The What, How, and Why of Alternative Investing
A guest essay from Austin Root... Explaining alternative investing... The positives and negatives of 'alts'... The 'private' universe... It's better to lend than borrow right now... Why and how to do it...
Editor's note: Today, we're sharing a guest essay from Stansberry Asset Management's Austin Root...
As some of you might know, Austin served as our director of research from 2019 to 2021 and managed our Portfolio Solutions products. He is now the chief investment officer at Stansberry Asset Management ("SAM"), a U.S. Securities and Exchange Commission ("SEC") registered investment adviser – separate from our publishing business – that uses some of our research and ideas, plus other sources, to help manage individual client portfolios.
In this essay, Austin takes a detailed look at "alternative investments," specifically "private" forms of investment that he thinks can boost portfolio returns and lower risk in the current market environment. This includes one type of private investment that is most attractive to him today... and Austin shares why individual investors may want to consider it, plus how to get exposure.
Should I own alternative investments?
If you haven't asked yourself this question yet, I (Austin Root) am willing to bet that you will soon...
After all, alternative investments are one of the fastest-growing asset classes around, particularly among individual investors. I'm talking about things like private equity and venture capital...
These are no longer a secretive "members only" club, available only to endowments and other institutional investors. These investments are now becoming popular with a broader group of individual investors and families.
So, should you be invested in alternative investments? The answer – as you might expect – is that it depends... both on you and on the alternative investment you're considering.
Just as each investor varies greatly in terms of his or her investment goals and financial situation, so too do the many types of alternative investments differ.
With that said, here's a more satisfying answer...
I believe that for many people the answer to the question about owning alternative investments is an emphatic "yes." And more specifically, I believe the best type of alternative investment for many folks in today's market is private credit.
In short, I believe a well-managed, well-diversified investment in private credit can provide highly attractive, equity-like returns with a lot less risk than publicly traded stocks or even fixed-income investments.
But before you invest a dollar into private credit or any kind of alternative investment, you need to be properly informed. This Digest won't get you all the way there given the unique nature of each investment offering and each investor. But I think it's a really good start.
(And once you're done reading, you can reach out to SAM here to learn even more.)
Let's start at the beginning...
What exactly are 'alternative investments'?
Alternative investments are also known as "alternatives." Many institutional investors and Wall Street insiders simply call them "alts."
Just like publicly traded stocks or bonds, alts come in many different flavors. But broadly speaking, the easiest way to think of "alternative investments" is as a grouping of many different investment assets that are NOT publicly traded stocks and bonds.
This includes a lot of assets that you likely already own, such as precious metals, cryptocurrency, and rare collectibles like art, fine wines, sports memorabilia, and vintage cars. And given their accessibility and wide ownership, I'm not going to discuss those assets. (Plus, you all have gurus at Stansberry Research to tell you about bitcoin and gold.)
Instead, I want to focus on the three largest parts of the institutionalized alts universe that don't get much airtime in the Digest: private equity, private credit, and private real estate.
Private equity is by far the largest and most established form of alternative investments...
As the name suggests, private equity ("PE") involves investing in the equity of privately held firms. While there are many different forms of private equity, the common goal for nearly all PE investment managers is to proactively work with private companies to add significant value to their businesses over several years.
The largest subgroup of private equity is buyouts or leveraged buyouts ("LBOs"). This involves a PE firm buying and taking control of an entire business so that the firm can manage all functions of a company to most efficiently effect change in the business.
Oftentimes, the PE manager will utilize significant levels of debt to buy the business and increase returns, which is why these types of investments tend to be called leveraged buyouts.
I started my career at Blackstone, one of the world's largest LBO investors, and the firm and its investors have enjoyed tremendous returns over the decades from most of its LBO investments. But this strategy comes with risk.
My role at Blackstone was on the investment-banking side, but still, I saw the perils of the LBO strategy, often representing LBO managers who had saddled portfolio companies with too much debt and were trying to find a way to avoid a costly restructuring or even bankruptcy for the investment.
The other large form of PE investing worth noting is venture capital ("VC")...
Venture-capital investing involves providing capital to early-stage private companies, including true startup ventures.
Venture-capital investors tend to back management teams they believe will harness secular trends in innovation or address a large, unmet need in the economy.
