Many investors today are talking today about the massive disparity between stock prices and fundamentals. To paraphrase Jeremy Grantham, we now find ourselves in the top 1% of stock market valuations and the bottom 1% of economic outcomes. With the stock market volatility starting to rattle investors and the bond markets poised for declines when interest rates rise, investors are looking increasingly towards non-correlated alternative asset classes. According to a recent survey from the research firm Peltz International, alternative investments made up the biggest part and were the best-performing asset class for a typical family office portfolio in 2018. The objective of creating a diversified portfolio of alternative investments would be to have returns remain positive during a future market downturn, a possibility given the recent industry predictions:
- At a recent Milken Global Institute Conference, asset management experts suggested “The 60/40 portfolio is largely a relic of the past, with alternatives likely to become a bigger portion of investors’ portfolios over the next decade”.
- Jeremy Grantham’s GMO suggested they are advising all out clients to invest as differently as they can from the conventional 60% stock/40% bond mix, just as they did in 1999. They forecast US Large Cap Equities will return -6.6% on average over the next 7 years.
- David Rosenberg, former chief economist at Merrill Lynch, has recently suggested “What makes the most sense in this era of financial engineering and central bank manipulation is to shift the portfolio to real or tangible assets that spin off a reliable cash flow stream”.
- Morgan Stanley Wealth Management predicted 60/40 will return 2.8% over the next 10 years in Nov. 2019 when the market was lower than today.
- Research Affiliates forecasts -0.4% over ten years for a 60/40 portfolio.
- Bank of America reports "The End of 60/40" confirms that the historical role bonds have played as a hedge to equities is coming to an end.
- Citibank Chief Economist: “There is a 100% historical probability of down markets in the next 12 months at current levels".
- John Hussman (Hussman Funds): “I continue to expect a loss in the S&P 500 on the order of 65-70% over the completion of the current market cycle”
Traditionally investors have allocated to hedge funds for their alternative’s exposure, yet these did poorly in 2008 and lackluster since. Amadeus Wealth Alternatives has conducted due diligence on a number of alternative asset classes and recommend investors consider the following:
Private debt, private equity and real estate on a primary and secondary basis, promissory notes, equipment and aircraft leasing, direct and co-investments, venture investing, energy, options trading (to hedge long positions), multi-alternative, GP (General Partner) interests, litigation finance, mineral royalties, and other special situations* Let’s review these categories.
A discussion of private debt can begin with business development companies. Recognizing the important contribution that small and middle market businesses make to the American economy, Congress passed the Small Business Investment Act in 1980 to allow for an increased flow of capital to privately owned U.S. companies. The result was the formation of Business Development Companies or BDCs. BDCs are investment vehicles that allow investors to pool capital in a tax advantaged manner in order to invest in the debt and equity of privately held American businesses. BDCs are exempt from all entity level taxation as long as certain regulatory and IRS guidelines are met. They must distribute 90% of their income and capital gains to their investors. They can be publicly traded in the form of mutual funds, or interval funds, as well as in non-traded form. They typically pay between 8% and 9% and at some point in the life cycle, the non-traded funds undergo a liquidity event, at which time you can liquidate or continue to receive the coupon.
Another form of private debt is available via Small Business Investment Companies or SBICs. These funds are privately-owned investment companies that have a license with the Small Business Association, the SBA. SBICs supply small businesses with financing in both the equity and debt arenas. They provide a viable alternative to venture capital firms for many small enterprises seeking startup capital. Typically, these funds raise between $50 and $100 million from private investors and they are then allowed to borrow a multiple of this amount from the SBA. The interest the SBA charges on these loans are relatively low compared to what the funds subsequently charge borrowers and this turn of leverage has allowed them to pay investors between 8% and 12%. These funds often have a “hurdle” or “preferred return” which is the return the sponsor must pay to the limited partners before they can take any of their profits. The preferred return is often 8%.
Other private debt funds, frequently referred to as mezzanine or ‘mezz’ funds represent a hybrid form of debt which is subordinated to another debt issue from the same issuer. Mezzanine debt often has embedded equity instruments, usually warrants, attached, which increase the value of the subordinated debt and allows for greater flexibility when dealing with bondholders. Mezzanine debt is frequently associated with acquisitions and buyouts, where it may be used to prioritize new owners ahead of existing owners in case of bankruptcy. Some examples of embedded options include stock call options, rights and warrants. These funds have been able to generate returns between 10% and 20%, the latter occurring when warrants have played a role.
