Time horizon, liquidity are key for alternatives

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Meric Koksal, managing director and head of product at CIBC Asset Management 

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Last week, in the first installment of our two-part Exploring Alternatives series, we heard from my colleague, David Wong, on the evolving investment landscape and purpose of incorporating alternative investments in portfolios. Today, in part two, I’ll be taking a deeper dive looking at some of the specific classes of alternatives, their features and benefits and how they can benefit a client’s portfolio. 

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There are many options to look at when it comes to alternative investments. Specifically, we can start off with private equity. 

Private equity is effectively investing in the ownership of private companies. This can come in a variety of forms. It can be venture capital, where the investment is in early-stage companies. It can be growth equity, where investment goes into more established companies, and buyouts, where the manager is acquiring controlling stakes. 

A second popular version that you will hear about is private credit or private debt. This is where the managers are lending money directly to private companies. Again, this can take various forms of lending, sometimes referred to as non-bank lending. 

A third fairly wide category is real assets, where the investments are in physical assets like infrastructure, real estate and natural resources. This can come in both equity or debt format. 

Last but not least we have hedge funds. Although sometimes considered separately, private investment funds that use various strategies and are not publicly traded fall under the broader umbrella of private markets. 

For the purpose of this podcast today, I will be specifically focusing on the funds investing in private assets, private equity, private credit and real assets. 

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Going into how each strategy can benefit a client’s portfolio. This comes in various forms, and the opportunity cost is a very important question in relation to the benefits that private market exposure can bring. 

Tying it back to what David mentioned in part one, investors can look to move some of their equity or fixed-income allocation to privates. Private equity can be considered for a portion of that equity allocation. The private equity investment can provide clients with enhanced returns. David shared some examples in part one last week. The relative pickup in returns in these private investments typically come as there needs to be a liquidity premium that the clients should demand. 

You also get an opportunity to invest in various stages of a company’s development. In public markets, you’re typically investing in the company when it’s a relatively mature company with a steady revenue stream. In private equity, you get access to companies either through venture at very early stages or in a little bit more mature stages. But in either case, there is more risk involved, and that is why they tend to deliver higher returns than what you may see in public markets. 

Moving on to private credit or debt, this category of private investments can be a great fit for the fixed-income portion of the portfolio, as at their core, these strategies effectively aim to pay a steady income to clients, typically on a monthly basis. And this income tends to be higher than what investors can achieve in public markets, even in the high-yield space. To give you an example, the typical income that you would expect in a private credit fund currently is around 10%, or even in low teens. 

Moving on to real assets, real assets can play a crucial role to create a well-diversified asset allocation, acting as a complement to the traditional equity/fixed income mix. Another additional benefit with infrastructure real estate or agriculture-linked investment is the hedge they provide against inflation. As the cost of living rises, the value of these physical assets, and the income they generate tend to increase as well. 

In all of these three – private equity, private credit and real assets — clients can not only enjoy returns that can be enhanced versus comparable public investments, but they also tend to be uncorrelated to public markets, which means adding them to your asset allocation typically reduces the overall risk or volatility of the portfolio. And at the end, clients end up achieving enhanced return with lower volatility, which means through this asset allocation, they achieve better risk-adjusted returns. 

This is one of my favourite stats when it comes to private markets: almost 85% to 90% of companies by count are held privately. So when investors are looking at only public markets, they’re really getting exposure to about 10% to 15% of what is available for investment out there. This means introducing private markets into asset allocation allows them to access part of the investment universe, which is diverse across industries and geographies. 

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When considering if privates should be a part of the asset allocation, the questions are not that different from other investments. A few key ones that come to mind: what are the investment goals of the client? Is it preserving capital, targeting growth, creating consistent income, or a combination of these? As I previously outlined, there are different private funds that will fit each one of these goals. 

A second question, and a very important one, is what is the time horizon for the client, as well as liquidity and cash flow needs? This is especially important as privates don’t offer the same liquidity profile as public investments. Public markets offer intraday or daily liquidity. As much as they have evolved, private investments still currently offer quarterly liquidity to a limit that varies by the type of investment. So this is very important when considering investment in private markets for clients that have very specific and constrained daily liquidity needs. And when it comes to time horizon, these investments should be considered as longer-term holdings versus a short-term tactical allocation. 

A third question that comes to mind: what is the client’s risk tolerance? Given the liquidity profile we just talked about, private investments are typically considered medium or high risk. This should be taken into account with regards to specific client risk profiles. 

A couple other questions that are particularly important and specific to private markets are, what is the client’s investment knowledge? This is still a new area for advisors and their wealth clients. There’s a lot more information available, but it is not as easily accessible as public investments. So really getting the clients up to speed before moving a significant allocation to private markets is very important. 

Last but not least, fees. It’s a question that should come up with every single investment. And as transparent as the fees are, they are not as straightforward as a traditional management fee. A lot of the investments that you will see will involve a management fee, as well as what’s referred to as performance fee. They do tend to be different from what you would see in public markets, so it’s very important for advisors to educate their clients as to the impact these fees will have on their returns. 

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Advisors, just like in any other investment, should do their research to see if private alternatives is the right fit for their clients. There’s a lot of great educational pieces available from various sources, and these tend to cover all the benefits, as well as the nuances that are involved with these private investments. 

So if advisors can map out how these investments can fit within the client’s asset allocation and how they can be additive in their path of reaching their goals, I think that sets the strong foundation to introduce these. 

It is very important to note that these are longer term investments with less liquidity versus public comparables. I personally think it’s very critical for advisors to provide regular updates to their clients once these private investments are introduced in the portfolio.

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