DFMs enter ‘murky’ private asset territory

But are they setting up investors for a fall?

There has been a fair amount of noise around private assets recently as an increasing number of fund managers have sought to bring such products to the UK wholesale market.

Investment houses are boosting their presence in the private asset space as investors, grappling with increasingly volatile equity and bond markets, seek alternatives.

As reported by Portfolio Adviser earlier this year, Schroders has appointed Georg Wunderlin to the newly created role of global head of private assets. Wunderlin is tasked with developing Schroders’ private asset strategy. Hermes Investment Management has also added private debt expertise to its fixed income team.

Takeup of private assets within the UK wholesale market has been slow, however.

Late last year, M&G revealed it was only halfway to hitting its target for the Credit Income Investment Trust. The fund manager played this down, insisting liquidity constraints made it tricky to deploy large amounts of capital into private credit markets quickly. It subsequently raised a further £25m for the trust.

While institutional investors and pension funds have been using private assets for some time, interest among the wealth management crowd has been relatively slow – but momentum is building.

A growing concern

Low correlation with other asset classes is seen as a key advantage of allocating to private markets, which is important in an environment where the performance and value of traditional asset classes, such as equities and bonds, is under pressure.

Rob Morgan, a Charles Stanley investment analyst, says the low correlation principle does not always apply. “Many private investments don’t actually offer diversification as they may be tied to the same economic or industrial cycle as listed investments.

“That they are less regularly valued shouldn’t hide the fact they are driven by similar factors.”

He says some undoubtedly do offer genuine diversification, however, and are attractive for that reason. They can improve the risk-adjusted returns of a portfolio.

“Direct infrastructure investments would be a good example, and these can provide non-correlated and attractive returns, usually income-driven and often linked to inflation,” he says. “This sort of investment merits a place in many portfolios.”

Craig Cordle, an asset management lawyer at Channel Islands-based law firm Ogier, agrees with Morgan that for private investors looking for somewhere else to put their money besides the bank, private assets can play a key role in portfolio construction.

“Private investors are looking for exposure to investments that have traditionally been out of reach for most,” he says. “Institutional investors and pension funds have been in this space for some time but wealth managers eager to increase their own remuneration have paved the way for their clients to gain access, too.”

Cordle concedes these assets won’t be for everyone. By their nature they may be illiquid, meaning investors could be forced to wait for a long time before they can divest. He does add that a listed vehicle investing in these types of assets can provide the exposure investors want, coupled with liquidity, should they want to sell.

“For ultra-high net-worth investors, risk-adjusted returns are often an added bonus. Their key focus is capital preservation, which is brought into sharp focus with the volatility of equity and bond markets,” he says.

“It’s easy to see why investors are growing their foothold in this area.”

Neil Mumford, a chartered financial planner at Milestone Wealth Management, says that although private assets are not to everyone’s taste, they do offer something different.

He adds a word of warning, however: “Significant expertise is required to understand at a fund level what is being held. This was a factor with the failed Arch Cru funds.” (In 2011, Arch Cru funds spectacularly fell in value after a private equity sell-off.)

Open and shut case

Mumford believes that if held as a small percentage in a multi-asset fund, private assets offer another layer of diversifi cation and return, while other liquid assets help lower the risk and increase liquidity.

He adds that at certain points in the market cycle, private equity assets may not be able to be liquidated at attractive valuations. As a result, he questions if they are appropriate holdings for a pure private equity open-ended fund.

During periods of market stress when valuations are under pressure, a manager could be forced to sell holdings to meet redemptions, inflicting large losses on investors.

Consensus among wealth managers is that they would be highly sceptical of using illiquid assets of any kind to a significant extent in an open-ended fund. The natural investment vehicle for private markets is closed-ended, ie an investment trust.

Mumford names a couple of providers with established multi-asset and equity funds that already run these private asset strategies successfully in their portfolios.

“The RIT Investment Trust has provided investors with very attractive returns,” he says.

“And 3I is one of a number of specialist investment trusts that deals only in private equity investments. The pure trusts are not for the fainthearted so should only be bought as a small holding in client portfolios with a long-term investment horizon.”

Martin Bamford, chartered financial planner at Surrey-based Informed Choice, believes the appeal of private assets is limited and for the majority of investors, particularly those outside the ultra-high net-worth bracket, a no-go area.

“Increasing allocation to private equity is a poor answer to the question of high equity market valuations. These investments are opaque and illiquid, so broadly unsuitable for the vast majority of retail investors.

“There’s no guarantee they would offer negative correlation to publicly traded equities during a period of significant market correction. In fact, investors in private equity could be left sitting on even larger losses.”

Bamford does not subscribe to the diversification argument for holding these alternative asset classes, arguing that investors can get sufficient diversification through the use of mainstream assets.

“Risk management is better achieved through other means, rather than trying to be clever and entering the murky private equity market,” he says.

A ‘murky’ market

While some might agree the private equity market is ‘murky’, there is an argument that for those chasing growth, private assets simply cannot be ignored.

As Morgan points out, investors are concerned that much of the growth of global companies is outside of public markets, believing private markets should be made mainstream, not the preserve of institutional or high net-worth investors.

Today, companies are remaining private for longer or avoiding going public at all. Growth businesses are no longer dependent on public markets and seek out patient investors willing to provide permanent capital, rather than facing the potentially more impatient public investor base.

Morgan says: “Recently listed ‘unicorns’ are a case in point. Such companies are coming to market at a later stage of development than a decade ago, meaning the bulk of investment profits have already been made.

“This is partly down to the proliferation of private money available through venture capitalists, sovereign wealth funds and private equity firms. Many of the recent IPOs are not seeking massive rounds of funding for investment; instead they are providing a route out for people who have already made
a lot of money.”

The real worry is that the breadth of opportunity on public markets is reducing and that growth engines of the ‘new economy’ are becoming harder to access. Once these companies float, the very steep part of the growth trajectory is behind them, certainly in terms of valuation.

Snap and Lyft are clear examples of recent stockmarket launches when the share price was significantly below IPO price.

This is where specialist private equity investments can help ordinary investors. Much of the recent success of popular investment trusts such as Scottish Mortgage and RIT Capital is built on access to private deal flow unavailable to ordinary investors.

Morgan concedes there are challenges. Valuations are not tested by markets, limiting transparency. Costs can be higher due to the structure of the investment deal putting them in line with hedge fund fees. There are also more esoteric areas where the nature of risks can be tricky to understand, such as aircraft leasing and reinsurance . They don’t just involve investment risks but other factors such as running costs, maintenance, resale value and insurance. These types of investment are therefore more complicated and greater due diligence is required.

As Morgan concludes: “If you don’t think you understand it fully, then don’t invest.”

By David Burrows

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