Investing in private market alternatives

Introduction

This is the first in a four-part series of papers that aims to provide investors with a broad appreciation of private market alternative investment solutions. Private markets have grown strongly over the past decade. Investment opportunities in a range of eclectic alternative opportunities are increasingly accessible to individual and high net worth (HNW) investors. In this first paper, we discuss recent private market growth, as well as investment opportunities and risks. The second paper will explore the methods of manager research as a means of identifying and appraising the opportunities and risks inherent in private market investing, including ESG. The third paper in the series will provide a deep dive road map through the various characteristics of the main private market investment opportunities: private credit and equity; real estate; infrastructure; and hedge funds. The final paper will address the question of how much to allocate to private market alternatives within investor portfolios.

A broad mosaic

They include less liquid private asset classes such as private equity and credit. They also include structured products that pool assets such as bank loans to provide repackaged risks and capital structures, real assets such as private real estate and infrastructure, natural resources and farmland, and intangible collectibles such as patents and copyrights, music publishing royalties, and Non-Fungible Tokens.²Each one of these asset classes can in turn be sub-divided into an eclectic set of distinct investment opportunities, and risks.

Unlike traditional investment solutions, alternative strategies are not constrained to long-only, benchmark-relative positions. They provide investors with the ability to express the full range of investment insights by implementing both long and short positions across and within various public and private market asset classes, often with the use of leverage. Liquid alternative strategies implement long/short positions exclusively in public markets, using similar investment strategies to hedge funds. liquid alternatives have a regulatory requirement to offer investors daily liquidity. By contrast, hedge funds impose limits on fund liquidity to facilitate implementation of positions in less liquid corners of the financial markets where inefficiencies and informational asymmetries may be relatively more persistent, and opportunities for skilled investors to realize diversifying outsized returns are commensurately higher.

Complements, not substitutes

Alternatives should be viewed as complements, not substitutes, to traditional asset classes. Investors are not presented with a choice between investing in traditional public assets or private alternatives, or between one private alternative versus another. Instead, their challenge is to determine how best to combine all of these opportunities into a more efficient portfolio than one that draws solely upon traditional long-only public market solutions.

Each private market alternative offers distinct attributes to investors. Private equity offers the potential for enhanced expected returns relative to public equity, as a reward for illiquidity and complexity. And within private equity, venture capital provides access to a different expected return opportunity than growth or buyout categories.

Private credit also provides investors with an enhanced expected yield relative to public market comparables, such as bank loans or high-yield bonds, and, in the case of direct lending strategies, floating interest rates which provide an ability to better hedge against rising interest rate risk. Diversification is also potentially available given the eclectic mix of sectors and structures encompassed by this asset class.

Real estate and infrastructure offer the possibility of steady income streams in strategies that emphasize the quality of assets. In addition, there can also be a greater ability to hedge inflation risks—particularly in sectors where rent or toll resets occur on a frequent basis and the threat of substitution is low. These types of private assets can also hold the potential to augment expected returns in cases where investors are willing to take on more development risk.

Hedge fund strategies can provide diversification benefits that help smooth the profile of long-term expected returns. They also offer the opportunity to implement tail hedges that seek to mitigate the risk of loss during periods of market stress.

Myriad risks alongside opportunity

Private market alternatives are not a panacea. They are very different to public markets, and are not appropriate for all investors given the effort and risk tolerance needed to participate. They are heterogeneous, often complex, and are more opaque and less liquid than traditional public investments. They have less disclosure requirements and fewer regulatory constraints—such as leverage—and as a result have less protections. They often involve layers of embedded fees. For all these reasons, most private market investment solutions are available only via Offering Memorandum and not prospectus. This limits their availability to accredited investors, with strict hurdles around income level, assets, and other criteria. And even for this cohort, the use of private market solutions requires selectivity. Rigorous investment and operational due diligence is at a premium, along with an acceptance of higher risk.

In some quarters, there has been a headlong rush to recommend investors add alternatives to portfolios. The motivation for this urgency is not always apparent. Allocating to alternatives only makes sense if they enhance expected outcomes associated with an investor’s existing portfolio. Given the additional risks involved, any supplementary portfolio utility needs to be carefully measured.

Sketching the growth of private market alternatives

In terms of absolute size, the market capitalization of private market alternatives remains relatively small compared with public equity and fixed income markets.

Vigorous growth

But the growth rate of private markets has been particularly impressive. Private equity continues to lead the way. The size of private equity funds is growing larger, the gap between fundraising rounds has declined, and the average fund is exceeding capital raising targets, by 18% in 2022.² Other asset classes have realized solid growth, too. As a result, private markets are becoming an increasingly important source of capital for the global economy, and an increasingly viable opportunity for investors.

