All about alts: The cases for (and against) private investments

Skepticism is growing about the ability of private markets to consistently outperform more conservative portfolios made up of stocks and bonds.

No matter, say advocates of private credit, private equity, private real estate and other alternatives to publicly traded investments. Even if private vehicles don't always generate greater returns — especially once fees and other costs are taken into account — they do have one benefit: They help shield investors from the sometimes sweeping fluctuations known to hit public markets.

In other words, they offer diversification.

"I do believe, fundamentally, alternatives can add a lot of benefits to anyone's portfolio from a risk-adjusted return perspective, or additional income with more diversification," said Robert Stark, the CEO of Nomura Capital Management.

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A U.S. subsidiary of Tokyo-based Nomura Holdings, Nomura Capital Management is primarily in the business of helping advisors and institutions gain access to private and public credit markets. Stark, who has been in the industry for more than 20 years, said he's well aware that one common criticism of private debt, private equity and similar investments is that they don't make it easy for investors to pull out their money.

"It does come at a price of less liquidity, so that is a dimension that advisors need to take into consideration as they construct this type of portfolio," Stark said.

Where are the returns?

But illiquidity is just one source of concern. Doubts are also growing about private markets' much-vaunted returns potential.

A recent study by the National Bureau of Economic Research took a close look at the performance of a particular type of private credit known as direct lending, or lending without the use of a bank or other intermediary. Its conclusion: Direct lending offers virtually no measurable gains over broad public benchmarks of publicly traded debt, especially once considerations like fees and additional risks are taken into account. 

Even so, the three authors of the study found, the market for private credit does have a distinguishing advantage. It provides investors a means of gaining exposure beyond standard stocks and bonds.

Still, worries about private credit abound. JPMorgan CEO Jamie Dimon recently became the latest global financial leader to sound the alarm about this market, estimated to be worth $1.7 trillion. In an interview with Bloomberg on May 29, he warned of an unpleasant reckoning if the businesses and other entities that much of this money is being lent to prove unsound. 

"And if a little old lady finds out that she can't get her money back — and there may have been disclosures saying this money is locked up for five years — but, you know what, retail clients tend to circle the block, call their senators and congressmen. There could be hell to pay," Dimon said. 

The benefits of illiquidity

Yet, paradoxically perhaps, many wealth managers say the diversification benefits of private investments stem in part from their relative illiquidity. 

For decades, advisors' fallback recommendation to investors seeking diversification has called for putting 60% of their money into stocks and 40% into bonds. But cracks began to appear in that 60-40 portfolio in 2022 when both the stock and bond markets tanked, showing that two weren't as independent of each other as some had thought. 

Gerald Goldberg, the CEO and co-founder of GYL Financial Synergies in West Hartford, Connecticut, said private investments can be particularly useful in times of economic distress. When stock and bond prices collapse, many investors' first instinct is to try to salvage what they can by selling.

The trouble is that they often end up parting with what were meant to be long-term investments at prices well below the underlying assets' true value. Private markets, by making it hard to pull money out, can in effect force investors to take time to reconsider their instinct to sell.

"So that's why you need to go in with eyes wide open into these investments and recognize that you're going to be holding on to them for a while," Goldberg said. "Quite frankly, more often than not, you're going to be holding on to them for the timeframe that they should be held for, assuming you went through some sort of thoughtful planning and allocation process."

Some of that planning simply consists of looking closely at how much cash a client is likely to need in coming years. The last thing an advisor wants, Goldberg said, is an investor who discovers they need money and suddenly worries, "Oh, where am I going to source that from?"

"Because if those are the thoughts that are going through your mind, it's not an appropriate vehicle," Goldberg said. "For many of these investments, you're going to be sitting with them for what could be 10, 12, 13 years."

The illiquidity of private investments is among the reasons why many maintain they should be reserved for the wealthy. Investors can't put their money into many private vehicles unless they first qualify as "accredited" — meaning they have a net worth of $1 million (not counting their primary residence) or $200,000 in annual income in the past two years ($300,000 if they file their income taxes jointly).

