About Alternative Investments and Private Equity

We have received several questions from our clients regarding the attractiveness of many alternative investments and private equity funds. Usually the sales pitch for those types of products revolves around the apparently lower volatility that they offer with similar return prospects or the higher and steady income stream they can offer compared to the measly one offered by traditional fixed income instruments. Are these claims legitimate or have the salesmen purposely left out some of the less apparent risks inherent in these kinds of investments?

• Liquidity: when one invests in stocks or bonds, these instruments are traded on a daily basis on recognized exchanges or through proprietary trading desks. One can see their market value whereas in many cases, private equities and alternative investment funds invest in assets that do not trade on any exchange. The latter are evaluated using mathematical models so the fund managers can come up with a theoretical market value. Unfortunately these models tend to be out of whack under unusual market conditions. The resulting effect is an illusion of liquidity during normal circumstances until the market conditions are under stress and liquidity disappears and investors are no longer able to sell and/or redeem their investments. The Asset-Backed Commercial Paper (ABCP) crisis is one prime example of this lack of liquidity that ended up costing la Caisse de Dépôt billions of dollars when marked to market in 2007. Worse, some speculators might just come in and low-bid for the assets in the funds, knowing the managers will have to sell to meet redemption, requests which effectively lock in a permanent loss for the funds.
• Volatility: when prices change, academics define it as volatility. Unfortunately, they also define it as a measure of risk. Since the assets inside private equity and alternative investment funds tend to not trade on any exchange, there is no price transparency. It is easy to reflect constant prices week in and week out on assets that have no transparent market until one wants to actually sell. In the meantime, no price change means no volatility; i.e. no implied risk… As an example, some real estate funds come to mind. Buildings are evaluated annually. However, it sometimes takes a while to sell a property and the price might be very different from the appraisal value, especially when the funds are forced to sell.
• Priority in the capital structure: lots of investors are attracted by the higher income stream coming from some alternative investment funds. The extremely low interest rate environment has made some of these funds quite popular. We simply would like to caution investors that in finance, it is important to pay attention to companies’ capital structure, especially when things don’t go well: in case of liquidation, bonds and debentures rank ahead of preferred equity and preferred equity ranks ahead of common equity. Lots of alternative investments are more equity-like than fixed-income like. The fact that it pays 5% does not make it a fixed income instrument. Think of Real Estate Investment Trusts (REITs) and income trusts as examples. They are actually equities and in many cases, they are returning your capital and not income that may have been earned in the funds. It also means that when things go awry, they will rank behind the bonds and creditors in terms of claims on the assets of the company.