Over recent years, alternative investments have attracted increased attention, particularly in the areas of private or unlisted infrastructure and equity.
Proponents argue that investors receive a so-called “illiquidity” premium for being locked into these types of investments, which typically have fixed commitment periods of as long as 10 years, or more.
They assert that, as compensation for the inability to exit at will, investors should be rewarded with a higher return than an equivalent liquid investment.
An added benefit is the diversification of investing in such assets, which seem to react differently to their listed counterparts and experience less volatility.
This article will examine whether the case for unlisted investments is valid and supported by empirical evidence.
What are alternative investments?
First, we should take a step back and define what we mean by “alternative” investments. This term is a wide, catch-all definition for investments which fall outside of the typical, traditional assets of listed equities (including property stocks), bonds and cash.
Alternative assets include hedge funds and unlisted or private equity, infrastructure, property and fixed income assets (such as unlisted corporate bonds and mezzanine loans). Each sub-category has its own distinct characteristics and must be understood separately within its own context. The focus in this article is only on equity, infrastructure and property.
Investing in alternatives
On the most basic level, private equity, infrastructure and property funds are investing in the same businesses as their listed counterparts.
A private property fund will hold one or several commercial or residential properties, just as a listed property fund will.
Likewise, a private infrastructure fund will hold infrastructure businesses, such as toll roads, airports or utility plants, in the same way a listed infrastructure fund will.
A private equity fund, while owning commercial enterprises in much the same way as a public fund, distinguishes itself by investing in private, smaller companies, often at an earlier part of the business cycle, or employing greater leverage (in other words loans instead of capital), or avoiding some of the more onerous, stringent governance issues of a publically-listed company.
However, all these distinctions in the private equity space have associated risks. This poses the question: if there is a premium to be received over listed equity, is it simply as a result of taking higher risk in the form of market cap, leverage, or governance risk?
The return of investing in alternatives – what could you expect?
Since it is broadly not the fundamental nature of the asset that is different, should returns be (or are they, in fact) higher in private equity, infrastructure and property? And if so, why?
We will answer these questions, but we should first point out that the difference in the private space is price discovery or valuations, and this important distinction drives another, which is the difference in volatility of private assets compared to listed ones.
For listed assets, returns are derived from a true transaction-based, market-clearing price, while for private assets, returns are based on long-term, appraisal-based valuations of a limited number of specific assets.
Since these valuation points are periodic (generally semi-annual or annual) and somewhat subjective, returns from private investments appear to be more stable and less correlated to listed markets. Note some of the major differences between private and public funds, below.
We will now turn to empirical evidence to answer some of the questions related to these alternative investments.
There is a longer history and depth of data in the private property sector and, to a lesser extent, the private equity sector than in the infrastructure sector, but we will discuss findings from all three sectors.
Returns – there is no compelling evidence for private markets but private equity shows some promise
The academic literature looking at short- and long-term trends in the property sector did not find that private property, with its illiquid nature, has produced higher returns than its public, liquid counterpart. In fact, the opposite is apparent.
Private equity and infrastructure
A large number of studies have tried recently to compare the returns of private equity with those of listed equities, and listed infrastructure with unlisted infrastructure.
Looking at listed and private equity, which has a longer history, there is no consensus or strong evidence from existing academic literature that private equity returns (net of fees) definitely exceed public or listed equity returns. Recent studies suggest that private equity may generally perform better than listed equities.
Volatility and diversification – apparent advantages but more fair comparisons weaken the arguments for private markets
What about the other arguments for private investments: diversification and lower volatility?
The following discussion focuses on property. However, the general principles apply to equity and infrastructure too.
Most risk models are structured to capture the risk of an asset class through the standard deviation, or volatility, of either monthly or quarterly returns.
However, using this methodology to determine allocations between private and listed property is fundamentally flawed and will bias results toward an over-allocation to private property.
Simply put, the volatility figures are not comparable. For listed real estate investment trusts (REITs), returns are derived from a true transaction-based, market-clearing price, while for private real estate, returns are based on a long-term, appraisal-based equilibrium price.
Thus, from a quarterly vantage point, while listed REITS are indisputably more volatile, the reason is that appraisers of private property inherently take a long-term view of values, guided principally by comparable sales and discounted cash flow models.
In volatile times for the economy or capital markets, appraisal values do not reflect true transaction-based volatility. It may take may take months, or even more than a year, before it is reflected in private property appraisals.
Is there not a more accurate way to compare volatility of private and public property? In evaluating how to measure risk, we must recognise that property is an inherently long-lived, typically less-liquid, real asset. As such, most investors understandably take a long-term approach.
Therefore, if real estate is a long-term investment, why measure its “risk” or volatility in months, or even quarters?
If we extend the period of time to reflect the long-term nature of the underlying asset, investors’ time horizon for private and public property, and the different time horizons of the valuation methods, the picture changes dramatically.
The following graphs chart annual rolling internal rates of return over 10-year holding periods by vintage year.
Visually, the listed REIT returns are clearly more clustered and consistent.
Thus, we would argue that monthly or quarterly volatility is not the best measure of investment risk, just as it is not the best measure in allocating to venture capital or private equity funds.
Instead, the best measure of risk lies in the consistency and predictability of long-term returns. On this basis, listed REITs are not riskier than private real estate. In fact, they have proven to be less risky over 10-year rolling periods.
RARE Infrastructure, an investment management company focused exclusively on global listed infrastructure, carried out similar analysis for private versus public infrastructure. RARE constructed a return series from both groups over different time intervals, from monthly to annual.
The chart below, from their August 2009 Special Fund Update publication, shows the correlation between the two series returns over each measurement interval.
The results are similar – as the time period of the measurements extend, the short-term differences in pricing discovery or valuation dissipate and the correlation increases between private and public assets in the same sector:
The correlations between public and private equity are difficult to analyse given the heterogeneous nature of private equity assets.
The body of available research indicates that there is a relatively high positive correlation between private and public equity, although the magnitude has not been clearly established.
Similar to the conclusions concerning the probability of outperformance of private equity versus public equity, while the empirical evidence is far from clear and there are many interpretations of the data, it does seem that there are some diversification effects, but the magnitude is not clear, and must be considered against other factors, such as the inflexibility, illiquidity and high fees that are related with a private equity investment.
Combining alternative investments into a diverse offering
From a global perspective, the empirical evidence of investing in private equity, infrastructure and property shows there is benefit, in terms of return and diversification.
However, there are factors that need to be considered before an investor can make a decision that will help them reach their investment goal.
Investors should therefore make decisions to invest in these long-term, illiquid private assets from an informed point of view, armed with sufficient knowledge concerning the advantages, disadvantages, risks and opportunities that private market investments provide.
Private markets are not the silver bullet of investing, and investors should be careful not to overstate the possible advantages, but it is certainly worth considering how to include them in an investment plan for effective diversification.
1: The Morningstar study compared returns of four indices for the 20 years between 1989 and 2009: the FTSE NAREIT All-Equity REITs index, which excludes mortgage REITs (listed); the National Council of Real Estate Investment Fiduciaries' Open-End Diversified Core Equity index (private); NCREIF-Townsend Value-Added index (private); and the NCREIF-Townsend Opportunistic index (private).