| Summary: Many US investors caught up with illiquid assets during the GFC – such as private equity holdings and property – have been scared off. But experts believe that the fear of illiquidity is overblown, and now is a good time to buy alternatives. |
| Key take-out: Before locking your money up for 10 years or so, do the necessary due diligence to select the right manager. |
| Key beneficiaries: General investors. Category: Investment strategy. |
The next big investment opportunity might not be stocks. Citi Private Bank’s chief investment officer, Steven Wieting, says that post-financial crisis investors have accepted that the world isn’t ending but still crave investments that can be exited quickly.
Patient investors with a longer time horizon can play this lingering anxiety by buying less liquid investment vehicles— like private equity firms and real estate— that are still sitting in the bargain bin. Among the opportunities are European corporate debt and investing in smaller North American energy firms.
With all the noise about folks moving up the risk curve, and the general shift from cash and fixed income to equities, it turns out a good portion of investors globally are still frozen in time. A recent Citi Private Bank survey of 50 family offices from over 20 countries found an average allocation of only 25% to equities and an astonishing 40% in cash.
Poor returns
Unbeknownst to these wealthy investors across the globe, their excessively conservative portfolios produced mediocre results, a paltry 6% return last year compared to the MSCI World Index’s 20.3% return. Citi Private Bank’s gains, for a portfolio with 51% in equities and 5% to cash, came to 11%.
While Wieting is not predicting another equities gusher this year, he still thinks US large-cap equities will grow by an additional 9% to 10%, with dividends reinvested. Generally, however, upward-trending markets like the US and Japan are nearing their historic averages and maturity from a valuation standpoint, he says, while emerging markets remain unattractive.
The commodity super-cycle – that realised 10 years of double-digit annual growth in emerging markets– is coming to an end. European equities are the most attractive of the lot and Citi expects them to grow 13% next year.
The alternatives strategy
But even more opportunities abound for investors willing to man up and brave the illiquidity of alternatives. Wieting estimates that over the next 10 years, private equity and real estate vehicles will produce annualised returns of 11.9%, almost double the 6.7% return he is estimating for developed market large-cap equities.
Why are alternatives so attractive? It’s partially because of post-financial crisis investor psychology, Wieting says. To some extent investors are warming to risk but alternatives remain a no-go zone. “There has been a thawing of risk tolerance,” he explains, “but if you tell investors that we can offer you a higher return – but that we can’t tell you exactly what length of time you need to commit to – there is suddenly much less interest.”
All too familiar in their minds are the precipitous declines from the financial crisis, when most alternative strategies fell in lockstep with the broader market, declining up to 40% in 2009 alone. Unable to exit private equity or certain real estate vehicles due to the five to 10-year lock-ups – or, if so, only at distressed give-away prices – investors couldn’t scramble up the cash they suddenly needed to pay their bills. They never want to experience that again.
Wieting thinks that while this psychology persists, the time to buy alternative investments is now. The fear of illiquidity is overblown, particularly since the economy is chugging along steadily again, and the disconnect means bargains are to be found.
How? Before locking your money up for 10 years or so, do the necessary due diligence to select the right manager. Data from alternatives research and consultancy firm Preqin, suggests that 65% of private equity and real estate funds with top or second quartile performance go on to manage a top or second quartile successor fund. So a strong track record, though not indicative of future returns, is important.
Market opportunities
The next factor to consider is market opportunity. One investment theme Wieting likes is non-performing loans, such as residential and commercial real estate, that are languishing on the balance sheet of European banks.
Wieting also is helping his clients lend directly to Europe’s cash-starved corporations. Euro zone banks are under deeper scrutiny to meet the demands of regulators and capital requirements, and are furiously cutting and pruning their businesses, while generally tidying up their balance sheets. Deustche Bank’s recently reported losses are just the latest chapter entry in this unfolding story.
The thing to bear in mind: Since December 2010, Europe’s 16 largest banks have cut exposure to corporate credit by 9%, or nearly $600 billion, which provides an opening for Citi and other international lenders. More opportunities are coming online. The securitisation products, known as collateralised loan obligations, that allowed the banks to slice-and-dice and offload tranches of European loans, are facing a cutback as well. That reduction in capacity will force yet more limitations on what the European banks can underwrite.
With these methods of financing drying up, liquidity-starved corporations will increasingly turn to private debt managers, who, in turn, will extract attractive terms for clients. Firms like Alcentra, a sub-investment grade debt specialist owned by BNY Mellon, and Marc Lasry’s hedge fund Avenue Capital Group, are among the recent market entrants.
Energy companies
Wieting also has a thesis that takes advantage of the North American energy revolution powered by hydraulic fracking. Wieting thinks the debt of the smaller energy companies, having trouble accessing public capital markets, are attractive holdings. A related and relevant report by PwC, projects that investments in US shale infrastructure alone will require $US5 trillion over the next 20 years.
But caution. There is an entire continuum of risk and return to choose from among these energy companies. Midstream energy transporters are lower risk and yield lower returns, since the business is fee driven via long-term contracts; gas storage companies, meanwhile, are exposed to demand volatility and price swings, hence the heftier payoffs for their investors. The smart money is learning the trade. Earlier this month, the fabled private equity shop KKR opened an office in Canada, announcing it expects to invest between $US500 million and several billion dollars in energy-related companies over the next five years. Early moving competitors, like Arc Financial and Kern Partners, already have billion dollar portfolios in the energy sphere.
Last year, conservative investors finally dipped their toes into the equity markets, some would say a little too late. Folks who are quicker to embrace illiquidity, the next thawing in our post-crisis “normalising” process, should be rewarded for their decision.
This article was first published in Barron's, and is reproduced with permission.