Think of investing in Google or Facebook before they went public. Those are the success stories that VC investors dream of. But there's another side to the coin: Failure rates of VC-backed companies tend to be much higher than other forms of PE.
The other two big forms of alts are private credit and private real estate...
Private credit is an umbrella term for many kinds of loans and fixed-income instruments that are neither publicly traded bonds nor loans originated by traditional banks. Private-credit lenders provide capital to companies in a direct and privately negotiated transaction.
Private-credit funds invest in all sorts of debt instruments, from the most senior, secured loans down to more junior, "special situation" financing. The borrower might be a cutting-edge biotech company that needs funds for the next round of research and development, or a well-established, capital-efficient software company that has fantastic recurring revenues but not that many hard assets.
All sorts of companies need to borrow for all sorts of reasons. And banks aren't always willing to lend at optimal terms. That's where private-credit lenders come in.
While there are exceptions, one major benefit to most private-credit instruments is that they tend to structure interest payments on a "floating rate" basis, rather than the fixed rates of most public bonds. That means private-credit investors are typically far more insulated from changes in prevailing market lending rates than fixed-rate public debt investors.
Thus, while most public debt investors were crushed in 2022 by surging interest rates, most private-credit investors performed quite well. (And currently, private-credit providers are often lending with interest rate "floors" as well, meaning that even if rates fall from here, their returns are protected.)
Private real estate within alternatives generally refers to investments in privately held property or real estate assets. This spans a wide spectrum, from owning and renting out a house or small strip mall to buying farmland or timberlands, and up to investing with real estate developers that build large commercial offices and apartment building complexes.
Two additional things to note about private real estate: First, while many private-property investments are structured as real estate investment trusts (or "REITs"), these are distinct and different from publicly traded REITs. Second, while most investors think of private real estate investments as solely equity investments, there are alternative investments within real estate that are credit related, including construction or bridge financing, mezzanine lending (a debt and equity combination), and distressed real estate investing.
So... what are the potential drawbacks and benefits of alternative investments?
Before highlighting any of the virtues, I should address the three main downsides associated with most forms of alternative investments...
The first drawback is liquidity, or the lack thereof, in alternative investments. In many ways, this is a defining characteristic of alternatives since most alts tend to invest in private markets as opposed to publicly traded stocks and bonds. But it goes beyond that...
In many cases – and particularly for the truly institutional-grade ways to invest in alts – this can mean no liquidity for your investment for years. In general, alternative managers require investors to agree to a "lock-up period," or a set period that the investors agree to not take their money out of the fund. This can range from a year to 10 years or more.
With that said, some newer forms of alternatives do offer monthly, quarterly, or annual opportunities for partial liquidity. But I generally advise investors to proceed with caution on pursuing such "semi liquid" investment vehicles. As we've seen countless times – most recently with the collapse of Silicon Valley Bank – it's never a good idea to mismatch the liquidity of your assets with that of your liabilities.
The second drawback to alts is fees. Generally speaking, alternatives managers charge higher fees than public-market managers. The most well-known example of this is the traditional "2 and 20" fee structure. This refers to a 2% management fee on invested assets, plus a 20% "performance fee" share of fund profits. In practice, more alts managers are offering lower fees than 2% and 20%, and the larger the check an investor can write, the more negotiating power they have. But in just about every case, the end result is a more expensive fee structure for private-market investing than for public-market investing.
The third and final major drawback to alternative investments comes in the form of greater potential risk. In general, alternative investments are less regulated, more opaque, and rely more heavily on the individual decisions of the investment manager (as opposed to movements in the overall market).
These factors combine to produce a huge dispersion in returns between the very good alts managers and the very bad ones, much larger than with traditional, public-market investment managers. And it means that prudent manager selection is mission critical to successful alternative investing.
So what about the benefits?...
Surely, the benefits must be significant to justify dealing with such significant potential drawbacks. Well, I'm happy to confirm, based on deep research and years of experience investing in alternatives, that for many investors, the benefits handily outweigh the drawbacks.
Here are the three big benefits...
The first and most cited benefit to alternatives is higher returns. Over time and in most cases, this has proven true. In an expansive study done by Cambridge Associates on returns from 1988 through 2017, both private-equity and private-credit assets outperformed their publicly traded counterparts...
