Last month we sent out a piece discussing private investments and their ability to optimize the risk-return equation for client portfolios. This month we continue, in more detail, that discussion on ‘privates’ and why we believe it is a timely conversation.
The current bull market is now more than a decade old – the longest in U.S. history. With more than 130 months of uninterrupted economic growth, the expansion the U.S. is experiencing is also the longest on record. Steady, if unspectacular, growth, along with ultra-low interest rates, subdued inflation, and accommodative monetary policies (e.g. low rates from the Federal Reserve) all have combined to provide the foundation for this extended rally. 2019 was a strong year in the public markets as both stocks and fixed income produced returns in excess of their historical norms.
But as we look to position investment portfolios for the decade ahead, we see mounting headwinds. These headwinds – slowing economic growth, elevated market valuations, investor complacency, less accommodative monetary policy, rising deficits, domestic and geopolitical tensions – could limit upside potential and increase the volatility profile for most traditional approaches to asset allocations.
While we acknowledge that attempting to precisely predict the future is a fool’s errand, we employ proven processes that build a framework for future portfolio construction. Gries Financial Partners studies a variety of quantitative and qualitative data as well as statistical techniques to formulate expected returns and estimates that represent long-term (typically 5 to 10 year) performance forecasts for various assets.
Our integration of internal and external research yields one resounding message: Investors should expect lower returns and more volatility over the next several years. For example, we would suggest that a traditional 60% equity/40% bond portfolio may return just 4% annually over the next five years, while still carrying a relatively higher measure of risk. Over the next 5+ years, we believe traditional asset allocations will fail to meet investors’ expectations, and we anticipate that risk-adjusted returns will be considerably lower than those realized this past decade. With this in mind, we believe that investors need to explore alternative asset allocations.
So how can individual investors and institutions continue to meet their return and distribution targets in a low-return world? We believe that incorporating private investments (investments that do not trade in the public markets) will be a critical piece in solving the low-return puzzle.
Gries Financial Partners has spent several years developing private investment solutions to address this specific concern. In a low-return world, we believe there are three primary themes to consider when constructing the proper asset allocation for the decade ahead:
1. Cash Flow: Investor gains come from a combination of price appreciation and income. In a low-return world, income generation (cash yield) becomes increasingly important as a stable way to generate returns, when the prospect for steady price appreciation is in doubt.
2. Uncovering Inefficiencies: Various factors such as regulatory changes, liquidity, and a general misunderstanding of complex situations have created idiosyncratic risk-return opportunities to the potential benefit of investors. Private markets are inherently less efficient than their public market counterparts.
3. Illiquidity Premiums: Liquidity describes the degree to which investments can quickly be bought and sold. Empirical research has shown the existence of a substantial liquidity risk premium across a variety of asset classes; in other words, if an investor can tolerate not accessing their capital for an extended period, they will generate more attractive returns on investment.
In order to execute on this concept, Gries Financial Partners has built and maintains a robust roster of alternative, private investment strategies that can be seamlessly integrated into existing traditional asset allocations. We do this because private strategies can on some level address the themes highlighted above. Private investments provide idiosyncratic return streams that carry the added benefit of lowering correlations to traditional stocks and bonds (e.g. these investments can go up even when the broader markets are going down, providing overall a lower risk portfolio).
As an example, one private investment approach we have employed recently is in the area of middle market direct lending. A middle market company is generally defined as a private company that generated between $50 million and $2 billion in revenues. Historically, banks have been the primary source of borrowed capital to middle market companies. However, following The Great Recession of 2008, changes in bank regulation (e.g. Basel III & Dodd-Frank) have made it extremely costly for banks to make loans to these types of businesses. In response to regulatory changes, bank participation in the space has fallen by 90%, which in turn, has created an opportunity for non-banks to meet the rising demand for capital. We find this type of strategy appealing because middle market loans are often more conservatively structured relative to the broader loan pool (e.g. secured loans, senior in the capital structure with more protections in place), provide investors very attractive cash yields, and historically have below market default rates.
Because private strategies hold unique attributes, when used correctly they can be a prudent way to enhance returns and mitigate risk. However, private investments encompass a wide variety of strategies and underlying manager quality. As a result, due diligence, sourcing, and manager selection is critical. Unlike the public markets, true private strategies cannot be indexed, but instead must be evaluated on a one-by-one basis and on their own merits.
Gries Financial Partners is dedicated to providing clients with access to best-in-class, institutional-quality, private investments. Our customized investment solutions are designed to meet long-term financial goals through an investment process that emphasizes risk-adjusted returns.
We welcome the opportunity to answer any questions you may have on private investments and to discuss our investment outlook with you in greater detail. Please contact Kris Jarosz, Director of Research, at 216-861-1148 or email@example.com for more information.