Independent Thinking^®

Selecting & Managing Illiquid Alternatives

Investing in illiquid assets is not for everyone: Assets can be tied up for seven years or more.

For qualified investors who have the ability and the appetite to participate in this asset class – manager and fund selection is key. It is critical to fully evaluate the strategy and structure of each fund, the depth of the management team, and its performance history.
 
In the first installment of a series of discussions on investing in illiquid alternatives, we explore some of the criteria that Evercore Wealth Management uses when evaluating private equity managers.
 
Private equity investments can provide access to differentiated return streams, as they can invest in fast-growing companies that are not accessible via public markets. Private equity firms also feature investment managers who have specialized industry knowledge that provides them multiple ways to create value in the companies that they own throughout economic cycles.
 
These factors have resulted in private equity outperforming public equities by 3%-5% per annum over the last 40 years. We refer to this outperformance as the “illiquidity premium.” This premium is significantly increased when investing in top-quartile funds.
 
We believe this outperformance is a reflection of the differences in skill levels among managers. But how do we as investors identify the best managers? One strong indicator can be past performance, as studies have shown that manager performance in illiquid investments tends to be highly persistent, meaning that those skilled managers who have outperformed their peers and the market in the past have a higher likelihood of outperforming again in the future.
 
While past performance is no guarantee of future results, it can be a strong indication. There are several additional indicators that we use to evaluate managers. Here, we take a look at each of these considerations in manager selection, as well as some of the red flags that indicate to us that a fund should be avoided.
 

Strategy

Is the strategy repeatable? Is there potential for consistent, outperformance, or does this strategy only work in specific periods of market cycles? Does the management team have a thoughtful risk management and portfolio construction process? Does the team have a proven ability to add value via operational and strategic measures, or do they simply rely on financial engineering or market timing?
 
How does the firm find deals – through off-market transactions or auctions? Does the team have a high standard for underwriting and negotiating deals? Are there actionable plans to drive profitability in various market cycles, including downside protection? Has the team outlined multiple options for a successful exit from each company? It’s important to look for a robust investment process and a strong deal flow.
 

The Management Team

Is the firm comprised of a high-caliber management team? Do the managers have specialized industry knowledge that gives them insight into which companies will outperform? Is the firm actively involved in the management of its portfolio companies? Does the team have a robust network of industry contacts that provide access to deal flow, management talent, and industry best practices?
 
Does the team have a strong understanding of market cycles and industry trends? Do they have the flexibility and insight to deploy capital across strategies, industries or geographies as the investment opportunity set shifts? Have they shown a successful track record of using their insight in the timing of deals (both investment and exit)? Does the team have multiple ways to add value to portfolio companies, beyond financial engineering?
 
Does the firm provide the appropriate level of transparency of the portfolio? How often do investors have access to speak with the management team? How is the management team incentivized? Do members of the management team have their personal capital invested in the strategy?
 

Structure

Are the terms and fees of the funds within industry standards? Does the fund’s liquidity match the liquidity of the underlying holdings and investment horizon of the strategy? How is the fund vehicle structured with regard to minimum commitment size, capacity, quality of investor base, etc.?
 
Red Flags: Just as the above indicators are positive attributes we look for in managers, there are several key criteria that we consider to be “red flags” for concern. These include:
 

• Excessive growth in total assets under management, in average deal size, or in total number of companies held in the portfolio
• Drifting away from the stated investment style of discipline
• Introduction of non-complementary products
• Portfolio managing multiple products/strategies without sufficient support
• Change in investment team or ownership structure
• High professional turnover or neglect of career development
• Poor compliance, operations or organizational procedures
• Underperformance, relative and absolute

 
A well-executed investment program in illiquid assets can generate strong returns relative to traditional asset classes. New investments should be evaluated in the context of each client’s risk tolerance, liquidity needs, and investment horizon.
 
Stephanie Hackett is a Managing Director and Portfolio Manager at Evercore Wealth Management. She can be contacted at [email protected].
 
Editor’s note: Illiquid alternative assets can enhance a client’s portfolio by providing both diversification and potential for risk-adjusted returns in excess of public markets. In many of our clients’ portfolios, we recommend an allocation of 5%-10%-to illiquid alternatives, which can include private equity, real estate and illiquid credit strategies.