Private Capital – The Paradox of Choice

Volatility, inflation, the desire to retire—all these issues and more are creating a new breed of investor. Investors once were happy with a nice bedtime story from the Wall Street Journal and simple monthly statements, but those days are done. Today’s investors want to know what’s in their portfolios and why and they want to know now. And they want to make their own investment decisions or at least be involved in the decision process. This growing sophistication and independence are shifting the balance of power, creating a vast new “green field” within UHNW, HNW and Mass Affluent wealth verticals, but perhaps most importantly, it’s also created new challenges in distributing and managing alternative funds. What is the future of management and distribution of alternative investment funds?

Now, well into the second decade of the century, most HNW and mass affluent investors still don’t really know what hedge funds, or private equity/debt or venture capital, are and do; but they all like and want access to the returns these investments can offer. Since inflation is real—not transitory—and we are seeing great waves of people retire and/or resign, the need for those returns is greater than ever. Even the U.S. Securities and Commission understands that a 60/40 portfolio can’t save an aging population’s collective retirement portfolio. And oh, by the way, most of these people who are aging out of the workforce have been exposed to alternative investments (GASP!) through defined benefit pension plans for more than 20 years.

While alternative assets are not new, they’re still considered to be non-traditional and unconventional to many investors. Nevertheless, there was a clear sign from institutional investors in 2020: As long-standing and firm believers of the alternatives space, they prioritized even heavier allocations to these investments.

That’s because of this asset class’s performance and the consensus that alternatives will achieve higher returns and meet future obligations, while also being able to protect against excessive downside risk. It’s an indication for retail investors to follow suit. Yet, despite this, the collectively normal dissemination of critical information about these funds remains elusive.

The Old Formula

Too many conversations with alternatives principals over the past 20 years invariably point to one immutable belief--exclusivity promotes sales. The vast majority of multi-billion-dollar funds cling to the perception that rarified air will naturally attract AUM. Sadly, I must point out that Bernie Madoff operated under this same belief system, though for his purposes inaccessibility provided him the shield he needed to perpetuate his fraud.

The SEC is largely to blame, with its accreditation rules, Lamp Letter, etc., which gives most fund managers the needed plausible deniability they need not to disclose information more openly. What the SEC fails to realize, is that while Joe the Plumber, is not qualified to invest directly, he most certainly already is via his pension, and likely to the tune of 15% to 20% of his retirement.

The SEC’s recent private fund reform concept does begin to recognize the key role that pooled investment vehicles, including private and regulated funds, can play in providing a more level playing field for retail investors. Though many of the SEC’s proposed changes are benign at best, frequent letters regarding performance and fees, and routine preparation and transmission of audited financials are common practice. Where the SEC falls short once again is the clarity of information that should be standard within these. But I will discuss this in more detail in another letter.

While investors and advisors alike are expressing greater interest in alternatives, considerable confusion remains about the specific nature of alternatives—particularly for individual investors.

Same Story/Different Audience

As increasing numbers of alternative fund managers have shifted their capital-raising focus away from institutional to more wealth- focused retail audiences, where the responsibility for investment decisions-and performance is being passed to advisors and individuals from traditional knowledgeable or qualified investment professionals.  Fueling this is the rise of so-called “democratization” platforms (please note I hate this phrase), like iCapital, CAIS, Conversus and the rollout of big private wealth units at Blackstone and Goldman, the appetite among wealth advisors and their clients is growing exponentially.

A recent study looked at the reasons advisors and institutions might hesitate to invest in alternatives. The study found that in one category—education—there was a clear gap between advisors and institutions Individuals (and their advisors) are far more likely to hesitate putting money into an alternative investment due to a feeling of uncertainty around the benefits of alternatives, and a lack of clarity on how specific strategies “work” in the portfolio.

In part, this is an industry failing. By labeling these offerings “alternatives” we make them seem more different than they are and may over-complicate them in the process. This argues for the need to clarify (and simplify) how we think and talk about “alts.”

So, what happens now? Pretty much the same thing that happened in the early 1990s. Professional investors need to learn about alternative investments, including what they are/aren’t, how to use them in a portfolio to greatest advantage, and how to explain them to their clients. This is what the consultants did for the pension funds and what advisors will need to learn to do for their high-net-worth and mass affluent clients. We’ve done this before, and we can do it better this time.

Recognizing Change

The wealth management industry needs a higher general level of information flow if it to fully embrace alternative investment. Just meeting fiduciary minimums, will not do and these organization which include Registered Investment Advisors, wire-houses, private and trust banks do not yet possess the level of granularity they need. Clearer dissemination of critical diligence and decision-making data such as the funds objectives, risk and return characteristics, and the type and diversification of the underlying assets in each alternative’s portfolio, fees and expenses, and biographical details about the portfolio manager or managers, are mandatory.

However, this flow of information needs to marry other missing pieces of the puzzle--education and functional ability to makes sense of all the inputs.

Educationally, a common mistake advisors and investors make is to treat alternative investments as a homogeneous category. The reality is alternatives are not a single asset class. Alternatives include an array of assets, strategies, and structures and should not be construed as some monolithic investment or a single slice in the allocation pie. It’s these varying strategies and their unique characteristics that make them the perfect complement to traditional public market strategies. Educational areas that demand immediate attention include:

1. Defining “alternative investments,”
2. Proper portfolio construction and management,
3. Full transparency and risk management, and.
4. Accurate, comprehensive, and clear advisor/client reporting and communication.

Buy a Shovel

Currently, the line between distribution channels, and funds sponsors seems to be blurring. How much can an advisor rely on any one source? When does information provided to enable the sales process, become less reliable, and the fiduciary responsibility of the advisor to provide independent analysis impaired?  While the sales channels for alternatives is changing, what stands is that many of the intermediaries, are too aligned with the issuers, and see their fortunes more aligned with selling product than truly supporting the needed level of fiduciary care that RIAs, wire-houses and wealth advisors need to provide.

For advisors to advise, and investors to invest, they need to fast follow the product adoption with infrastructure and capabilities, essentially running around behind the elephant with the shovel. The corollary for this is when hedge funds went “multi-prime broker” in the late 1990s. Using multiple platforms increases flow, knowledge, and ability to get better rates. But this is predicated on the advisors’ ability to aggregate and report on all which they transacted and are exposed to.

Technologically, the paradigm demands a robust advisor and client ability to collect, management and makes sense of all the inputs. The wealth management vertical wants choices, the paradox is there are too many choices! ALTSMARK helps them make sense of it all.

After all, over-burdened wealth advisors, brokers or bankers are generally not experts in operations, and compounding the problem is the highly fragmented and often manual process of collecting private fund data. Regardless, the industry needs to evolve to meet not only current expectations but future wide-scale demand being the 20+ million potential HNW and mass affluent investors interest in private capital solutions. On the opposite side of the coin, those tasked with communicating private fund information will need to up their game and continue to play a necessary role in educating the broader market, from the do-it-your-self'er to the well-heeled private client.

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Brian Shapiro is CEO of ALTSMARK LLC Private Capital Super Application developed specifically to provide institutional-quality alternative investment portfolio management, risk, reporting and value-added data aggregation services to wealth management firms.  He can be reached at 802-855-3754, or via e-mail at brian@altsmark.com