Real Estate Investment Trusts (REITs) are an excellent diversifier. Equity REITs invest in and own properties. Their revenues come principally from the properties' rents. Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate or purchase existing mortgages or mortgage-backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans. Hybrid REITs combine the investment strategies of equity REITs and mortgage REITs by investing in both properties and mortgages. We prefer registered but non-traded REITs. Why non-traded? If you study the price behavior of the REIT ETFs (exchange traded funds), you’ll discover they are highly correlated with the S&P 500. Since our objective is to find non-correlated return streams, the non-traded structure is preferable. REITs can be well diversified or concentrated in certain sectors. In addition to well-diversified national portfolios, you can find portfolios concentrating in health care properties, shopping malls, residential, global, industrial, and even New York City real estate. The non-traded REITs also frequently have liquidity events after the fund becomes fully subscribed and closes, allowing for an exit if you so desire.
Another popular real estate investment is multi-family housing. Here a sponsor can either construct a new development or buy an existing one. The latter is often done as a “value-add” project, one where an older, perhaps poorly maintained property is acquired and then renovated, allowing for price appreciation. Rental income is often distributed, and the better sponsors can generate cash on cash returns of 9% or higher and upon sale of the property achieve an IRR in the high teens or even ‘20s.
There is also the availability of real estate secondary funds. These will acquire a diversified portfolio of mature, high quality real estate limited partnerships, often with a 10-20% discount to NAV in the secondary market. Today they might be focused on funds with 2015 to 2018 vintages (the years the funds were established and bought properties) since these will have previously gone through the real estate risks such as leasing, financing and development associated with primary funds. These funds can invest globally, often have a preferred return of 8% and a target net IRR of 15%.
Private Equity (PE) is a popular alternative investment. In the private equity market, you can purchase an interest in a privately held company. As you’d suspect, these investments have much less liquidity than more traditional investments. The cash flows associated with these investments are typically described by the so called “J-Curve”, where a portfolio is constructed in years 1-5, improvements to the companies are made and debt paid down in years 3-7, and companies are sold in years 5-10. In addition, after market declines, institutional investors sometimes end the year with too high an allocation to private equity given their target allocations. Many of these institutions will sell their private equity interests into a secondary market created for purchasing these illiquid partnerships. Secondary Funds may have outsized returns because they’re buying further into the J-Curve, reducing the holding period and bypassing the early years’ negative returns. These funds often have an 8% preferred return.
The “preferred return” or "hurdle rate" (“Pref”) is a term used in the private fund world. It refers to the threshold return that the Limited Partners of a fund must receive, prior to the General Partner receiving its share of profits, often referred to as carried interest or "carry." The former is often 8% and the latter 20%. The so-called “2 & 20” fee structure consists of an annual 2% management as well as the 20% carried interest. Occasionally a fund will offer a higher Pref; 10%, 12% or even 15%, as an incentive for investors to participate in the early phase of a fund’s life.
Private equity firms sometimes offer co-investment opportunities. A co-investment strategy generally entails the construction of a portfolio of private equity investments made alongside, or “co-invested” with equity sponsors or funds. Because a co-investor is making a direct investment into a targeted portfolio company, the investor generally does not pay the management fees or carried interest that would be required if it had indirectly invested in a portfolio company as a limited partner. If a fund has an existing portfolio company which requires another round of capital, but the Fund is fully committed or if a new acquisition opportunity arises which is too large a commitment for one fund, a co-investment opportunity can occur, otherwise the private equity fund manager may either have to pass on the investment opportunity. Co-investments can be offered by PE funds or by funds which invest exclusively in co-investments.
Venture investing will target newly formed companies. After “friends and family” invest, angel investors, high net worth individuals, often invest in venture. If company makes it past this stage and appears like it may be on a path to eventual profitability, the institutional investor will get involved. These rounds of fund raising are given letter designations, the ‘A’, ‘B’, ‘C’, etc. rounds and are often invested in by venture capital funds.
