Alternative Investments: A Primer for Family Offices
It’s now well known that the world’s best investors allocate considerably to private markets and alternatives, with 60/40 stock/bond allocations a thing of the distant past. That said, while institutional investors allocate over 25% on average to privates, non-institutions lag at less than about 10% on average. The latter number skews higher when looking at family offices and UHNWI’s, some of whom allocate as much as 50% or more to alternatives. It’s easy to understand why, considering that private markets have outpaced publics over the past 15 years, returning a blended net 15% vs. 10% from the MSCI All Worlds Index tracking publics (recent market calamity excluded). Beyond returns however, alternative and private investments have unique characteristics that public investments simply don’t possess. And they can be some of the most value-aligned, where investors can really make a tangible difference with the capital they deploy.
This post is meant to serve as a primer on alternatives for the less-acquainted, and those with interest in evolving their private portfolios.
General things to consider when allocating to alts:
- Proactive vs. Reactive – many investors react to private investment opportunities, especially when getting started. Without a thoughtful framework, it’s easy to make mistakes, and losses can pile up quickly. Proactive approaches include portfolio allocation strategies, single investment limits, fund vs. direct exposure, co-investment, follow-ons, etc.
- Liquidity – it’s absolutely critical to understand cash flow and liquidity realities when making private investments (and commitments); returns take longer than expected, while simultaneous outflows to fund capital calls and to make new investments will certainly arise.
- Fund Managers & Co-investment – especially in the early days, it’s a smart strategy to invest in competent fund managers, particularly those with expertise in areas where you are lacking – you’ll learn by watching, avoid certain risks, and from time to time be presented with opportunities to co-invest directly with the fund.
- Negotiate Fees – when possible, try to negotiate fees. Asset owners have been able to push down fees somewhat over the prior years, particularly with larger check sizes. Co-investing can be a strategy to bring down overall blended fees if you are not paying extra for those opportunities.
- Consistency – once you set an allocation goal, try to invest consistently over a period of time rather than all at once; this will allow you to be exposed to more market cycles and avoid isolated vintage risk in a given fund timeline.
Private Equity & Venture Capital – have you seen my MOIC?
Why?
Private equity and venture capital funds are among the most popular alternative investments, offering professionally managed access to companies with potential for significant growth. Funds of course charge fees, which can sometimes be high, though they do all the work to source, diligence, and manage portfolios, resulting in a hands-off way to access the category for end asset owners. Ultimately there can be a risk/reward trade-off as investing in a portfolio of private businesses will tend to be more balanced vs. the risk associated with direct investments in individual companies.
What to look out for?
This class of investment, particularly venture capital, is characterized by very high return dispersion among managers. As such it’s important to be in the top quartile of managers (or better decile), or returns are likely to be unimpressive.
~Historic Returns:
Venture Capital – median 14%, top decile 35%, bottom decile -5%; Private Equity – median 14%, top decile 30%, bottom decile 1%
Private Credit & Yield – sometimes cash flow is king
Why?
Private credit and other yield oriented investing refers to providing capital without buying equity in the business. Investment lifecycles are shorter, and cash flows turn on more quickly. Upside is capped by an interest rate, or an agreed upon return on capital (as is usually the case with revenue based financing). In the current market, private credit and yield structures are a fantastic complement to equity investments.
What to look out for?
Similar to equity investments, it’s important to recognize that total or majority loss of capital is possible. If the company fails, credit investors may have a senior position and can receive some partial return from sale of assets, ahead of equity holders. Underwriting the fundamentals and financial health of a given business is critical, and it’s best to build a diversified portfolio to account for potential defaults.
~Historic Returns:
Ranges from low single digits to mid teens in the US, with higher interest rates availability globally or in nuanced direct lending instances.
Direct Investments – chasing the next 1000x
Why?
Either via private equity or private credit, deploying capital into companies directly offers the best value alignment for investors. These investments offer the opportunity to propel forward the people, ideas, and ecosystems you wish to see succeed.
From an economic perspective, direct investing is more affordable (no management fees or carry), alongside higher risk. As a contrary to investing in a fund run by a professional manager, direct investing can be very time consuming both in sourcing and structuring new deals, and monitoring them throughout the investment lifecycle, which can last a decade or more. Further, it may be difficult to find allocations at the direct level, especially with smaller check sizes or few obvious strategic advantages.
What to look out for?
Before jumping into direct investing, it’s a good idea to consider your objectives and constraints – what are you looking to achieve, and avoid. Timelines can be long, and many losers are likely to realize before any winners (which may not emerge for years). Founders can be erratic, and even in some cases dishonest. Investors should expect a wild ride, though also a rewarding one, as entrepreneurs work to achieve their biggest dreams. It’s important to have a defined strategy, including number of target companies for the portfolio, check ranges, follow-ons etc. Typically direct approaches come in two flavors, either focused on a given sector or geography well known to the investor, or spray and pray across the board.
~Historic Returns:
Like VC, these vary heavily, in this case ranging from complete loss of capital through 25+% for top decile returns. It is important to consider blended returns across a portfolio vs. one-off investments which can see wilder swings.
Real Estate – brick and mortar, where returns are concrete
Why?
Passive income from rent, and capital appreciation as property prices rise over time. Depending on the type of property and structure of the investment, real estate can often provide stable returns and act as a hedge against inflation.
What to look out for?
Leverage is the key word here. Projects over saddled with debt can go wrong with unforeseen delays or expenses. Timelines are often longer than projected, regulatory concerns exist, and specific markets face individual risks, as do particular asset classes (ex. office space markets during the pandemic and persistent work-from-home trend).
~Historic Returns:
Median 10%, top decile 23%, bottom decile negative 7-8%. Direct investing has a higher return dispersion with funds falling in a more narrow range.
Real Assets – let’s get physical
Why?
Real assets (infrastructure, commodities, farmland, e.g.) can act as an inflation hedge, and are typically less correlated with the broader portfolio. These investments can offer stable returns over the long term, and provide exposure to tangible value vs. other financial assets.
What to look out for?
Capital expenditures are typically large, and individual projects carry idiosyncratic risks – geopolitical, regulatory, and operational among classic financial risks like overleverage and valuation considerations.
~Historic Returns:
Ranges from 20% to -5%, median mid-single digits.
Lifestyle & Collectibles – when it’s time to let the hair down
Why?
Because they’re fun! And sometimes you might even make some money. Art, cars, watches, wine, etc. Many will exclude these from a formal investment strategy and rather tend to think of these as expenses – while they’ll likely have some residual asset value, it may not be necessary to track returns and performance, but then again, they can offer returns over longer periods and are seen as less correlated with the markets.
Other
Mostly referring to Hedge Funds, Crypto, Derivatives, etc. While normally considered alternatives, they’re out of the scope for this one as we’re focused on private vehicles.
Before you go
We know this guide just scratches the surface of the dynamic, complex, and exciting space of alternatives. We live and breathe these asset classes, and have seen it all over the past decade—helping some of the world’s most interesting private investors build resilient, high-performing portfolios. So if you’re looking to refine your approach, expand your allocation, or just want a sounding board as you navigate the space—we’d love to connect.