Private equity beat listed equities (the S&P 500 Index) by nearly 5% annually on average, and private credit outperformed public fixed-income investments by more than 2% per year over the period...
It makes sense that investing in private assets should offer higher potential returns since investors are giving up the ability to freely trade in and out of assets the way you can in public markets. After all, if two assets produced the same level of returns and are equal in every way except one was liquid and the other illiquid, nearly all investors would choose the liquid option. This dynamic is called an "illiquidity premium" that alts and private assets generally must provide to compete with liquid investment options.
The second major benefit of alternative investing is greater diversification. Put simply, by expanding your investment universe beyond publicly traded stocks and bonds, your portfolio should benefit from a more diverse and, ideally, less correlated set of investments.
Historically, publicly traded stocks and bonds have been regarded as the core building blocks of a diversified portfolio, often split 60% and 40%, respectively. This mix is intended to capture the growth upside of stocks and the yield and price stability of fixed income.
Yet as you know, the average 60/40 portfolio had one of its worst years in recent history in 2022, with stocks and bonds highly correlated to the downside.
Alternative investments, on the other hand, have added considerable value to an overall portfolio by diversifying risks and mitigating volatility under different types of market stress. Private real estate, for example, has historically been an effective hedge against inflation. Unlike traditional fixed income, which generates fixed cash flows, income from real estate can rise over time as rents rise. The same is true of most private-credit investments which tend to have floating rates of interest that rise when inflation and prevailing interest rates rise.
Combined, these two benefits lead to the true holy grail of investing: better risk-adjusted returns.
What alts can do for a portfolio...
Increasingly, we at SAM find that what our investors are looking for is not necessarily the prospect of higher absolute returns, but rather returns that are greater relative to the risk they're taking.
To measure risk, many investors look at the average annual volatility of asset returns over time and then compare that with average annual returns. Investment-grade corporate bonds, for example, tend to have lower returns than U.S. stocks. But they also tend to have much lower volatility in their return profiles.
Professional investment allocators know that the same is true for alternative investments – in fact, volatility tends to be much lower for private investments.
How they use this knowledge is key: They reduce the volatility – or risk of capital loss – in their overall portfolio by owning private investments while also increasing returns.
Think back to that 60/40 portfolio. Per a recent study by JPMorgan for data from 1989 through the first half of 2023, moving from 60% stocks and 40% public bonds to 40% stocks, 30% bonds, and 30% alternatives had the effect of lowering portfolio volatility by more than 17% but increasing returns by more than 7%.
Generating high returns with less risk sounds like a wise move in any market. But it strikes me as particularly wise in the current environment with geopolitical uncertainties, still-too-high inflation, and massively overindebted governments around the world debasing their fiat currencies.
Why do I think private credit is the best alternative investment right now?
In short, private credit offers the single best risk-adjusted return profile current markets have to offer. Not leveraged buyouts. Not private real estate. Not venture capital.
Consider four factors in the current environment that make generating strong returns (i.e. 12%-plus annual returns) from most alternative investments challenging.
- Prevailing interest rates are high after the Federal Reserve raised rates by more than 500 basis points over the past year and a half.
- Banks have dramatically tightened lending standards and capital availability.
- Asset prices remain elevated.
- The appetite for companies to go public (via an IPO or otherwise) has almost completely dried up.
These first three features of today's environment make generating great returns from buyouts and real estate investments extremely difficult. Both types of investments produce the best returns when they can borrow lots of money at low rates, buy assets at affordable prices, and then sell those assets later at much higher prices.
The last two challenges make excellent returns in venture-capital investing exceedingly hard as well. One could argue that we have the opposite of ideal conditions for all three.
Juxtapose that with private credit, and specifically private direct lending of senior, secured, floating rate loans. Other than higher asset prices, the other three prevailing market conditions are not a hindrance but a boon to the asset class...
Higher interest rates increase returns for private credit... banks pulling back lowers the competition and increases the addressable market size... and so, too, does a closed IPO window – if a company can't go public, maybe it will finance its business with debt until it can.
Said differently, in the current environment, it's far better to be a lender than a borrower.
But don't just take my word for it. How about Stephen Schwarzman, CEO of Blackstone? Mr. Schwarzman recently said to a room full of institutional investors...