And the beat goes on

The scope for continued vigorous growth in private market alternatives appears substantial. Private companies constitute more than 99% of all U.S. employer firms, and 86% of U.S. firms with 500 or more employees. In Canada, of 1.22 million employer companies, just 2,200 are publicly listed.^4,5 Anecdotally, Pitchbook—a well-known source of private market data and analysis—provides research coverage on 3.4 million private firms, and just 102,000 publicly listed companies.⁶ Evidence suggests the trend growth rate of private companies remains vigorous and that many firms are choosing to remain private for longer, fueling greater demand for private market financing solutions to fund future growth.⁷

For real assets, the gap between projected and required global infrastructure spending though 2040 is projected at $15 trillion, including on megatrends such as the transition to green infrastructure, urbanization, and digitization.⁸ Private infrastructure funds raised $117 billion in 2021, so there is plenty of scope for this sector to grow and satisfy a substantial chunk of megatrend capital funding requirements.⁹ And many countries are confronted by a shortage of real estate, particularly in terms of various housing sectors. Again, this provides an important opportunity for private capital and, by extension, private market investors. So the canvas of investment opportunities available to private market investment managers and investors will likely remain very extensive for the foreseeable future.

Lessons from institutional asset allocation trends

Private market alternatives have long been a key component of institutional, family office, and endowment portfolios. Even so, survey data suggest allocations have yet to reach steady-state (Nuveen, 2022; Jupe, 2022, op. cit.).¹⁰ And the mix of alternatives in institutional portfolios underscores the complementarity of the various opportunities.

Ultra-high net worth (UHNW) investors have also already embraced the opportunity presented by private markets. By contrast, retail investors are at an early stage of participation. This includes both the size of allocations within overall portfolios, as well as the sophistication of available solutions. For instance, many retail investors active in real estate and infrastructure participate via REITS or listed funds that provide access via publicly listed securities. The participation of this cohort is expected to grow and evolve over time. We return to this topic in the third installment of this series of papers.

Investing in private market alternatives—the opportunity

Several features motivate investor interest in private market alternatives. These include enhanced expected return and income, enhanced diversification, and volatility and tail risk hedging.

Enhanced expected return

At the core of the investment case for private market alternatives is the opportunity to enhance expected returns.¹¹ This opportunity arises from a willingness to forego liquidity and to participate in niche, emerging or segmented markets and sectors. Here, information asymmetries, frictions and heterogeneities are relatively persistent, complexity and transaction and search costs are high, and competition is scarcer. All these facets enable investors with skill, and often scale, to prosper.

The 2022 equity market and 2020-2022 fixed-income market corrections have rendered this motivation a little less urgent, as long-term hypothetical expected returns to traditional public market solutions have improved. But it remains a truism that investors prefer more expected return to less, for a given level of risk. Allocating to private markets may provide this enhancement.

Diversification

Private market alternatives can provide diversification through two routes. First, by allowing investors access to opportunities, and risks, not available from traditional public market vehicles. For instance, private commercial mortgages and private infrastructure debt provide different sources of risk and return relative to an investment in developed

market sovereign or corporate bonds. Similarly, an allocation to a merger arbitrage hedge fund strategy will provide exposure to a different set of risks than a long-only large cap equity fund. Combining complementary risks in a portfolio provides greater breadth and diversification, and enhances expected performance.

Traditional balanced portfolios often exhibit concentrated exposures to growth and inflation risks, performing well when economic growth is robust, and less well in periods when the economy is relatively moribund. Adding an eclectic mix of alternatives, including private market solutions, can help smooth out this performance profile, making portfolios more resilient to the economic cycle, and concurrently enhancing expected return.

The second source of diversification comes from artificial return smoothing associated with private market alternatives. This smoothing reflects irregular marking-to-market of fund net asset values (NAV), due to the illiquidity of underlying investments. It allows valuation methodologies to look through market volatility and concentrate upon the long-term fundamentals driving expected future cash flows. The voting machine of the public markets is replaced by the weighing machine of a private valuation process

Return smoothing is valued by many investors. It eliminates excessive volatility observed in the public equity markets over short to intermediate investment horizons. It reduces pension plan funding and contribution rate volatility, and minimizes the extent of reported losses during equity market stress for all investors. It also minimizes the risk of ill-timed asset allocation switches during periods of market downturn. These switches often lead to long-term underperformance relative to a portfolio that remains fully invested (the so-called investor gap).

Return smoothing comes at a price. This includes a reduction in the magnitude of any expected return premium from allocating to alternatives; investors have to pay for the ability to look through market volatility. Smoothing may also obscure the true risk of an investment, which presents measurement challenges and has the potential to breed investor complacency. To emphasize this point, the technology sector has been particularly adversely impacted at times during the 2022 public market equity correction. This sector often has a high weight within private equity funds. While the valuation sentiment of the public market may ultimately prove to be too short-term focused, private equity might not be immune to the market correction, if the speculation of perceived fundamental challenges becomes a reality in underlying businesses. This applies to other private market alternatives, too. It is difficult to consistently make wine from water.

Volatility management and tail hedging

Private market alternatives are expected to help smooth the profile of portfolio returns. This smoothing results partly from valuation methodologies, as discussed above. It also comes from accessing strategies more adept at mitigating the impact of specific risks. These risks include periods of heightened inflation and inflation uncertainty, as well as recession and equity drawdown risk. For instance, floating rates offered by some segments of private credit, inflation-indexed rental income in real estate, and contractual agreements offered by many infrastructure assets mean that all these asset classes represent attractive fundamental hedges against inflation.

