Publications

- September 1, 2021: Vol. 8, Number 8

The evolution of access to alternatives

by Nick Veronis

Over the past decade, there has been a quiet revolution in access to private capital investments for the mass affluent investor. Investment in funds designed for accredited investors has boomed.

In 2009, there was less than $50 billion in assets under management (AUM) in accredited investor funds targeting alternative strategies. By the end of 2019, this figure had risen to more than $260 billion. Numerous well-established, major players in the alternatives space have entered the market, including Ares, Carlyle, KKR, Pantheon, PIMCO and, in just the past year or so, Hamilton Lane, StepStone, and Neuberger Berman.

PRIVATE ASSET CLASSES AND DIVERSIFICATION

First, why are so many individual investors looking to gain access to alternatives? On a functional level, the entry into the space of many experienced managers, alongside innovations in terms of structure and technology, is likely driving down previously elevated fees, simplifying reporting processes and improving transparency.

From a portfolio construction perspective, alternative asset classes have distinct characteristics that fulfil unique objectives for an investor. Private equity is typically sought to potentially help enhance total returns, private credit may strengthen a portfolio via inflation-protected income, while private real estate can add both regular income and returns with lower correlation to public markets.

More broadly, an appropriate level of diversification has long been recognized as a way to improve overall risk-adjusted returns, or return per unit of risk assumed. And private asset classes can help diversify a portfolio that is entirely invested in public securities.

Private real estate, for example, is valued only periodically, and this valuation is based on the specific attributes of the underlying investments. This creates a buffer against the daily volatility in public markets in which perceived value dictates pricing. Private fund structures are also generally a potentially more appropriate and efficient way to invest in assets with longer-term investment horizons. By virtue of their limits on liquidity, private funds wield more patient capital and therefore have greater latitude to hold investments through periods of market stress.

These attributes may help reduce portfolio volatility and weaken return correlation to equity markets when compared to public real estate funds. Some of the same fund dynamics that separate private real estate from its public cousin also help create significant diversification benefits for private equity and private credit. The ability to invest in private companies over longer time horizons and leverage unique value creation models can provide investors with differentiated exposure to economic and market trends.

OPENING UP THE ALTERNATIVE SPACE

Historically, only institutional investors and large family offices had been able to take advantage of these benefits. Individual investors had been shut out by high minimum investments, often $5 million or more, stringent asset requirements, and holding periods that can exceed 10 years. Qualified purchasers have more recently been able to access private capital funds via feeder funds that offer much lower investment minimums — often $100,000. However, qualified purchasers must have $5 million or more in investments, excluding primary residences or business properties, which kept these structures out of the reach of accredited investors.

Accredited investor funds, on the other hand, are registered with the SEC to permit individual investor access and are designed with broader access in mind. They offer transparency via frequent public filings and often feature oversight by an independent board of directors. Investment minimums can be as low as $10,000 and, while they are intended as long-term investments, they generally provide enhanced liquidity options.

All of these factors combine to allow wealth advisers to incorporate alternatives into client portfolios as a potential source of enhanced returns, differentiated income and broader diversification.

EVOLVING FUND STRUCTURES FOR PRIVATE ASSET CLASSES

The three major alternative asset classes accessible via funds designed for accredited investors are private real estate, private equity and private credit. The specific structure typically used to provide access varies in accordance with the unique characteristics of each asset class.

Private real estate is usually accessed through nontraded REITs, which fall into one of two categories: perpetual life and lifecycle, or private REITs.

Perpetual life or net asset value (NAV) REITs are more akin to institutional-style real estate offerings, as they are open-ended funds that report NAV on a regular basis and allow for periodic repurchases. Lifecycle REITs, meanwhile, are offered through an IPO and have limited or no repurchase options and a defined lifespan that ends with a liquidity event. Lifecycle REITs were originally most popular, but perpetual life funds have become increasingly common in recent years.

While the nontraded REIT industry once primarily comprised smaller real estate firms, in recent years, larger and more established firms (such as Blackstone, Starwood and Carlyle) have entered the space and, we believe, brought with them more efficient fee structures and greater transparency. Account statements now show share value based on a valuation of fund assets and liabilities rather than just the offering price. This gives investors a clearer view into the underlying value and the impact of upfront fees. Furthermore, these fund managers have adopted lower fees and more realistic policies around distributions — all of which has supported rapid growth in assets raised. Nontraded REIT AUM has more than doubled over the past decade to well over $100 billion.

Individual investors’ other access routes to private real estate are private REITs and real estate LLCs and LPs. In addition, 1031 exchange offerings or qualified opportunity funds may be more tax-efficient approaches to real estate investment.

Private REITs, LLCs and LPs are not registered with or regulated by the SEC, nor are they publicly listed. Investment minimums may be higher than for nontraded REITs, and though redemption frequency varies fund by fund, it tends to be less frequent than other private real estate vehicles. Investors may, however, benefit from this illiquidity premium, since it allows fund managers to enter and exit investments at the times they see as most profitable.

1031 exchange offerings represent a potential option for individual investors looking to defer taxes from appreciating commercial real estate properties. These offerings are capital pools that usually invest in a single property or a highly targeted portfolio of real estate. Investors may benefit from the deferral of capital gains taxes, as well as the transfer of management responsibilities to a third party and targeted diversification into specific sectors.