Some funds will target specific rounds, an A round fund for example, while others specifically target late stage venture, a few years ahead of the IPO. Venture funds often target IRRs above 20%.
Equipment leasing funds will invest in revenue producing equipment that is essential for businesses to conduct their operations. The equipment will have substantial economic lives. They may also finance infrastructure and energy projects. The investments can include equipment leases, participation agreements, residual sharing agreements, project financings and vendor and rental programs. In many cases, they hold title to or have a controlling position in the equipment. These funds focus on equipment needed in a number of fields including: agricultural, medical, manufacturing, technological, transportation, energy, environmental, infrastructure and others and typically pay 7% accompanied by an 8% preferred return. The Funds can operate globally. They typically raise funds over the first two years, operate the program in years 1-4 and then liquidate the portfolio over years 4-7, aiming to have a majority of investor money returned by year five.
Aircraft leasing funds build a portfolio of approximately 30 to 50 mid-life aircraft. They typically build the Fund’s portfolio through acquiring multi-aircraft portfolios with less than 5 years in lease terms remaining and execute sale-leaseback transactions with the airlines. The investment strategy is built on the premise of leasing aircraft to their break-up metal values, where an aircraft’s airframe and engines are monetized separately. These Funds invest in commercial aircraft, engines and related assets that produce attractive returns.
In addition to mutual funds, ETFs and individual equities, there are a number of alternatives available that provide more direct exposure to the energy markets. Limited partnerships, working interests, master limited partnerships (MLPs) and unit investment trusts (UITs) all provide pass-through treatment of both income and deductions derived from oil and gas investments at the wellhead. You can participate in the industry up, mid or downstream. Upstream operations deal primarily with the exploration stages of the oil and gas industry. Midstream activities include the processing, storing, transporting and marketing of oil, natural gas and natural gas liquids. Midstream is represented by the oil and gas operations that take place after the production phase, through to the point of sale. Downstream operations can include refining crude oil and distributing the by-products down to the retail level.
We prefer funds that diversity across many of these categories, combining riskier aspects with more conservative. For example, a fund could develop a diversified portfolio of mezzanine capital investments (thereby combining features of the private debt space), along with investments in independent producers, acquiring high quality long-lived oil and natural gas assets, financing and/or investing in midstream assets. These managers can also participate in oil and gas exploitation and development projects. Funds typically offer an 8% preferred return and a target IRR in the high teens.
You may also be interested in the tax benefits associated with oil and gas drilling partnerships. These deductions typically include both Tangible and Intangible drilling costs (75%-85%) and a depletion allowance (15%) on a portion of the income received from the partnership wells. Limited Partner interests are typically used by investors seeking to offset a portion of their Passive Income. If you invest through an entity that limits your liability, then your investment is considered passive. The character of losses for Limited Partner investors are such that the losses passed through from the K-1 can only offset Passive Income from another source or be carried forward indefinitely to offset income from the program in future years. However, you can also elect to invest in a Partnership as an investor General Partner for the tax benefits instead of as a Limited Partner. If you do, you will have unlimited liability for the Partnership’s activities until you are converted to Limited Partner status, however the character of losses for General Partner investors are such that the losses described above (intangible/tangible/depletion) can offset Active Income reported on a tax return (wages, interest dividends, capital gain, other income, etc.) and as such act as if they were a tax credit. The oil and gas exploration and transmission industries are speculative, heavily regulated and involve a significant degree of risk so a thorough due diligence process is recommended.
Investments in various oil and gas mineral rights are also referred to as oil and gas royalty interests. In the United States, sub-surface minerals are usually privately owned. The right to develop these minerals are leased to oil & gas firms for a one-time up front “lease bonus” payment, as well as a share in the future revenue from oil and gas production. U.S. property laws are unique in the world in that they allow private citizens to share the revenue generated from extracting natural resources from the earth. Energy firms will typically pay mineral rights owners approximately 12.5% to 25% of the net revenue generated by wells on their acreage and these income streams are frequently sold to funds you can invest in. Distributions are targeted in the 5-7% range and IRRs in the high teens to 20s.
