The Bear Market Made Alternative Investments Shine. Will A Bull Market Kill Alts, Or Are They Now A Permanent Fixture?
Regardless of your politics, back at the start of the summer few people would have predicted that, by September, President Joe Biden’s abysmal approval ratings would surge to their highest levels in a year. This demonstrates the inherent uncertainty of forecasting anything, and that sobering thought can apply all too well to financial markets.
Year to date through Sept. 13, the S&P 500 was down almost 17% in response to rampant inflation, Federal Reserve interest rate hikes and supply chain issues related to the Russia-Ukraine war. Yet the S&P 500 also rallied more than 17% between June 16 and August 16, before retreating again.
Although where the S&P 500 is headed next is anyone’s guess, history shows that alternative investments tend to perform well during stock market downturns. As a result, many financial advisors have made alts crucial components of their offering to clients. So the trillion-dollar question is, will the next bull market kill alts or have they become a permanent fixture for advisors regardless of how equities perform?
Relevant – With The Right Analytics
In the view of some industry experts, alternative assets have already been a core part of the wealth management landscape for some years, a fact that is unlikely to change.
“For the past couple of decades, alternative investing has been a quintessential and growing part of the Ivy League endowment model,” says Steven Brod, Chief Executive Officer and Chief Investment Officer of Crystal Capital Partners. “Replicating this model requires being able to build diversified portfolios across firms, funds, strategies, and vintages.”
Brod’s Bay Harbor Islands, Fla.-based wealthtech company provides financial advisors with a full suite of cloud-based alternative investment services, including analysis of and access to high-quality private equity, private credit and hedge funds. Crystal Capital Partners has over 500 client portfolios spread across more than 200 advisory relationships.
The firm’s relationships encompass wealth management teams based at banks, RIAs, independent broker-dealers and multifamily offices, representing over $100 billion in assets collectively.
According to Brod, access to top-tier alts managers is just one part of an ecosystem of solutions necessary for financial advisors to successfully align alts solutions with their clients.
“Financial advisors need to have access to an open architecture platform that really provides a broad overview of the entire investment landscape. They need a platform equipped with a strong analytical tool suite that empowers advisors and enables the comparison of underlying strategies of hedge funds and private market funds.”
Brod notes that this requires quantitative tools to benchmark returns, as well as capabilities for advisors to weigh the qualitative elements of each fund and firm.
“This type of research provides advisors an extra layer of subject matter that can’t be distinguished by performance numbers alone.”
Alts For The Long Term?
One of the less common ways of embracing alts in the long-term is to go beyond merely holding shares in funds. For example, although key personnel at Los Angeles-based Evoke Advisors also invest in almost every alt it offers to clients, the RIA takes the extra step of enabling clients to invest in the operating entity of PE companies instead of solely investing in their underlying funds.
The RIA oversees $26 billion in assets, including from high-net-worth and ultra-high-net-worth clients such as start-up founders, investment bankers, asset managers and hedge fund managers.
David Hou, a Managing Partner and co-founder, said, “One area where we have applied a distinctive value-add approach is by investing in the operating entity of private equity companies versus solely investing in their underlying funds: Our clients actively own the PE business entity, versus the investment product.”
“This can potentially provide enhanced and asymmetric return profiles through management and promote fee sharing and cost efficiencies, such as reduced or waived fees and expenses.”
Hou notes that the firm’s professionals – who collectively have over 150 years of experience in investing in private equity, private credit, real estate and hedge funds – were early adopters in aligning wealth management clients with private market investments.
It is a first mover advantage that the firm continues to leverage to the benefit of its clients.
“Researching and vetting a strategy or manager is only one step in the process. Our goal is to vet and to thoroughly understand the strategy and the people managing the fund. We want to thoroughly underwrite our managers to ensure alignment with our core values.”
GP Stakes Investing In Private Equity
Investing at the general partner level may be another way for financial advisors to approach alts without subjecting clients to underperformance during a prolonged stock rally. This is a primary line of business for Christopher Zook, Chairman and Chief Investment Officer of Houston-based CAZ Investments.
“We believe that GP stakes investments are better insulated from cyclical downturns than the majority of other sectors within private equity,” he says. “This is largely due to the inherent predictability of the business model and the consistency of revenue that management fees are able to provide.”
The RIA, which oversees $3.8 billion in AUM, invests broadly across the PE landscape but its largest theme has been Growth of Private Asset Management Firms. CAZ Investments sees continuing growth of demand from institutional investors as a strong tailwind for quality firms in the space – along with the hard to match combination of significant cash flow, upside optionality and downside protection. Zook estimated that, in most GP stakes, his firm has 20% or less of downside and more than 300% of upside.
“A portfolio of GP stakes provides substantial diversification across vintage years, where the sponsors have funds that were launched at all different times of the economic cycle. That provides material protection from the economic cycle,” Zook says. “Of course, that is all in addition to the extensive style diversification in private equity, private credit, real estate and real assets, as well as across geography and industry.”
Is Dr. Doom Right?
Some analysts, such as those at Bank of America, have forecast that a resurgent equity bull market could arise in the fourth quarter of 2022 and continue well into 2023. A few economists, such as Nouriel Roubini, known by his nickname “Dr. Doom,” think the Federal Reserve will keep interest rates high in 2023, which could preclude a stock rally. According to Bloomberg, Roubini stated, “Markets expecting a pivot and the Fed cutting rates next year to me sounds delusional.”
Since Roubini is famous for making correct market calls, if his prediction comes true this time, the economic hard landing the Fed is currently generating might punish the markets for some time to come, potentially extending the popularity of alternatives even further as they continue to outperform. Of course, the various alts are each their own asset class and could encounter headwinds independent of whatever happens to interest rates and stocks.
Additionally, there is the question of how specific alts solutions are recommended to financial advisors across many of the third-party platforms that market to them.
In particular, Crystal Capital Partners’ Brod cautions against “pay to play” arrangements between alts managers and alts platforms that distribute their products, which he characterizes as “fairly common these days.”
According to Brod, such arrangements typically take the form of a placement fee, a percentage of the management fee, or performance fees charged by the platform to the alts managers in exchange for shelf space.
“We have refused to engage in these practices, as they inherently create a conflict of interest, while reducing the quality of the products by diluting the alignment of the platform with the advisor and their investors…The best managers generally don’t have to pay for shelf space.”
Assessing The Merits Of Alts
Inherent volatility in the stock market should not distract investors from the bigger picture, according to Francois Schramek, CFA, Managing Director at Manhattan West. In addition to alts, the Los Angeles-based global strategic investment firm provides private wealth, business management and tax services.
Schramek argues that whether the stock market is currently in bull or bear mode is less important than that muted return expectations are diminishing the overall appeal of equities compared with more innovative structures.
“Putting aside more traditional valuation frameworks that apply to both public and private investments, the private markets have a key differentiating property: difficulty of access and information asymmetry,” he says. According to Schramek, being equipped with the knowledge, tools and access to invest in private companies represents a distinct potential advantage, because the presence of fewer bidders results in less of a price war for those assets.
“Private markets offer the potential of attractive investment returns for those willing to roll up their sleeves and do the work,” he says. “Manhattan West believes in finding those opportunities and investing its capital in well underwritten deals, for not only its own benefit but also the benefit of the clients and families the company advises.”
Chris Latham, Deputy Managing Editor at Wealth Solutions Report, can be reached at clatham@wealthsolutionsreport.com
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