Alternatives Without Barriers

The “search for yield” has brought various alternative assets to the forefront of many investors’ set of investment choices.

There is a large body of research making the case for investing into a range of alternative assets (see accompanying article by Joao Frasco on page four). This view is emphasized in the current economic environment where investors worldwide hold muted return expectations from traditional assets.  The resulting “search for yield” has brought various alternative assets to the forefront of many investors’ set of investment choices.

In line with these sentiments, offshore investors have been increasing their allocation to alternative assets, particularly over the last three to five years.  In most cases the allocation has delivered a good result.

Yet, for most retail investors and many South African institutions, while the case for investing may be clear, allocating their investable assets to the alternative asset classes remains off-limits.

So why is that? Many factors are contributing to an environment where access to what should be a sought-after asset class is hindered. Let’s take a closer look.

Minimum investment size

Private equity funds typically have minimum investment sizes of R50 million or more. This is a clear disqualifier for many investors.

Illiquidity

Many alternative assets have lock-up periods of ten or more years. Even though most long-term investors should be able to wait this out, much can change in ten years resulting in the potential need to withdraw from the investment. The lack of a deep secondary market means that investors often have to sell out at a discounted price.

Furthermore, funding the investment is not discrete. Private equity and other funds often require a commitment of capital from the investor, which is called on and invested as and when the fund manager makes an investment for the fund. When the underlying investments are disposed of, cash is gradually returned to the investor (see graph below). This places a liquidity management burden on the investor – something most investors are ill-equipped to manage.

Simply sitting on enough cash to ensure that capital calls can be met is a rather blunt tool and can result in a significant performance drag. An ideal situation would be to have ten different private equity funds, each at a different stage of their life – this is referred to as ‘vintage diversification’. That way the cash distributions coming from the older funds can be used to fund the cash drawdowns from the newer funds. The result is that the portfolio remains more ‘invested’.

Complexity

Some alternative assets are complex in nature. Many investors will not have the required expertise to feel comfortable selecting different kinds of alternative assets. Even once the asset category has been selected (e.g. private equity versus hedge funds), selecting the manager is not only difficult but also extremely important due to the increased dispersion of returns between different managers. This dispersion is illustrated in the chart below, showing that the difference between the top quartile and bottom quartile private equity funds have historically been twice as large as the difference between the top and bottom quartile listed equity funds. The same applies to most alternative assets.

Fees

Alternative assets are perceived and often criticized for being expensive. Many good arguments are made in defence of the fee structures, yet this remains a deterrent for many investors, particularly those who do not appreciate the complexity and the return profile expectation.

It is important to not only consider the explicit fees, but also the implicit fees as there are various frictional costs involved. These include legal fees for the contracting process, specialised advice fees and the ongoing governance costs.

Fee structures also tend to create a conflict of interest whereby the fund manager participates in the upside via a form of performance fees (referred to as ‘carried interest’ in the case of private equity funds), but not the downside. Not only does this incentivise excessive risk taking, but it can also result in orphan or ‘zombie’ funds where the fund manager disregards the fund when it becomes clear that the fund performance is so weak that there is no hope of receiving any performance fees.

Governance burden

Monitoring and evalutaing alternative asset performance, especially in contrast to traditional assets and within the context of a portfolio, is onerous. Typical examples of challenges that investors are presented will include:

  • Infrequent valuations that are based on subjective models rather than prices observed from market transactions.
  • Delayed redemptions requiring the investor to wait longer than anticipated to get his money out.
  • Portfolio companies experiencing headwinds to the point where they are either written off or require additional capital injections.
  • Fund manager failures that may require investors to jointly appoint a new fund manager to take over management (or at least phased liquidation) of the fund’s assets. Examples could be as innocent as the loss of key persons through to fraudulent activity which is hard to uncover.

This results in the investments taking up a disproportionate amount of airtime in the boardroom. It also tends to require that investors participate in oversight of fund activities via a seat on an advisory board.

Lack of transparency

The perception of opaque and complex structures sits in the minds of many investors and is an immediate deterrent. However, disclosure and transparency in the industry has improved markedly over time. In the early days of alternative asset funds (particularly hedge funds) investors had very little insight into the underlying holdings and risk exposure. The resulting risk (market, fraud, etc.) materialised in well publicised cases. Thanks to customer demand and regulatory development, this has greatly improved and fund managers are providing clear and concise information to investors.

Maturity of our market

Whilst South Africa has an excellent financial market system, our private capital market is well behind that of developed markets. This limits the number of private transactions and credible fund managers.

Ironically the inverse holds for the rest of the continent – their capital markets tend to be less developed which places more reliance on private markets to gain access to many of the attractive investment opportunities.

Regulatory environment

Policymakers recognised the inherent value presented by alternative assets which resulted in Regulation 28 (governing pension fund investments) making allowance for meaningful allocations to alternative assets.

Implementation has however proven problematic. Despite breakthrough hedge fund regulations being released recently, collective investment schemes are still not allowed to invest in these new fund structures. Private investments tend to make use of partnership structures which are onerous to administer, largely unregulated and not suitable for inclusion into collective investment schemes. The implication is that the bulk of the savings industry can simply not participate in the alternative asset market. So unless you have a large enough chequebook to make segregated investments, the only choice is to invest via a policy of insurance with one of the life companies.

Overcoming the barriers

Listing a fund of private assets is a popular route to overcoming the barriers of liquidity and transparency highlighted above. The best example of this in the South African market is commercial real estate which was popularised through the growth in the listed property market. Infrastructure intuitively lends itself to this model but efficient tax legislation does not yet exist to enable the growth of such a sector on the JSE. There is also a growth in listed Special Purpose Acquisition Companies (SPAC’s) which presents an alternative to private equity funds. Listing does however introduce unwanted volatility and “short-termism”.

Pooling is another effective solution to overcoming the minimum investment size barrier as it involves multiple investors combining their funds to invest in a homogenous collection of investments. Appointing a professional to manage the pool of investments further helps to overcome the complexity and governance barriers. The additional layer of fees introduced is the most common objection to this model, but the economies of scale achieved could more than offset the additional costs. Pooled vehicles are however yet to find innovative ways of providing liquidity to customers.

What the market needs is an investment vehicle that overcomes all the barriers highlighted above without sacrificing the unique benefits that alternative assets are known for. This is not only essential to allow the broader savings community to participate in this category of investments, but it is also critical for the development and prosperity of our country. Most of the capital funding the growth of small-to-medium enterprises and the capital supplementing our country’s infrastructure needs, like roads and energy supply, is coming from alternative asset funds.

Conclusion

Alternative assets present many benefits for longer term investors, yet they are notoriously difficult for many of these investors to access. Barriers to investing include large minimum investment sizes, liquidity constraints and high fees. These investments also tend to lack sufficient transparency and are very complex which increases the governance burden for investors. 

Our market is maturing and the regulatory environment is evolving to support the growth of the alternatives market. The onus rests on the financial services providers to make these attractive investments more accessible to the investor community at large.

This can be achieved through pooling vehicles which create the necessary scale and professionalism whilst retaining the unique attributes of private investments. Another solution is listing alternative investments that were previously not available on exchanges. Both avenues help to channel capital to the enterprises that form the bedrock of our economy whilst offering attractive reward to investors.

Our market is maturing and the regulatory environment is evolving to support the growth of the alternatives market. The onus rests on the financial services providers to make these attractive investments more accessible to the investor community at large.

By Chris Roelofse,

Alternative Assets Portfolio Manager,
STANLIB Multi-Manager