Intellectual Property (IP) funds will acquire the IP of retail and consumer brands, license out the brand to licensees and collect royalty payments in return. These funds target investments with equity-like return potential with a high current yield, hoping to increase the intellectual property's valuation as well as provide downside protection through guaranteed minimum royalty payments. The intellectual property acquired include trademarks, patents and copyrights in targeted sectors including apparel, accessories, health & beauty, electronics, housewares, food & beverage and entertainment. Such a fund would enter into licensing agreements with retailers and wholesale licensees who pay royalties and related income and fees for the right to use the IP owned by the fund.
Litigation finance funds will provide asset-backed capital investments into mature litigation cases where there is established liability of the defendant and precedent regarding settlement. They invest in recourse and non-recourse advances to fund the following: commercial litigation or arbitration proceedings, enforcement of judgments and awards, and recovery of misappropriated assets; debtor-in-possession matters; and cases or portfolios of cases from certain law firms throughout the United States supported by personal injury, wrongful death, medical malpractice, mass tort, class action, and other similar cases, whether those cases are settled, in settlement discussions, in court, or have jury verdicts (on appeal or not), and whether they involve one or more jurisdictions, class actions, or other circumstances. Target returns are in the high teens.
While we are not disenamored of hedge funds, many have underperformed since the market declines in 2008. Generally, we recommend you considered smaller funds that specialize in a sector, a long/short health care fund for example, or funds that are more broadly diversified in less trafficked asset classes. Global macro funds offer an ability to capture this diversity. Funds to consider might invest in equities, currencies, commodities and debt in developed, emerging and frontier markets. They can invest long/short, in event driven trades, in IPOs as well as other strategies. Fund of funds can also be considered.
Promissory Notes can be a good investment. One fund we recommend makes loans to US government contractors. What better collateral for a private loan than the Fed! These can generate a 9 or 10% return for a 3-year note.
Finally, there are a number of very unique funds that acquire a minority interest in private equity funds, enabling the limited partners to participate in the general partner’s 2% & 20% fee structure.
Here is a summary of common terms related to alternative investments:
- 2&20: Private funds often charge a 2% management fee and take 20% of the profits, often called the “carried interest” or “carry”.
- 40 Act:The securities act of 1940. We use the term to describe alternative investments which are registered with the SEC. They often have quarterly liquidity because they come in the form of an Interval Fund or BDC and can be custodied at a brokerage house.
- Asset Class: Broad category of investments. Alternative asset classes include:Private debt, private equity and real estate on a primary and secondary basis, promissory notes, equipment and aircraft leasing, direct and co-investments, venture investing, energy, options trading, multi-alternative, GP (General Partner) interests, litigation finance, mineral royalties, and other special situations.
- BDC: A business development company is a fund that invests in small and medium-sized companies as well as distressed companies. A BDC helps the small and medium-sized firms grow in the initial stages of their development. With distressed businesses, the BDC helps the companies regain sound financial footing. Set up similarly to closed-end fund, , many BDCs are typically public companies whose shares trade on major stock exchanges however they can be illiquid as well.
- Capital Calls: Many private funds frequently ask investors to send the commitment they’ve made to the fund over a period of years, ranging from all at once to up to 4-5 years.
- Co-investment: Where a private equity fund offers investors the opportunity to invest alongside the fund in a company they are acquiring, or lending to, but not through the fund, rather, as a direct investment, so often no fund level fees apply, like the 2&20 for example.
- Correlation:Refers to the behavior or one security or class of securities to another. If Stock A goes up 10% and stock B does the same, they are perfectly correlated and behave the same, a 100% correlation. If Stock A goes up 10% and Stock B goes down 10%, they are perfectly negatively correlated, so they do the opposite. Correlations range from -1 to +1, with a zero representing no correlation. The more non-correlated investments you have in a portfolio, the less volatile it will be. Alternative investments have low correlation to the stock market.
- Illiquidity Premium: Investors of illiquid assets require compensation for the added risk of investing their funds in assets that may not be able to be sold for an extended period. Accordingly, illiquid investments can have higher returns than liquid ones over similar time horizons.
- Interval Fund: An intervalfund is a type of pooled investment vehicle similar to a mutual fund that allows the issuer to repurchase fund shares from its shareholders at certain points in time, or intervals, allowing the investor to sell an otherwise illiquid investment, usually on a quarterly basis.
