Negative interest rates: what can be done about it?
As it is known, years of financial repression and central banks’ intervention have completely reshaped the fixed income universe, with a large portion of the market trading today at negative or close to zero yields. Bonds worth $15tn, more than a fifth of the debt issued by governments and companies around the world, are currently trading with negative yields. A substantial proportion of corporate debt, including that rated as high yield or “junk”, also trades at negative yields even though there is a heightened risk of default by these issuers.
This new reality has affected not only institutional investors, but also private clients that used to allocate to fixed income the majority of their portfolios.
It is therefore no surprise that investors have had to look elsewhere, rethinking the foundations of a multi-asset portfolio. Alternatives and so-called private markets (private equity, private debt, real estate and infrastructure) were obviously one of the most attractive candidates.
“Diversification is the obvious one as adding private markets to a balanced portfolio can potentially improve overall performance and risk-adjusted returns.”
There are genuinely compelling reasons to consider private markets. Diversification is the obvious one as adding private markets to a balanced portfolio can potentially improve overall performance and risk-adjusted returns. A broader universe is also a compelling reason: in the U.S. alone there are over 17,000 private companies with annual revenues over $100 million vs. approximately only 2,600 public companies with the same annual revenues. The investment horizon it is also a key differentiator as generally private equity managers focus on long-term value-creation by driving strategic change in private businesses without the pressures of quarterly earnings targets of public markets.
As expected the first movers were decades ago endowments, family offices and some institutional investors that in different ways allocated, sometimes in a sizeable way, to private markets funds or direct deals. Today some US university endowments, which are amongst the most respected institutional investors, run allocations as high as 60%. The Yale University started this trend in the 1980s and is now over 75% invested in alternatives, and it is the norm to see 40% to 60% allocations to alternatives in large endowments. Global family offices allocated an average 37% to a variety of alternatives according to a UBS recent survey. Large public pension plans and sovereign wealth funds typically allocate 15% to 25% to alternatives nowadays and are considering increasing their alternatives allocation.
The real news of the last few years however it has been the slow but constant interest of private investors. If years ago the access was reserved to the very ultra-high investors, mainly due to the large entry ticket and operational complexity, the last three to four years so a progressive “democratization” of private markets, with different solutions and innovations allowing smaller clients to finally allocate to the asset class. In this context, we are mainly assisting to three clear trends materializing in the space.
The first one is the appearance of several “fintech facilitators”, operating in both the B2B or B2C space and simplifying and automating the operational and contractual burden of investing in private markets. The result is a platform allowing pooling smaller investors and making available investment programs that would be otherwise beyond the reach of those type of clients.
The second trend, more common for larger banks and asset managers, is the creation of “master-feeder” structures which are used for internal distribution. In this case, a bank create one or more vehicles that pool internal clients and then deploys the capital towards one or more external mandates.
The last trend is the proliferation of dedicated vehicles launched and managed by private market managers that are natively friendly to high net worth individuals. This specific segment has it roots mainly in the Luxembourg fund eco-system. It started with the SIF (Specialized Investment Fund), gained further traction with the RAIF (Reserved Alternative Investment Fund) and it achieved its final stage with the European ELTIF (European Long Term Investment Fund). Recently we also saw a large number of pre-funded “evergreen” structures which are probably the most investor-friendly type of fund, although it does not come without potential liquidity mismatch risks.
“It is our role as private wealth managers to educate clients on such a heterogeneous asset class, and that is not a quick fix, as it spans from strategic asset allocation considerations to operational caveats, liquidity and risk profiling.”
All the above trends are certainly welcome by private investors and professionals, but having access it is not by itself a positive innovation for clients unless the pitfalls of private market investing are mitigated, which are several and potentially of large magnitude.
Firstly, the reality is that most HNWIs have little to no experience of investing in private markets and their technicalities. It is our role as private wealth managers to educate clients on such a heterogeneous asset class, and that is not a quick fix, as it spans from strategic asset allocation considerations to operational caveats, liquidity and risk profiling.
Secondly it is important to be transparent towards clients in regards to the “true volatility” and risk adjusted returns of those investments, as sometimes investors forget that the absence of mark to market does not equal to stability and it is in certain cases valuations before an exit can be quite debatable.
Embedded costs are also an issue that needs to be clearly addressed, as the level of transparency in that regards it is not comparable to public markets. The fee structure, with claw backs and sometimes debatable performance fee schemes, can be a negative surprise for many less experienced investors.
Finally and most importantly, there is the issue of selection. This is really a key point to address for clients, and where professional help is needed. Why selection it is more important in private market funds compared to listed ones it is due to statistics, and the so-called “interquartile range”. This metric simply tell you what is the performance difference between the top quartile performing funds compared to the bottom one. If for traditional bonds or equity funds this differential tends to be relatively contained, it is very wide for private market funds, with the most extreme case of venture capital funds. In simple words picking a bad fund can be a very, very costly mistake, hence a do it yourself approach for clients should be avoided and wealth managers should advise carefully in this universe.
To conclude, private markets democratization it is certainly welcome as the asset class can be an important building block of a well-diversified portfolio that will need to navigate through the next decade. Nevertheless, it is key to approach it carefully and diligently, in the best interest of clients. The lack of returns in other asset classes cannot be the only driver dictating an investment decision, and naively replacing fixed income with private markets would be a dangerous move. For this reason, we at Banque Havilland have worked intensively to set-up a platform and a philosophy where clients come first and each solution that we advise is the most suitable and appropriate for their objectives and risk profiles.
Daniel Bischof
Member of the Executive Board of Banque Havilland (Liechtenstein) AG
(source: Wirtschaft Regional – German version and Volksblatt – German version))
