High-net-worth investors and family offices are increasing their allocations to alternative assets. Claire Madden, managing partner at Connection Capital, examines why…
In turbulent times, should investors “keep calm and carry on” or take unusual (and innovative) measures to hedge against economic uncertainty and volatility in public markets? At a time when Brexit and international trade wars show no signs of clarifying or calming either, the logic for retaining heavy weightings to equities and bonds in portfolios is being questioned. Many in the private capital community (high-net-worth investors and family offices) are widening the field of options they will consider to increase resilience and drive returns.
We are seeing this first hand. Research among our private clients reveals that exposure to alternative assets has increased significantly. Now, more than a third of respondents are allocating 20 per cent or more of their investment portfolio to alternatives like private equity or private debt, up from around a quarter who said the same last year. Over half have increased their allocations to alternatives in the last 12 months.
That’s a fair slice of illiquidity. Why would so many investors be prepared to tie up such a substantial proportion of their capital like this?
In the current climate, many investors are re-calibrating portfolio liquidity. On the one hand, cash may become a key consideration. By moving long into cash, they will be in a position to capitalise on investment opportunities if further dislocation comes, either by re-entering markets when prices hit a floor or by snapping up distressed assets.
On the other hand, cash needs a counterweight. Despite its opportunistic benefits, an extremely cash-heavy position is not an ideal one to be in for long. By balancing it with an increase in more illiquid, potentially higher returning alternative assets, private capital can maintain – and even enhance – overall portfolio performance.
Furthermore, if investors do decide to retain liquid investments like quoted equities or increase allocations again later on, having holdings of longer-term alternative assets is a sensible approach, both as a portfolio diversifier, and given the ‘illiquidity premium’ that such assets can generate. Private equity is a prime example, having outperformed the FTSE All-Share over the last three, five and 10 years, according to the British Venture Capital Association.
A spectrum of opportunity
Still, a portfolio allocation of 20 per cent or more to alternatives sounds like a lot. And it would be – if it were all to be invested in the same thing. The beauty of alternatives, though, is their variety. The extensive range of possibilities within this bracket was highlighted by the Association of Investment Companies earlier this year, when it introduced a number of new sectors and sub-sectors to its list of investment categories. By tapping into several different types of assets and sophisticated strategies, private capital can ensure sources of returns (and risk) are well spread. Many alternatives have the advantage of being uncorrelated to mainstream market movements, allowing investment returns to be targeted even during times of market stress. One example is litigation funding, since cases decided by the courts are not related to the economy, or life science strategies focused on breakthrough medical treatments where returns are more influenced by the efficacy of the treatments and the likelihood of commercialising them.
As demand for alternatives grows, private capital is in good company. Institutional investors are ramping up allocations too: research company Prequin forecasts institutional alternative assets under management will reach $14trn (£11.3trn) by 2023, from $9.5trn last year. This chimes with our finding that 35 per cent of our private capital client respondents plan to increase their exposure to alternatives in the coming year, compared to only 11 per cent who say the same about listed equities.
Private capital vs institutional investors
That’s where the similarities end, however. Institutions are likely to have a much higher threshold for alternative allocations than any private investor (up to 50 per cent of portfolios in some cases), and the investment rationale and approach will differ significantly too.
Private capital simply won’t be competing on the same playing field for opportunities. Most do not have the size to gain access to bigger, more mainstream options. There’s no guarantee that bigger equals better performance either. For instance, recent Prequin data shows that small private equity buyout firms have outperformed larger ones, delivering more consistent returns over the past 10 years. For private capital, small, niche or emerging opportunities may provide the most fertile ground for attractive risk-adjusted returns: run by experts with specialist strategies in innovative areas of the marketplace, who are either too early stage or too esoteric – or who simply don’t want – to attract significant institutional inflows.
Even so, accessing such opportunities remains challenging, even for those who know where to find them, not least because investment minimums are typically in the millions – even small alternative asset funds are still ‘institutional’ in nature, after all. However, it’s an issue that is being addressed, with innovative models now established that provide that entry route for private capital with far more manageable commitment levels in the thousands.
While awareness of, appetite for, and access to alternative assets increases, traditional portfolio composition is receiving a shake-up, as private capital re-assesses what it is investing in and in what proportions. Though fuelled to an extent by economic and mainstream market unpredictability, more and more investors are recognising that including alternatives could benefit their portfolios whatever the conditions. It’s a shift that may well be here to stay, if and when ‘normality’ returns.