There is a current euphoria taking place in the public markets, but if you look forward it seems as though we are borrowing from future returns. Many financial institutions and analysts are projecting lower returns for both U.S. equities and U.S. bonds moving forward, and more broadly across major asset classes. Higher inflation levels are expected in the future as well, and with those higher levels, it’s going to be difficult to find places in the public markets that provide a good return without losing purchasing power.
This is why, for the right investor, alternative investments can really add value to a portfolio today. We look at incorporating alternatives into a person’s portfolio to enhance diversification and improve the risk-reward profile. Said differently, for the same level of risk, alternative investments help us to create portfolios that have a better expected return. But just like most things in life, not all alternative investments are created equally. We like the core, foundational alternatives: private equity, private real estate and private credit. Let’s explore each a little further.
There is tremendous opportunity in private equity. 80 percent of the companies in the United States with sales greater than $100 million are private companies. Now compare that to the shrinking opportunity set in public markets. In the 1990s, there were about 8,000 publicly listed companies in the U.S. but that number is now just under 4,000, meaning the opportunities there have decreased dramatically.
You’ll also see the opportunity in private equity if you look at the overall market cap. The average size of private companies is smaller than public companies, meaning they have more room to grow. And if they have more room to grow, that’s a growth opportunity for the investor.
When you’re looking for returns that are larger than what public markets have offered, private equity offers a huge opportunity partly because of the liquidity premium. Simply put, if you’re going to put your money in something that is difficult to get it out of, you can expect greater returns for that inconvenience.
Now is a great time to explore an investment in private equity because there’s been an amazing evolution in the vehicles and structures that investors now have at their disposal. It used to be that your only option for investing in private equity meant your capital would be locked up for 7-8 years before you’d see a return of your capital. These days, many new investments provide quarterly liquidity opportunities, which provides far greater flexibility for investors.
Private Real Estate
Real estate is a major contributing factor to consumer net worth, which makes these hard assets a great wealth accumulation vehicle. As I look at the current environment, investments in private real estate make even more sense because they serve as a natural inflationary hedge. As interest rates go up, lease rates go up. Landlords are able to pass along rising rates, instead of suffering from them.
Many private real estate investments are also very tax efficient, between the usage of depreciation, taxed deferred growth, and even 1031 exchanges that can allow investors to roll gains from one property or offering forward to another without having to recognize the capital gain at the time of the transaction
Finally, real estate doesn’t necessarily need to be confined to one particular sector. Many people think of retail stores, office buildings, or apartments when they think of this asset class, but other segments such as data centers, industrial warehouses, and even cell phone towers also provide access to secular growth trends in the economy.
For investors who need income ,where can they get it in this current low interest rate environment?
With private credit, you’re also able to extend to other areas of fixed income that you can’t touch in the public markets. For example, collateralized loan obligations or CLOs offer shorter duration fixed income exposure for your portfolio, which helps to limit interest rate risk. If you can get your money returned to you quicker, you face less risk from inflation lessening your purchasing power. Private lending can also offer higher rates of income for the same level of credit risk, again due to the illiquidity premium that is typically associated with these types of products.
As we have noted, alternative investments can provide a significant diversification benefit as well as inflationary protection for an investor’s portfolio. But they also help instill better investor behavior. This was evident in March 2020 when the market crashed at the start of the pandemic. Alternative investments are often harder to pull one’s money out of in a hurry, so instead of panic selling, investors stay in and reap the benefits of the recovery.
Today’s environment calls for outside-the-box thinking for investors hoping to achieve healthy returns while maintaining a reasonable level of risk. There is by no means a perfect solution for everyone, and there could be some additional requirements necessary to participate in these types of investments so they must be used carefully, only as a satellite option to complement, rather than replace, a traditional investment portfolio. Because reporting requirements are not as stringent as those for publicly traded securities, a thorough due-diligence process is an absolute necessity before investing, and on an ongoing basis for monitoring purposes. This is where having a research team on your side can be incredibly helpful. If you have questions about alternative investments and how they can best be incorporated into your portfolio, don’t hesitate to reach out to us here at Prime Capital Investment Advisors.
Advisory products and services offered by Investment Adviser Representatives through Prime Capital Investment Advisors, LLC (“PCIA”), a federally registered investment adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Prime Capital Wealth Management (“PCWM”) and Qualified Plan Advisors (“QPA”