Private investments, less transparency

Of course, with an asset class as varied as private investments, not all the opportunities are equal. Goldberg said he generally views private equity as coming with slightly higher risks but also possibly better returns. Private credit, by contrast, tends to be safer, he said; that's because of the steady income it can offer in the form of interest payments and because private lenders can recoup their money before equity holders in cases of default.

"It's really important that we're very particular and very precise when we're talking about alternative investments," Goldberg said. "Because, at the end of the day, with every investment vehicle, we need to understand what its purpose is and what you're trying to accomplish. Some people will think about it from a return-seeking perspective. And some people will think about it from a risk-mitigation perspective."

Advocates of private markets are quick to point out that the investment opportunities they offer far outnumber those provided by their public counterparts. A research paper published in August 2022 by The Ohio State University's Fisher College of Business found that the tally for publicly traded companies in the U.S. had decreased by half from 7,509 in 1997 to 3,530 by the end of 2020. Meanwhile, the Cato Institute economic think tank puts the number of private firms at 25 million.

Advisors know well that it's no easy task to discern which companies among those millions are worth lending to or buying pieces of. Jeff Kalapos, the chief investment officer at Coastal Bridge Advisors in Westport, Connecticut, said it's a myth that all private investments are by their nature "black boxes" that provide little information about their asset holdings.

Some private fund managers claim proprietary status for their investing strategies and decline to share details, saying they need to shield their secrets for success from the prying eyes of rivals. In such cases, investors should consider looking for opportunities elsewhere, Kalapos said.

"While there are many black box strategies out there, there are also plenty that do actually provide a pretty deep look into their process and portfolio," he said. "It's really always nice to have full transparency. From an investor standpoint, it provides a little bit more clarity and more of a roadmap into the risks and expected movements of the portfolio, which is a very important thing when you're trying to figure out the benefits of diversification."

Pulling your money out on their terms

Private fund managers have been making improvements not only with transparency but also liquidity. Many private equity deals are now structured through interval funds that allow investors to pull a certain percentage of their money out at set intervals, often once a month or quarter. Many privately traded real estate investment trusts, or REITs, have similar features. 

For instance, Blackstone's popular fund known as BREIT — which invests in industrial properties, student housing, apartments, warehouses and data centers — lets investors make monthly withdrawals. But if more than 2% of the REIT's total is taken out in a given month, or more than 5% in a quarter, the redemptions have to stop until the next quarter.  

Miguel Sosa, the head of market research and strategy at the New York-based alternatives firm BlueRock, said such features show why it's important for investors to go into private REITs and equity deals with their eyes open.

"I think there's a trend towards trying to offer more liquidity," he said. "But, ultimately, these are illiquid asset classes."

Give them what they want?

Yet, whatever the dangers of private markets, advisors also see benefits. The research firm Cerulli reported in September that just over 80% of 200 firms it surveyed said they think their private offerings set them apart from rivals. And nearly seven out of 10 said providing access to private markets has particular appeal to high net worth clients.

The investment firm Hamilton Lane came to similar conclusions in its own recent study. Surveying 232 investment advisors from late November to late December, it found that 92% of the respondents already have clients in private markets. Just over two-fifths said their primary reason for turning to private vehicles was a desire for diversification, the same percentage who cited the prospect of high returns as their main impetus.

Cliff Corso, the president and chief investment officer of Advisors Asset Management, said there's a real need to help advisors find the good bets among the myriad options offered by private markets. His firm offers this service not only with private investments but also mutual funds, managed accounts and other vehicles.

"One of our base value propositions is that we bring institutional-quality investment and asset management solutions to the financial advisor," he said. 

Corso said he thinks advisors these days are, on average, recommending about 3% of clients' portfolios be placed in alternatives like private markets.

"And I think, through time, the expectation is that the alternative component would grow to something more to the order of 10% to 15%," he said. "And then some firms are even higher than that. So now we can see how it is being thought of at these wealth management firms on behalf of the individual investors — obviously, again, with the caveat that it all depends on the individual investor's position." 

Goldberg agreed that advisors have a particular responsibility to help investors discern good opportunities among the myriad options on offer in private markets. 

"If you're just getting the average, run-of-the-mill return experience within the alternative space, it's probably not worth the candle being burned," Goldberg said. "However, if you have access to top quartile managers, it really makes a significant difference."