Big isn’t always best: overlooked niche alternative asset fund strategies could provide more interesting returns
24 September 2019
“As demand for alternative investment strategies from both institutional investors and private capital grows, the latter will need to find its own approach away from the mainstream”, says Claire Madden, Managing Partner at Connection Capital
Interest in alternative asset funds is escalating. Global growth in alternative asset investments hit 11% last year, compared to an 8% fall in listed markets and a 12% decline in high-yield bonds, according to figures from asset manager Fidante Partners , as institutional investors seek to drive returns and reduce volatility at a time of heightened stress in public markets. Demand for alternative strategies is ramping up on the private capital side too (high net worth investors and family offices), for similar reasons. Research among our private clients has found that over a third of respondents are now allocating 20% or more of their portfolios to alternatives, up from around a quarter of respondents last year. Although the motives and the logic are the same, the tactics the two different types of investor deploy will need to be very different.
As ever, for many major institutional investors it’s often a case of ‘go big or go home’. All too often institutional investors will only look at funds of a certain size with managers who have been around for a long time. Other restrictions could include a reluctance to consider emerging asset classes or insistence on liquidity even if the underlying assets aren’t particularly liquid. Recent headlines around the freezing of the Woodford Equity Income Fund is a perfect example of why that mismatch can be detrimental to investors. Given the weight of institutional capital in the market, it can only really be targeted at larger funds to keep its fund manager relationships down to a manageable number.
For private capital, this dynamic provides an opportunity. Zooming in on small, niche or emerging alternative asset funds is likely to provide the richest seam of opportunities for investors – and not just because it is almost impossible to compete with institutional capital for access to bigger, more mainstream fund options.
Several studies have shown that funds with higher assets under management (AUM) have a negative correlation to performance. Private equity funds are a prime example. According to recent research from eFront , a Blackrock-owned alternative investment tech company, small-cap focussed leveraged buy-out (LBO) funds are more profitable than larger LBO vehicles in the US.
In the UK too, British Venture Capital Association (BVCA) figures show small buy-outs are outperforming large management buy-outs (MBOs) with a 16.7% since inception internal rate of return (IRR), compared to 15.6% . Today, with big buy-outs typically more highly geared than their smaller counterparts (especially in the current climate), many in the private capital space think the rationale for focusing on the upper end of the market is questionable.
Early, emerging, expert
So what kind of funds are we talking about here? There is a range of potential options if private capital is prepared to be innovative and target those alternative funds that are either too small or specialist for the big institutional investors to bother with, or that are focusing on areas that are too new and ‘untested’ for them to want to get involved in. This might include opportunities that are:
- Early stage - Perhaps a fund set up by a new manager whose team has demonstrated an excellent track-record and developed extensive expertise and essential contacts in their careers at well-known market players previously, but does not yet have the ‘brand’ or AUM to tempt large institutions
- Emerging - Maybe it’s a relatively new asset class that’s gaining momentum but seems too leftfield or lacks sufficient market scale and is, therefore. likely to be overlooked by many institutions where risk appetite is lower or where it does not fit the established investment criteria
Expert/esoteric – And/or the fund might operate in a very niche area or involve a highly specialised strategy, which is too focused or too expert to feature on more generalist institutional radars. Sometimes these niche strategies need to remain relatively small in order to work. Therefore, as they are not trying to attract significant institutional interest, private capital may be welcome.
Of course, even small, niche funds are still ‘institutional’ investments: they have familiar structures and governance but they just don’t have mass appeal (yet). But if it can find a route in, private capital is well-suited to these types of funds. Being entrepreneurial in nature, investors are prepared to do things differently, assess opportunities on their own merits and put risk into context in a way that few of the major institutions are set up to do. As often, anything non-mainstream gets filtered out early on by junior appraisal teams who are not incentivised to think outside the box.
Small is smart
A classic example is litigation funding. A decade ago when one of our portfolio companies, Therium Capital Management, set out as a pioneer in the sector, institutional capital was almost non-existent. In the early years, private capital played a crucial role in driving growth to the point where it was worthy of institutional attention. The current position is such that investment demand has exploded with the asset class now firmly established as mainstream across the globe.
Other areas where we believe private capital can tap into markets that are too small or unfashionable for larger funds (but are capable of generating better risk adjusted returns) include niche alternative lending funds or specialists in areas such as life sciences.
Putting this ‘small is smart’ ethos into action requires access of course. With clients increasingly looking to invest in alternatives to traditional asset classes, one might think that private banks have a role to play here. Instead what we find is that even if they currently offer their clients alternative asset funds, it’s likely to be only for the very wealthiest and still with an emphasis on the larger mainstream participants. News that fund manager Baillie Gifford may offer shares in its private equity investment trust to private investors in future may help if it happens – but the size of its focus remains to be seen.
Treading a different path
However, new and innovative investment models are already available to meet this demand, targeting opportunities that are institutional in style but that either don’t want large volumes of institutional capital or are not ready for it yet and connecting them with investors who can participate with smaller entry multiples. For those new providers with the right expertise, reputation and industry connections, there are some very exciting opportunities out there.
Rather than trying to follow the herd, private capital would do well to find its own path and pursue less obvious targets. It has an important role to play in the alternative asset fund space, investing in innovative ideas, new market entrants and value-driven strategies, with attractive risk-adjusted returns as the prize. Small and unusual: that’s where the best prospects are to be found.