Qualified opportunity funds invest in real estate development in economically depressed communities designated as opportunity zones. These zones provide tax incentives to spur economic development and job creation. They allow investors to defer their existing or current capital gains taxes on appreciated assets by selling and rolling their gains into a qualified opportunity fund within 180 days of them being realized.

The biggest incentive, however, is tax elimination that gradually scales primarily based upon the length of time that an investment is kept in a qualified opportunity fund. After 10 years, tax is eliminated on capital gains generated by these funds.

It is important to note that 1031 exchanges may be altered or even eliminated by the current administration. Changes will likely be announced in the fall for implementation in 2022. Opportunity zones may also be affected by potential changes to capital gains tax treatment.

Private equity is usually, but not exclusively, accessed via tender offer funds. These funds are registered, continuously offered, closed-end funds that usually price monthly at NAV and are not listed on an exchange.

The “tender offer” in the name refers to their liquidity mechanism. These funds generally offer to repurchase 5 percent of outstanding shares from investors once a quarter, offering them a period of no less than 20 days in which to opt to receive cash proceeds. However, a rigidly established cadence for these tender offers is not required, and they are always held at the discretion of the board of trustees.

This fund structure suits the characteristics of private equity, which by the nature of its value creation model requires security in terms of funding and a degree of illiquidity. Although tender offer funds typically provide quarterly liquidity features, they have the option to gate or suspend tenders if they believe doing so is in the best interest of all shareholders. For example, it may be that during a period of severe market dislocation, the board may decline to offer redemptions to avoid selling investments at prices significantly below their true market value, which may not be in the best interests of the overall shareholder base. Such circumstances are rare, but it is important that investors are aware of this liquidity risk.

Total AUM in the private equity tender offer market is still less than $12 billion. However, growth is accelerating as major private equity firms create vehicles that allow accredited investors access to some of the same funds and private companies made available to their long-time institutional investors.

Private credit is primarily accessed via interval funds and private business development companies (BDCs).

Like tender offer funds, interval funds are SEC-registered, continuously offered, closed-end funds, valued on a daily basis, and not listed on an exchange. However, interval funds must provide redemptions of no less than 5 percent, but as much as 25 percent, of shares outstanding on a quarterly, semiannual or annual basis. Credit-focused funds can meet the challenge of this mandated liquidity because they can hold a percentage of shorter duration, more liquid investments and benefit from regular income payments.

At the end of 2020, the interval fund industry included 66 funds with $32 billion in net assets, and another 20 funds in registration. Many of the most established managers in the private capital industry have brought products to the market in recent years, including Apollo, Ares, Bain, Blackstone, Carlyle, KKR, and PIMCO, among others. Though primarily focused on private credit, there are interval funds that invest in private real estate, and ones that also incorporate equity and hedging strategies.

BDCs, which can be public, private or nontraded, are SEC-registered, closed-end companies that typically make loans to middle-market companies. Private BDCs account for roughly $30 billion in AUM, out of the nearly $120 billion invested in the BDC space.

Private BDCs generally deploy capital in a similar way to private equity funds, by gradually drawing down investors’ committed capital as needed to make investments. This allows these funds to invest more patiently and opportunistically to hopefully generate greater returns, but this comes at the expense of investor liquidity. While private BDCs may conduct periodic repurchase offers, they generally operate with five- to seven-year periods in which to deploy capital and realize those investments.

TAX REPORTING CONSIDERATIONS

Before committing to private capital funds, it is important to consider the various tax and administrative burdens associated with each of the different investment structures.

While traditional closed-end fund partnerships issue a K-1, many of the newer fund structures for accredited investors choose to be taxed as a regulated investment company, or RIC, by the IRS, which means they deliver a 1099 form to investors.

The 1099 tax reporting simplifies an investor’s annual tax filing process, making it less costly and less time-consuming. K-1s are not required until March 15, and many are delivered much later, requiring investors to file for an extension. By contrast, 1099s must be issued by Jan. 31. Additionally, funds that issue K-1s may allocate and report taxable income to investors even if that income has not been fully distributed.

THE CONTINUED BROADENING OF ACCESS

Private funds are not suitable for every investor. Fund structures for accredited investors generally provide enhanced liquidity relative to direct investments in private funds and enable individuals to invest much smaller amounts than these funds have historically required. However, they are still intended to be treated as long-term investments and have redemption options that align with that goal.

Furthermore, not all private funds are created equal. The spread between the top and bottom quartile managers in private markets tends to be much larger than for funds investing in public instruments. The ability to carefully select and access the best managers is therefore crucial to creating positive outcomes from allocations to private markets.

Fortunately, private markets and leading fund managers are now more accessible to mass affluent investors than they have ever been. And new opportunities are emerging all the time. Fund managers continue to create innovative structures to tap into the opportunity presented by the massive individual investor market, while technological and software innovations are facilitating and simplifying investment and reporting processes for managers and investors alike.

In the context of a public market environment characterized by stretched equity valuations and limited opportunities for yield in fixed income, advisers and investors should consider taking advantage of the growing opportunity to diversify into the private capital markets.

 

Nick Veronis is founder and managing partner of iCapital Network.

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