Independent Thinking^®

Illiquid Alternatives: Looking for Diversification and Alpha Opportunities

Illiquid alternatives is an umbrella term for different types of investment strategies that range from venture capital and private equity, to illiquid credit strategies, to investments in real estate and infrastructure projects. Many of the portfolios that we manage have a 5%-20% allocation to these illiquid assets, as these investments have the potential to generate strong returns relative to traditional asset classes.
 
An optimal allocation should have exposure to multiple strategies and diversification across vintage years, industry sectors, stages of investment and geography. In addition, illiquid portfolios can be structured so that maturing investment proceeds can be reinvested in similar strategies, allowing the pacing to become self-perpetuating. As with any investment, illiquid alternatives should be evaluated in the context of each qualified investor’s risk tolerance, liquidity needs and investment horizon.
 
Investors should consider adding illiquid assets to their portfolio that have the potential to provide diversification and alpha opportunities:

• Diversification: Adding investments that are uncorrelated to stocks and bonds may improve a portfolio’s risk-adjusted return. Opportunistic niche investments generate returns based on risks unrelated to equity markets, such as weather events, drug approvals, litigation outcomes, or cryptocurrencies and blockchain technology. Private real estate offers diversification and a potential hedge against inflation. Real estate spans broad risk-return opportunities from development/construction to core properties, and across a range of property types including office, multifamily housing, retail, industrial and logistics.
• Generating income in a low-yield world: As global yields remain at or near historic lows, many investors trade liquidity for nontraditional income with higher yields, such as middle market corporate lending, consumer lending, real estate lending, and specialty finance. Income-producing real estate, such as triple net lease or self-storage properties (see our Q&A with SROA Capital here), generate attractive cash flow with the potential for capital appreciation. Some investments, such as solar development, can offer attractive uncorrelated yields and may help investors meet their impact goals.
• Growth: Private equity growth and venture investments offer exposure to fast-growing companies and new technologies not accessible via public markets. Private equity managers have multiple ways to create value through economic cycles, including strategic and operational measures, acquisitions, and capital structure optimization.

Illiquid alternative strategies can be attractive additions to a portfolio for qualified investors comfortable with a degree of complexity. They are long-term investments that may take a decade or more to return capital. The fee structures are generally higher than for stocks or bonds, and the timing of capital calls and distributions is unpredictable. Illiquid alternative investments also often have more complicated tax filing and require extensions. Investors rightly expect a premium return to compensate for this lack of liquidity, such as the potential to outperform public markets by at least 300-500 basis points, along with portfolio diversification.
 
Even investors who are older should consider illiquid investments, as they can be a valuable tool in estate planning. For other investors with compressed timelines or other constraints, illiquid alternatives may not be suitable. But for many high net worth investors, foundations and endowments, these investments offer the prospect of enhanced returns and diversification.
 
Stephanie Hackett is a Partner and Portfolio Manager at Evercore Wealth Management. She can be contacted at [email protected].