Alternative assets can generate above-index returns, but investors need to do their due diligence when it comes to performance and risk management.
Smart investors understand that the world of alternative assets is not to be entered into lightly, in good markets or in bad. While alternative assets—particularly hedge funds, private equity partnerships and real estate partnerships—offer hope for market-beating gains over time, they can also be dangerous for less-than-careful investors.
Anyone considering investing in alternatives should keep two cardinal rules in mind.
1. Judging the performance of a fund manager and your assets is tricky.
2. Meeting regulatory requirements will take time and effort on your part.
The challenge presented by investing in alternatives starts with the terminology. “Alternative assets” is an imprecise and ever-changing term. This article will address only private market assets such as hedge funds, private equity and real assets, which have the shared traits of being manager-priced and somewhat opaque.
Even prior to recent market events, investors were concerned with understanding the performance and risk of alternative assets. Today’s economic conditions have exacerbated those worries.
Such alpha-promising assets are tantalizing, but investors struggle to truly understand how these mostly unregulated vehicles operate.
Investors in alternatives often face a dizzying array of unique concepts and metrics on performance and risk management. Furthermore, they may struggle with the amount of time required for performance evaluation and administration details. A common lament among investors goes something like this: “These assets are less than 15% of my portfolio but take more than 50% of my time!”
Investor Issues
Most of the performance and risk management challenges faced by investors in alternative assets come from three main areas: pricing, transparency (or lack thereof) and liquidity.
Pricing concerns – When a fund manager is the source of the investment valuation, a number of issues arise for investors, including staleness, infrequency and lack of timely information. For example, hedge fund prices may be monthly, but they may be smoothed and not available until weeks after month end. Private equity and other partnerships are usually valued quarterly, with the valuations not available until weeks or even months past the end of the period. Even with fair value standards for pricing, many company holdings in private equity partnerships are often priced at cost, or the price is based on a past event such as the last round of financing.
As soon as a new partnership is started, the private equity investor will see an immediate drop in performance as fees and start-up costs are taken out of the first contributions by the manager. This means that in the first several years of a private equity partnership investment, the manager valuations are typically lower than the amount paid in, resulting in the “J-curve” effect. Even the most seasoned investors become impatient with this aspect of private equity investing.
It is now well accepted that after the investment period of the downside of the J-curve, manager-supplied values track public market movements. However, the ups and downs are only reflected six to nine months later. With such delays, investors need to choose between using the best available data for performance and waiting months until all valuations have arrived.
Investors choosing to wait claim they have a more accurate picture of performance. Proponents of using the best available data adjusted for activity argue that valuations of private market assets are the manager’s best guess and that you only know the true performance of a partnership once all cash has been distributed.
Valuation challenges are a fact of life with alternative assets, and the investor must understand the exact process used by the manager. This includes knowing if the manager has a written valuation policy and/or a valuation committee, and if the methods used comply with industry guidelines for the asset class. Valuing private market assets is far from a perfect science—two managers can hold the same private company at different values, yet both are considered acceptable by auditors as long as they can articulate their valuation process.
The pricing behaviour of hedge funds, private equity and real assets also results in the need for different performance metrics. Hedge funds use the traditional time-weighted return, but volatility measures need to consider that hedge fund returns can be “spiky” or skewed to the low or high end. Volatility measures for private equity and real assets break down due to the infrequency of pricing and the J-curve effect of private equity.
Since the manager does control contributions and distributions to private equity funds, an internal rate of return is used, which takes into account the timing of these manager decisions. Public market managers typically do not have control over how much money is given to them to invest, so the time-weighted return is used, as it does not reward or penalize managers for cash flow decisions outside of their control. Investors need to be aware that there is clearly a different set of rules for measuring hedge funds, private equity and real estate.
Transparency – The lack of transparency in hedge funds and private equity creates challenges for investors in a regulatory environment in which an investor must prove not only an understanding of the industry and the geographical exposures of the underlying investments, but also, a knowledge of the managers’ valuation process for the holdings. The challenge of transparency in private market assets is threefold: availability, timing and completeness.
The main transparency issue that investors often face is access to the underlying investments. In the world of hedge funds, managers often resist providing information on their holdings (transparence), or even an indication of leverage or industry exposure (referred to as “translucence”). Private equity managers are increasingly willing to provide data on their holdings on a quarterly basis, but they remain sensitive to this information being made public—especially to government investment entities with strict disclosure rules. The only solution to this challenge is for the investor to outline transparency expectations in the manager agreement prior to investing.
Even when information on the holdings is provided, the delivery of manager statements remains problematic. With both private equity and hedge funds, valuation data usually arrive late—past the end of the period—making timely analysis close to impossible.