In another article about alternative investments, this publication talks to HarbourVest about trends in the sector, and the approach that private clients should take.

This publication is running a series of interviews with organisations working in the field of alternative investments. Here, we interview HarbourVest Partners’ managing director, Simon Jennings. 

How useful do you consider it to think of “alternative assets” as rather being at the less liquid end of the spectrum (with venture capital and special situation hedge funds, private equity, etc, at one end, and listed equities at the other)?
There is a lot of debate around this. It ties in to the trend that sophisticated investors are using increasingly advanced Strategic Asset Allocation (SAA) techniques. The more they adopt these techniques, the more they realise the importance of private equity as a component in terms of risk mitigation and diversification, as well as returns.

As more people immerse themselves into SAA models, the key constraint is usually their tolerance for illiquidity. Long-term institutional investors, like pension funds and insurance companies, have a very high tolerance for illiquidity by their long-term liability nature, but the perceived wisdom has always been that this is less so for private clients. Once private investors understand that they can tolerate some degree of illiquidity, they start viewing it as a feature of the asset class and not a risk or a reason not to engage.

I like to ask private clients that “if 2008 happens all over again, what percentage of your total wealth would you want immediate access to?” The answer is never 100 per cent, and sometimes much less than 100 per cent. So if you don’t need access to it, it makes sense to take advantage of the illiquidity premium. Once clients embrace this concept, conversations shift to portfolio construction and whether they want to focus on diversified offerings, single funds or single companies. 

In the alternative asset class space that you track, what are the main trends you see (in hedge funds, private equity, venture capital, real estate, infrastructure, commodities, other)? For example: increased/decreased wealth management interest in certain areas (please give examples); use of specific types of vehicles (listed alternatives, offshore structures), redemption/liquidity requirements, etc?
About 20 years ago in private equity, private clients used to be invited by brand name funds to invest directly, but these were mainly large family offices. Seeing market opportunities, private banks then started building feeder vehicles for their high net worth clients, usually with a $250,000 minimum, and aggregate 100-200 clients to invest as one Limited Partner into the underlying fund. In the years leading up to the global financial crisis (GFC), these pools helped broaden the exposure to the asset class to more high net worth clients.

At the same time, family offices started making direct investments and co-investments, either alongside funds or in sponsorless deals and began building up their own investment teams.

Since the global financial crisis, there has been a bifurcation amongst private clients in terms of those who want to invest on their own, and those who now rely on private banks or other intermediaries and advisors. One trend that I’m seeing in the private client space is that private banks are no longer just doing feeder vehicles into single funds, but now establishing a “core diversified holding” - especially for their smaller high net worth clients - which includes secondaries and direct co-investments as part of this “core offering”, while single fund feeders become the satellites in their core-satellite positioning.

Another trend I’m seeing among both family offices and private banks is a move to outsource some, or all, of the private markets investment function. Even a large private bank with a sophisticated feeder fund programme sees the benefits of partnering with established, global and diversified private markets investors which can lend to the benefit of scale. This scale can take the form of access to general partners, originating and executing co-investments, generating secondary deals, portfolio construction and risk analysis. 

There is a lot of money going into private capital (private equity, debt, property, infrastructure) and we read comments about the build-up of “dry powder” (uncommitted capital) that is accumulating. Is that a cause for concern? Could yields be squeezed? Has the chase after returns caused some excesses? 
This may be the biggest concern currently, but I think the industry is approaching it in a far more mature way than it did in advance of the global financial crisis. Also, we have been here before. The deals done by some of the large buyout firms in 2006 to 2007 drew reactions like “this deal is going to ruin their franchise.” But most of these deals did not lose money. Perhaps they did not provide the kind of returns that investors would have liked, and what they did return may have taken longer, with the associated impact on IRRs being in single digits, but they still made money.

Several lessons have been learned over previous cycles that are worth reminding ourselves about. Investors have to be diversified and disciplined to invest consistently over multiple vintage years. Doing so produces better results compared with trying to time the markets.

To illustrate the importance of consistent investment through cycles, HarbourVest looked back at the performance of its portfolio over 20 years to see what would happen if certain vintages were missed. When we excluded the worst three vintages the portfolio did better by 4.8 per cent, but when we excluded the best three vintages the portfolio would have underperformed by 9.8 per cent. This demonstrates the value of committing to this market for the long term.

Our industry is currently pricing in a recession along with negative multiple arbitrage exit assumptions. In times like this, it is helpful for investors to also look at assets with lower correlation, such as secondaries and real assets. Tactically allocating to assets with less correlation, industries not dependent on continued GDP growth or areas of disproportionately high growth is one way to play environments like the one we have today. 

This has been difficult for private banks offering single funds in a feeder, as they are often restricted to two to three feeders a year focusing on buyout funds which their clients have heard of. This is why a core diversified holding is so important, and it’s something that we at HarbourVest believe in passionately. For example, the HarbourVest annual Global Fund series was designed with private clients in mind to incorporate diversification, consistent pacing, and the inclusion of secondaries and co-investments to speed up both returns and distributions and mitigate the private equity J-curve.

How much has the squeeze on yields for listed equities and other conventional asset classes encouraged a shift to alternatives?
There is an increasing recognition from private clients that illiquidity is acceptable. You now see investors moving from their fixed income portfolio to illiquid credit structures, and from their public equity portfolios into illiquid private equity, driven by both the promise of higher returns but also the recognition that illiquidity is not a risk.

There is a sort of wealth management quest for the “Holy Grail” of uncorrelated returns, encouraging interest in ideas such as life settlement funds, liability finance, not to mention traditional areas such as gold and diamonds. What is your take on whether such uncorrelated returns are ever really possible? 
Going to uncorrelated areas in isolation can be a dangerous game. Even if they do show signs of good returns, they still need to be a proven asset class, run by a proven manager, and the assets need to have lived through different cycles. Very few of these have stood the test of time in isolation. Generally speaking, it is better to focus on less correlated but proven assets rather than uncorrelated, unproven assets. Ultimately, this is all part of the wider strategic and tactical asset allocation discussion where no single sub-asset class in isolation has all the answers. A diversified, consistently paced portfolio achieves the optimal results - but with the ability to tactically overlay specific sub-assets, for example low correlation assets.

Has the 2008 financial crisis and its aftermath radically changed how you think of alternative assets, or just added to the data that you take into account about these areas?
The financial crisis reinforced our thesis that investors must remain diversified and disciplined and that they must invest consistently across vintage years to achieve optimal results while also incorporating assets with lower correlation and modelling in recessions. 

It has also strengthened our focus on areas not related to GDP growth and on areas where there’s a limited universe of buyers who require specific domain expertise.

Are there other points you want to make?
I think there is an increasing recognition among family offices, multi-family offices and private banks that it is hard to do what a firm like HarbourVest does. Increasingly, they look to us as partners to complement what they are doing themselves. This is most obvious in secondaries and co-investments, but even getting access to the best primary managers is tough for some groups.

The combination of experience, scale and skill is something that is difficult to emulate, so we find that it’s best to work in partnership. A private bank or multi-family office knows its clients and what they need – whether it’s a core diversified holding for the smaller high net worth clients or single company direct investments for its ultra-high net worth clients. We work in partnership with these groups to understand the areas where they want to complement their in-house skills and we work together to deliver a suite of solutions to address those needs.