A fresh look at alternatives and illiquidity

Spending that illiquidity budget wisely through a diversified set of alternatives is crucial, as investment types typically respond differently to various market trends and forces, much as they provide distinct risk-return profiles.

Reset and reassess
Investors might want to review their funded ratio and projected liabilities, then ask themselves to what extent they can spare liquidity. When investors take a calculated approach to examining the risk-return profiles of more illiquid alternatives such as a home, antiques or art, they might find that those profiles are more consistent with their stated objectives versus the assets they have accumulated in the fight to liquidity begun during the financial crisis. Investors may want to look at a 30-year horizon and manage to that kind of time frame with a corresponding investment in longer-duration assets, where appropriate, for their allocation strategy.

Inflation protection, while not necessarily top of mind in the short term, is certainly a concern over the long term, as inflation may play a bigger role in the global economy. How fast that may occur is unknown. Accordingly, investors need to consider positioning their portfolios to navigate and insulate against this unpredictable situation.

According to consultants surveyed inflation fears are driving demand for illiquid investments, with consultants predicting significant increases in private equity and real estate mandates.

Real estate: Reality check
It’s no secret that, as a category, Canadian real estate had a severe and protracted market downturn in the 1990s. The commercial real estate industry since then has been characterized by cautious development. This caution, and prudent lending practices, helped many Canadian investors avoid the collapse seen in the U.S. Nonetheless, some investors got caught in the American downturn and should be relieved that liquidity is returning unevenly to real estate markets there

Real estate investors are increasingly aware that the combination of income, preservation of capital, inflation hedging and capital growth is imperative for investors in this sector. Ongoing assessment of investment, operational, organizational and liquidity risks in the context of expected returns, as well as the role that assets play within the larger portfolio, should be standard best practices for institutional investors.

In the past, investors may have sought higher returns than the sector could provide over a normalized period. In this new market environment, investors must adjust to what the sector’s realistic returns are likely to be, given the capital and operational markets. There remain some good reasons to be in this sector as a return to the fundamentals of owning property prevail.

Private equity: Strong growth
Increasingly, Canadian investors have turned to private equity. to the Canadian Venture Capital and Private Equity Association, activity soared in 2011 to $11.5 billion, up 69% over 2010 on the back of a record number of deals. Those numbers were driven by blockbuster deals such as the acquisition of Husky International Ltd. by the Ontario Municipal Employees Retirement System (OMERS). Another OMERS deal that illustrates the migration from diverse private equity to direct investing is its sale of a portfolio of 11 private equity investments to AXA Private Equity.

Private equity investments can perform an important role, offering higher return characteristics and diversification when invested in the right set of opportunities.

By targeting reasonably stable, well-established businesses, investors can take control and can potentially generate returns by adding value to the investment. In addition, privately owned businesses are not as vulnerable to the short-term view that arises from the focus on quarterly earnings seen in public companies. Private ownership typically enables owners to build out a management team and execute on their strategy over a longer time horizon, and both owners and management are aligned in their focus on creating operating efficiencies and longer-term value.

Despite this explosion in private equity, the fundamentals remain: investors must use leverage prudently, stress-test each transaction and create assumption scenarios that ask how the company and its industry operate in a down cycle. It boils down to the same fundamental question: Can this investment generate adequate returns to compensate for the corresponding risk?

Renewable power: Ramping up
Renewable power has seen significant growth over the last 15 years, with Canada playing a leading role. The natural resources of wind and sun are predictable, thanks to environmental data and long-term weather and climate modelling. Plus, they’re free. There is a great deal of policy support for renewable power projects, and utilities must hit renewable power targets for which they are already behind the curve.

Costs have been dropping in renewables, and onshore wind generation is now competitive with natural gas-generated electricity. Wind and solar assets, typically, are not volatile and offer long-life predictable cash flows, substantial cash yields over the life of the assets and attractive returns relative to other types of investments in the sector.

Amid increasing alternatives interest, use caution
Alternatives are expected to become a growing part of institutional portfolios globally and play a key role in helping institutional portfolios achieve their investment objectives. Much of this expansion is expected to come at the expense of equity allocations. In addition, many investors are re-evaluating the risk in their bond portfolios and are considering using alternatives as a modicum of inflation protection.

Buoyed by exciting market and regulatory dynamics, alternatives can bolster a portfolio by providing diversification and generating strong risk-adjusted returns in a low-return environment for traditional asset classes. Negative past experiences in certain investment types should not forever close the door to those asset classes, nor should enthusiasm for an asset class’ potential override generally accepted best practices in portfolio construction. In this brave new investment world, there may be an opportunity to enjoy excess returns associated with illiquid investments in a portion of a portfolio, so long as there is adequate provision for liquidity needs in the construction of the overall portfolio.

Eric Léveillé is a managing director and head of the Canadian Institutional Business for BlackRock Asset Management Canada Limited. eric.leveille@blackrock.com