Private-market assets are all the rage, but are they worth the bragging rights?

PRIVATE bankers espoused the value of alternative investments when interest rates were ultra-low some years ago. They continue to push alternatives today when rates have climbed steadily and substantially.

But are alternatives – such as hedge funds, private equity and private debt – all they are cut out to be? How appropriate are they for individuals who qualify as accredited, but whose total portfolio may be far less than US$10 million?

Under Singapore’s rules, those who have net financial assets of at least S$1 million or income of at least S$300,000 in the last 12 months qualify as accredited investors.

Recently, Gerard Lee, retired former chief executive of Lion Global Investors, observed that while people invest sensibly for retirement, they also invest for entertainment.

The irony, he said, is that private banking clients who typically run businesses may be “such good negotiators” in their business dealings. “They negotiate down to the last cent. But when they have a private banking account, they happily pay for the latest structured products – because they’d have bragging rights. And it’s also entertaining.”

Entertainment value aside, recent years when interest rates scraped bottom would have justified some allocation. Private debt, for instance, was regarded as “bond substitutes” as investors stretched for yields.

A recent paper by Laurence Siegel, research director at the CFA Institute Research Foundation, argued that illiquid alternatives are “reasonable” for the ultra-high-net-worth individuals with at least US$30 million, and are “like institutional investors in their skill sets and ability to bear risks”.

But he questioned their suitability for those in the US$1 million to US$10 million range. “In this range, significant capital losses in part of the portfolio can threaten one’s ability to retire.”

Siegel is described as an advocate of the “endowment model”, which invests heavily into alternatives. Yale’s endowment, run by the famed late David Swensen, began in 1989 with three-quarters of its portfolio invested in US stocks, bonds and cash. Today, domestic marketable securities’ share is less than 10 per cent. The lion’s share is in foreign equity, private equity, absolute return strategies and real assets. It boasts a resounding record of long-term outperformance.

Individuals, of course, are nowhere near the scale of institutions such as Yale and the GIC. Still, if you have a private bank account, you are likely to be pitched an allocation into alternatives, ranging from 5 per cent to 15 per cent, or even 20 per cent. Should you consider this?

Here are some reasons for caution.

Look beneath the hood

The historical track record of alternatives looks good. You’ll be presented with various charts which show outperformance and a distinct benefit for your portfolio in enhancing overall return at lower risk. Preqin’s all-hedge-fund benchmark fell 12 per cent on an annualised basis in 2022, compared to a decline of 27 per cent for the traditional 60-40 bond-stock portfolio.

But the broad picture masks many caveats. First, far more than the public markets, alternative investments carry unique risks. There is a greater premium in the skill of the underlying fund manager, and the way the strategies are combined in a multi-strategy fund. You could fare better than a broad market index, but you could also fare worse. An absolute-return orientation does not shield you from losses. In fact, leverage coupled with mistimed bets within the fund could magnify losses.

Two, advice and due diligence are critical in alternative investments, particularly in assets where mark-to-market valuation is infrequent, and there is neither transparency nor liquidity. Large institutions employ teams of people with the depth and breadth of skills to evaluate funds, strategies and managers – for good reason. Individuals don’t have such resources, let alone access to the best funds. They rely on bankers’ recommendations. How thorough is your bank’s due diligence?

Illiquidity and a higher hurdle rate

Illiquidity is one reason that alternative and private-market assets are able to deliver excess returns. The lock-in period allows time for investments to mature and managers need not manage sudden redemption requests.

On the flip side, investors must demand a sufficiently high return to compensate for the illiquidity. But are you compensated adequately for the risks of alternatives today, when you can get an attractive yield in liquid public markets?

This was a relatively easy equation in the years when risk-free rates were nearly zero and inflation was benign. But times have changed. Today, based on Bloomberg indices, corporate debt can fetch 5 per cent and high-yield debt 8.5 per cent.

These hurdle rates are even more pointed when it comes to private debt, where high interest rates plus a recession or stagflationary scenario raise risks for borrowers, who are typically small and mid-sized companies. In private debt, it’s also hard to get a handle on credit quality and default rates.

S&P Global said: “The switch to higher-for-longer rates with elevated inflation and the continued risk of recession raises the spectre of defaults for all borrowers – especially private markets.”

It noted that vintages that deployed capital just before the sharp increase in rates are likely on “shakier footing” than those that invested when rates were higher and multiples were lower. “Higher rates have already added new sources of competition to the private market. Investors may not be so willing to search for yield in the private markets if they can find more liquid and lower credit risk assets that offer an acceptable yield.”

Of course, there are so-called liquid alternatives which package private assets into funds which even offer daily liquidity. But liquidity isn’t assured. In recent months, real estate funds by managers such as Blackstone have resorted to severely limiting redemptions.

And then there are the significantly higher fees of alternative funds, which typically charge a base annual fee and performance fee. A survey by private debt manager Cliffwater on fees and expenses of private funds engaged in direct lending found an average fee for private partnerships of 3.14 per cent. It also found in a separate survey that fees varied widely – between 2.22 per cent (10th percentile) and 4.5 per cent (90th percentile).

I haven’t even touched on the fees of funds of funds yet. And of course bankers are compensated richly for selling alternative funds, compared to the pittance they earn when clients buy and hold bonds.

To be sure, access to alternative assets is relatively easy today if you qualify as an accredited investor.

ADDX has tokenised private assets where the initial investment may be as low as US$10,000. Endowus has also onboarded alternative funds, where the minimum outlay ranges between US$10,000 and US$100,000. The funds are liquid or semi-liquid. The firm charges a platform fee, which is separate from underlying fund fees.

In the end, balance is key. Endowus chief investment officer Samuel Rhee said institutions’ allocations may be as high as 25 per cent. “But theirs is long-term money locked in like an endowment or sovereign wealth fund. We believe individual investors may allocate 5 per cent to 15 per cent, depending on the amount of wealth and risk appetite.”

Illiquidity is a major caveat that people need to grasp. “For closed-end private funds, you are not required to commit your capital upfront, but you need to have money ready when the fund is investing. So you need to manage liquidity even more.”

Siegel’s view is unequivocal. Alternatives, he wrote, are more “fun”. “They make the holder feel sophisticated and special. They foster good conversation at cocktail parties.” A “very modest” allocation can provide those “psychic benefits” without costing the investor much money if returns are bad.

But for investors with a portfolio size of less than US$10 million, advisers should “do everything (they) can to keep the allocation small”, he wrote. “The default allocation should be zero. Any non-zero amount should be the exception, not the rule.”