Risk mitigation through a combination of diversification and tail risk hedging is often considered the primary purpose of an allocation to hedge funds. There are many hedge fund strategies to select from. Some are relatively narrow and exploit a specific risk; for instance, short-bias funds designed to profit during periods of equity market drawdowns. Others are broad and expect to deliver relatively consistent returns that exhibit low correlation to both public equity and fixed income. Examples include macro, multi-strategy, and hedge fund of funds. And managed futures implement processes designed to exploit trends and have often been effective at hedging tail risk during periods of equity and fixed income market drawdowns.

Investing in private market alternatives—the risks

Not all alternatives diversify risks inherent in public market exposure

Some private market alternatives load on risk factors similar to traditional public market solutions. For instance, within private equity, venture capital exhibits evidence of a positive exposure to the size risk factor similar to small cap public equity. Buyout strategies often exhibit a positive loading on value.¹² These risk exposures mean there is often substantial overlap between traditional public solutions and private market alternatives in terms of the sources of value-added that both offer to investors.¹³

The magnitude of expected value added may well be persistently higher in private markets than public market equivalents, at least for top quartile managers, but investors have to ensure they understand the source of the risk, and the reason why it merits inclusion in their portfolio. Only those asset classes and strategies that have fundamentally distinct sources of value creation, and therefore risks, offer true diversification.

Valuations

Given a variety of factors including accommodative monetary policy, many private market alternatives have relatively high valuations, similar to traditional public assets. This means that future return expectations are lower than the historical performance investors have become accustomed to, including from top-quartile private managers. As Treon (2022) highlights, strong market growth and fundraising are a double-edged sword: with dry powder reaching a record high in 2021, managers across private markets are under pressure to allocate this capital at valuations that may be excessive. This makes future returns more challenging

It is also important to understand how private alternative managers calculate fund valuations, given that many holdings are illiquid. One of the key priorities in manager research is to ascertain whether valuation processes are sensible and consistently applied, and subject to third-party validation.

Performance dispersion and persistence

The range of historical performance outcomes is wider for private market alternatives than for traditional public market investments. The persistence of manager performance is also often lower. Both facets again place a premium on rigorous manager research and selection.

Illiquidity and leverage

Many investors are willing to accept exposure to illiquidity risk since it is associated with a positive premium. Illiquid assets typically trade at a discount to compensate investors who forego the convenience of liquidity. For other investors, liquidity continues to be a concern, and this cohort is looking for better tools to understand, evaluate, and mitigate this risk.¹⁴ Whatever an individual investor’s attitude towards illiquidity, it is important to size this risk appropriately, to complement other features of investor portfolios. Replacing one concentrated risk with another is typically not an optimal strategy.

Most alternatives utilize at least some leverage. Liquid alternatives are limited by regulation in Canada to using leverage equivalent to no more than three times their fund’s NAV. In addition, this leverage is often created by the use of derivatives to implement positions. For instance, forward currency contracts require only a fractional initial margin payment.

This level of leverage is relatively benign compared with balance sheet leverage used in private market alternatives. Here, funds often borrow to invest and boost expected returns. The amount of leverage inherent in private alternatives can be relatively high, occasionally reaching levels perhaps indicative of excessive risk-taking. In an environment of rising interest rates, leverage itself becomes more risky. Along with non-traditional product structures and fee opacity, the use of leverage will be an important limiting factor for some investors on the extent of their participation in private market alternatives.

Artificial return smoothing and risk measurement

It is important to be clear as to what we mean by risk in private markets. As discussed above, in many cases returns to private market alternatives are artificially smoothed, reflecting irregular marking-to-market of fund NAVs. This smoothing alters the profile and volatility of returns—and therefore their fit within a portfolio—and can encourage a false sense of security during periods of generalized market drawdowns. It requires investors to broaden their definition of risk beyond a common reliance upon standard deviation, and pay attention to risk metrics such value at risk, leverage, cashflow, and liquidity to adequately assess the risks in their portfolio.

Manager specific investment, operational, and organizational risks

Given the reliance on specialized managers to access alternative return streams, manager-specific risks are a key source of risk in the private markets. We dedicate the second installment in this series of papers to a discussion of issues related to this topic, including the CIBC Asset Management manager research framework.

Conclusion: Take a team approach to private alternative investing

In this paper, we have attempted to provide a balanced view of the unique benefits and risks of private market alternative investing. Ultimately, we consider the potential benefits to be very attractive. Many of the risks can be mitigated with a professionally managed support system around asset allocation, as well as by diversifying types of alternatives, and by utilizing manager research to help investors govern the controllable elements of private market investing.

Equally important is ongoing access to experts who can provide context and updates to respond to ever-changing market dynamics. Sophisticated institutional investors have been able to meaningfully enhance portfolio performance with this approach. With over 50 years of history and resources designed to bring this ecosystem to intermediaries, CIBC Asset Management is a great alternative for alternatives.

To learn more about private market alternative investment solutions, please contact your advisor at CIBC Private Wealth