in the refinancing business or insurance repackaging.”
Unrealistic expectations
Thematic investments may also not match the publicity generated by the private banks’ highly polished marketing machines. “As with traditional investments, alternative investments should earn their place in portfolios by providing an appropriate return and enhancing diversification,” warns Alessandro Poli, Chartered FCSI, an investment consultant on multi-asset solutions and member of the CISI wealth management committee.
“A thematic approach to alternative investments could be used to identify investment ideas, but the key criteria to discriminate in investment selection is whether the market is already discounting a superior expected return, what is the expected source of the return, and whether such return is sustainable,” says Mr Poli. “Otherwise there is a major risk of investing in what is potentially a bubble just before it pops. As with all investments, we should ask ourselves what is the risk involved in the first place and whether such risk is appropriately rewarded.”
Others warn of investing in assets that do not have the required liquidity which many family clients crave. “In debt and real estate, I don’t see a lot of compatibility with liquid fund structures. These assets tend to be multiple year, relatively illiquid and difficult to value,” says IQ-EQ’s Mr Partington, with special responsibility for alternative investments.
Real estate projects are particularly difficult to value, offering only “an illusion of liquidity”. Because of these long-term time horizons, investors need to avoid those jurisdictions which are frequently changing their funds legislation, as domiciles for their investments.
“You need to go with jurisdictions that have shown a track record of stability, rule of law and transparency, should things not go according to plan, which is why a lot of UK affiliated jurisdictions like the Channel Islands have done pretty well,” he says. Luxembourg and Dublin are often first choice domiciles in the private markets space.
“If you are looking at a closed, illiquid structure over five to 10 years, you have to think about how will the jurisdiction involved evolve over that period of time, as it’s like a long-term marriage, not a short-term fling.”
Mr Partington also urges caution over Special Purpose Acquisition Companies (Spacs), providing private equity-style experiences and returns to a broader market of investors.
“This feels like a bubble to me. They came out of nowhere into sudden popularity. The first time I heard about Spacs picking up was in July 2020,” he says.
“Now we hear a long-term crescendo, but it is too early to tell where it will play out. In my personal opinion, whenever you give somebody a blank cheque, there is always a risk that you don’t get exactly what you paid for. Normally, with these kinds of bubble situations – it takes one blow-up to create a bit of a turn. Then everyone retrenches into a reputable, defined, sustainable product, or it goes away. I don’t think Spacs in their current form will be a reliable product for many years ahead, but may proliferate in an evolved slightly different version, with more visibility of what people are investing in.”
This long-term evolution of alternative investments is crucial to their attraction. Hedge funds, much maligned since the global financial crisis of 2008-2009, are enjoying a renaissance, according to Swiss private bank Pictet, which manages $11.2bn of alternative assets and tracks 3,500 macro managers across all strategies.
While quant and systematic funds also had a tough time in the most recent crisis, they are now re-establishing themselves, with substantial exposures to assets including commodities.
Restructuring vehicles, buying up distressed assets, are also being launched, investing in firms requiring substantial balance sheet repair. “The full impact on the economy of the crisis we are going through has not yet been seen,” says Nicolas Campiche, CEO of Pictet Alternative Advisors.
“Many companies are in a desperate situation, where rescue finance will play a key role, repairing the banking industry, helping companies with capital, to get through this crisis. We have not yet seen the entire story play out, but that will happen during the next 12 to 18 months.”
According to strategists at Pictet, the reports of the death of the hedge funds industry have been premature and vastly exaggerated. “We had gone through a decade where many of our clients were frustrated by the poor contribution of hedge funds to their portfolio,” admits Mr Campiche. “This has changed dramatically, particularly in the last three years. Many competitors gave up, but we never did. We are delighted to see we were right, keeping resources allocated to that activity.”
The alternatives space has always been a colourful and volatile one, with recent headlines and controversy focusing on the likes of GameStop, Wirecard and Archegos Capital, with frenzied retail speculation highlighting investor exuberance. Although there is clearly possibility of greater dislocation going forward, as the experts at Pictet remind us, there is no substitute for manager due diligence to avoid pitfalls and preserve capital.
Battle for alternative talent
The proliferation of vehicles favouring private assets has sparked a war for alternative investment talent.
“With private assets, there is more room for industry knowledge of the best practices and flair for understanding the expected effects of disruption,” says independent family offices adviser Didier Duret. “A desk-work thematic approach is doomed to fail in private equity as it is a result-based endeavour, with appreciation for the intangible assets.”
Many funds and private banks can struggle to attract highly qualified candidates, with the required knowledge of alternative assets. “A number of firms have not organised enough training, development, variety or growth of jobs and functions,” says Justin Partington, funds boss at IQ-EQ. “People really look for growth, training and development in an employer. Some may want to become private equity CFOs in their own right, when they develop their career, so you need to be a high-growth organisation in order to attract the top talent, with a high-quality internal training programme. Some competitors have struggled in the Covid environment to engage with their staff, the way of working, and technology.”
Big data and artificial intelligence are being integrated into investment management to ever greater degrees, particularly in the alternatives sphere, says Heinrich Merz, head of hedge funds at Pictet Alternative Advisors. “It is hard to fund a hedge fund, even a traditional fundamental one, which has not hired data scientists and implemented a more quant-style process,” he concludes.