- J-Curve: The early years of a private equity investment are often negative, so the shape of the investment return looks like the letter “J”. A fund will acquire companies in years 1-3 of the fund’s life, improve them in years 4-7 and sell them in years 5-10, so the investor’s profits don’t materialize until later on. Meanwhile the 2% management fee is charged every year, so the returns are negative early on.
- Opportunity Zone: A Qualified OpportunityZone (QOZ) is an economically distressed community where private investments, under certain conditions, may be eligible for capital gain tax incentives, in particular, the deferral of capital gains until 2026. Opportunity Zones were created under the 2017 Tax Cuts and Jobs Act , signed into law by President Donald J. Trump on December 22, 2017, to stimulate economic development and job.
- Options:Options can be a CALL or a PUT. A CALL is a right to buy a security at a specific price and a PUT is a right to SELL. CALLs go up in value if the associated stock price rises and PUTs go up in value if they fall, similar to going “short”. Combinations of options in a “spread” are often used to hedge stock exposure in anticipation of a market decline.
- Private Debt: Like a private equity fund but using debt. A private debt fund will make loans to private companies.
- Preferred Return: Often 8%, although sometimes higher or lower, which the limited partner (LP) investor must earn before the general partner (GP) can take their carried interest.
- SBIC:A small business investment company is a type of privately-owned investment company that is licensed by the Small Business Administration (SBA). They have the potential to outperform owing to the leverage associated with the low interest loan the SBA provides to the fund.
- Secondary Investments: The purchase of a limited partnership from an investor who bought it years ago. For example, if the Yale University Endowment invested in a private equity fund years ago, and then decided they wanted to sell it today, how do they accomplish this given the fact the fund requires a ten-year commitment and is illiquid? There is a secondary market for these interests and many funds are established for the very purpose of buying these illiquid shares.
- Standard Deviation: a measure of the volatility of data including a portfolio’s return. It measures the extent to which returns vary above and below its average 68% of the time (one standard deviation) and 95% of the time (2 standard deviations). Given two portfolios with the same average return, the less volatile it is, the higher the value over time.
- UBTI:Unrelated business taxable income is income earned by a tax-exempt entity, such as an IRA, that is not related to the exempt purpose of the tax-exempt entity, thereby causing the IRA to have taxable income. This tax can be avoided by investing in an offshore vehicle sometimes offered by private funds since the offshore entity can block the UBTI.
- Waterfall:In the traditional waterfall structure, the GP receives carried interest after the invested capital and preferred returns have been paid back. This assures the GP will receive its carry early in the life of the fund. However, in the "European style" waterfall, GPs must pay back the invested capital on the investments liquidated as well as the invested capital on investments that have not been sold yet. This precludes the carry from being paid to the GP until the later years of the fund when all invested capital has been repaid back first.
- Warrants:Warrants are a derivative that give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration. They are sometimes issued to debt funds alongside their loans to private companies so the fund can participate in the appreciation of the company’s private stock.
While historically made available only to institutional investors, Amadeus Wealth Alternatives has access to these funds at lower minimums for individual investors. Please do not hesitate to contact us at 212-697-330 should you wish to discuss investing in any of these alternatives. Our opinions are subject to change without notice and are not intended as investment advice or a solicitation for the purchase or sale of any investment or security. Please consult your financial professional before making any investment decision.
*Potential investors should be aware that an investment in Limited Partnerships involves a significant degree of risk and, therefore, should be undertaken only by investors capable of evaluating the risks of a Fund and bearing the risks they represent. In addition, there may be occasions when the Principals, General Partner, Advisor, Sub-Advisor and their respective affiliates may encounter actual and potential conflicts of interest with respect to a Fund. Prospective investors in a Fund should carefully read the Risks Section of the Private Placement Memorandum for each fund and consider the information discussed therein which enumerates certain material risk factors and conflicts with respect to the Fund. If any of the events discussed in these sections occur, the Fund’s business, financial condition, results of operations and prospects could be materially adversely affected. In such case, performance could decline, the Fund’s ability to achieve its investment objective could be negatively impacted and investors may lose all or part of their investment.