Feb 2015 by Dan Vene
Andy Rachleff wrote an excellent post on the Wealthfront blog Feb 5th titled “You Can’t Get Access to the Best Alternative Assets.” It is a very interesting post and highlights many truths about investing in alternative assets. So why are we now writing a blog post with the exact opposite title?
Like many financial markets from consumer lending (LendingClub) to funding for startups (Angellist and FundersClub), the alternative asset marketplace is in the midst of a significant evolution. This evolution is being powered by innovative technology that increases access to information, provides tools to analyze performance, and in select circumstances, increases access to institutional quality investment opportunities.
Our post will aim to provide additional perspective on two of Andy’s key points:
1) Higher returns usually require taking on more risk, and
2) Investors cannot access funds managed by high quality alternative asset managers because high quality managers are selective with the investors they choose
1) Return vs. Risk – Are all Asset Classes Created Equal?
Andy makes the statement, “Higher returns usually can only be achieved by taking on more risk.” Let’s examine that statement for a moment. Would this mean that every investor who has produced high returns over time must have taken on higher risk than investors who produced lower returns?
This would seem to discredit all the hard work, analysis and experience of the top ranked investors in every asset class from public markets to private equity. If higher returns can only be achieved by taking on more risk – then by definition – over time those risks would come to light and it would not be possible to generate a long term track record of outperformance such as Warren Buffet, Bill Gross, or Howard Marks. So there must be other factors that contribute to “alpha” or the ability to generate above average returns while taking the same level of risk (risk-adjusted return).
How about investing in overlooked or undervalued assets? Or the ability to buy when there is fear and panic in the markets and sell when there greed and exuberance?
Lastly, how could the overall returns of all private equity funds across the market almost triple the returns of the S&P 500 over the past 15 years? As the data below shows, US private equity funds delivered a 12.09% return after all fees & expenses vs. the S&P 500’s 4.68%. This is a 7.41% annual outperformance over the past 15 years. Source: Cambridge Associates US PE Index vs. S&P 500 Dec 2013 Report
How can this outperformance continue for such long periods of time? Where did all that incremental risk these managers are taking go and why is it not affecting returns?
The answer is that not all asset classes are created equal. Private equity can take the form of venture capital buying a stake in pre-IPO technology companies, middle market companies in a high stage of growth, oil rigs pumping out proven reserves, distressed debt trading at a big discount, commercial real estate, or even timber and farmland. This ability to focus on private assets is an “unfair advantage” over public market investors.
One example – a typical private equity strategy may be to acquire two companies in the same industry both trading at 8x cash flow. Private companies almost always trade at a 20-30% discount to similar companies on the public market. The private equity investor would then merge these two companies together to achieve large operational and expense synergies and then sell to public market investors via an IPO at 15x the combined company with a now higher earnings stream! This is called EBITDA arbitrage and can lead to massive value creation in addition to any organic growth the company experienced while under the ownership of the private equity firm. Maybe you already knew all of this and agree private equity has tools in their toolbox that public market investors do not. This brings us to Andy’s second point, which is that you can’t access these investment opportunities.
2) Can you Access Leading Alternative Assets?Taking another direct quote from Andy’s article: “That’s why David Swensen, Yale’s Chief Investment Officer and the man most identified with employing alternative assets, essentially says in the introduction to his groundbreaking book Pioneering Portfolio Management, that if you can access premier alternative assets like hedge funds, you should, but it’s highly unlikely that you can, so you shouldn’t.”
So can individual investors access premier alternative assets? Well, that depends on whom you are and where you seek to find these alternative assets. If you are a high net worth individual and have an account with a major Wall Street private client platform or one of the these new innovative platforms referenced earlier you likely can gain access to some very high quality alternative investment managers. Almost all of the top-ranked hedge funds and many of the top-ranked private equity funds have raised tens of billions of dollars from individual investors in the past few years.
In fact, this has become the fastest growing segment of capital sources for alternative fund managers according to this Oct 2014 NY Times article, which states:
“Carlyle, the Washington-based giant that Mr. Rubenstein co-founded in 1987, is at the forefront of an effort to open the cloistered and risky world of private equity to doctors, lawyers, well-heeled entrepreneurs and others with a brokerage account or, one day, a robust 401(k).” Source: NY Times - Private Equity Titans Open Cloistered World to Smaller Investors
Why would Carlyle, one of the best performing alternative firms in the world, open its doors to individual investors? Can Carlyle not attract all the high quality endowments that Andy refers to as the “ideal investors”? Of course they can. The answer is that the market is evolving and there is now $7 trillion dollars in defined contribution plans such as self directed IRAs and there is over $2 trillion dollars in independent wealth management firms such as RIAs looking for high quality alternative assets.
Just like Wealthfront is paving the way for an entirely new breed of technology enabled money management platforms delivering high value at low fee structures, iCapital is hard at work delivering both education about private equity funds, performance analysis, and access to some of the leading private equity managers. Right now, as in today, if you are a qualified purchaser (defined by the SEC as having more than $5 million in investable assets) you can research performance data, conduct diligence, and gain access to a variety of top quartile private equity funds on iCapital Network. The market is evolving and through the use of innovative technology qualified investors can in fact access the highest quality alternative investments. Thank you for the great post Andy and keep up the awesome work at Wealthfront!
PE delivered a 12.09% return vs. the S&P 500’s 4.68% resulting in a 7.41% annual outperformance over the past 15 years Source: Cambridge Associates US PE Index vs. S&P 500 Dec 2013 Report
This communication and all data contained herein are provided for informational purposes only and do not constitute a recommendation to buy or sell any security. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources iCapital Network believes to be reliable. However, iCapital Network cannot guarantee that data’s currency, accuracy, timeliness, completeness or fitness for any particular purpose and has not sought to independently verify such data. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind that investing in alternative assets involves substantial risk, including the risk of losing your entire investment.