If you can earn 12 percent, maybe 13 percent... in senior secured bank debt, what else do you want to do in life?
If you are living in a no-growth economy and somebody can give you 12, 13 percent with almost no prospect of loss, that's about the best thing to do.
In my mind, this is particularly noteworthy since Blackstone is the world's largest private real estate and private-equity investment firm and not the world's largest private-credit firm. He is not "talking his book."
Who can invest in alternative investments?
When it comes to the less institutionalized categories of alts, such as cryptos, gold, rare wines, and classic cars, just about anyone can invest. However, with alts that were historically focused more on institutional investors, there are restrictions.
Generally speaking, the intention of the restrictions and regulations is to protect less sophisticated and less informed investors from products that can have significant risks associated with them.
So the U.S. government's restrictions fall into two categories... First, you must be knowledgeable enough to invest in these products (for example, be a licensed investment pro or a "knowledgeable employee" of a company with a private fund) or second, you must be wealthy enough that you should know what you're doing (or at least have a high enough income or investable assets to be able to better absorb a painful loss).
Specifically, these institutional-grade alternative investments have three levels of accreditation that are summarized here:
Who should invest in alternative investments?
In my view, who should invest in alts is a more interesting question than who can, in part because there's no one-size-fits-all answer. Still, here are a few types of investors that should consider an allocation to alternative investments after consulting with a financial adviser:
- You have a long-term investment horizon for part of your capital,
- You have at least $1 million in net worth,
- You understand both the potential drawbacks and benefits up front, and/or
- You are seeking new ways to diversify your portfolio and potentially improve your investment returns.
Okay, so how should you invest in alternatives?
The good news is that accessing alternatives is becoming easier with more alts investment providers opening their doors to individual investors. But you need to be careful.
And, again, whether it's SAM or another experienced firm, I recommend you consult with an adviser who will consider an allocation to alternatives in the context of your overall financial picture and broad investment goals.
Beyond that, remember two things. First, liquidity is an extremely valuable feature to give up, even if it comes with the prospect of better returns. So only do it for part of your capital. Second, manager selection and diversification are mission critical. Only invest in the best managers and spread those investments around.
To provide a more specific answer... I'm pleased to announce we've launched the SAM Alternative Investment Opportunities Fund, available to accredited investors, including qualified client ("QC") and qualified purchaser ("QP") investors. We view the part of the private-credit market that this fund will target – namely, senior secured direct lending to capital-efficient businesses with strong recurring revenues – as ideal in today's environment.
If you meet at least the accredited investor threshold and would like to learn more about the fund, there are two ways to do it now...
First, we at SAM have recently recorded a webinar that provides details about our fund and explains how private credit can upgrade your portfolio. Access that webinar here.
Or, if you already know you're interested or would first prefer to speak with someone right away, click here to schedule a one-on-one call with us to discuss.
In either case, if you are interested, I ask that you respond quickly. Due to the nature of this fund, a limited number of investors are allowed to participate. Earlier this month, we held a first close of the fund. A final close of the fund is expected on February 29.
So there's still time left and there are still spots available. But I encourage folks that are interested to reach out today.
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In today's mailbag, more thoughts on Argentine President Javier Milei's speech at the World Economic Forum last week... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"In response to Milei's speech in [Thursday's] Digest:
"WOW! This is just what the people of the world needed to hear, to give them hope and the strength to begin to take back control of their own countries. For too long, we have let the elites and the government take away freedom after freedom, both economic and personal." – Subscriber Kenneth G.
"Well, [Milei] is certainly a radical, and thinks he has the absolute answer, [and] has some valid points, which are poor policies (either socialist tending or capitalist tending) have their weaknesses, [but the] capitalist weaknesses he does not acknowledge. His tip-of-the-tongue approval of a would-be 'strong man' like Orban or Kim, or Putin or the U.S. self-declared strong man Trump seem to be more to his liking. Both economic systems have their better and worse points, he exhibits no real depth of understanding of the subject." – Subscriber George O.
Good investing,
Austin Root
Towson, Maryland
January 23, 2024
Disclosure: Stansberry Asset Management ("SAM") is a Registered Investment Advisor with the United States Securities and Exchange Commission. File number: 801-107061. Such registration does not imply any level of skill or training. For more information on SAM, please visit here.
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