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What you need to know about investing beyond the limits of public markets

Having access to private capital enables investors to construct portfolios capable of transcending the limitations of stocks and bonds

Investors nowadays may be looking for opportunities outside of what was once generally considered a standard investment portfolio of 60-per-cent equities and 40-per-cent bonds, since this type of asset allocation is anchored to the volatility of the public markets.

It’s no coincidence they’re looking elsewhere now. The current environment features low interest rates and high equity market valuations. The solution lies on the other side of the public market. Enter, private capital.

Much like the far side of a distant mountain range, the lesser-known realm of private capital can be daunting or simply inaccessible, since it presents a significant barrier to entry for a typical investor. But this reserved asset class can be extraordinarily lucrative for those with a sense of adventure and know what they’re doing, or at least have a trusted and qualified guide.

The term private capital, simply put, describes assets that are not accessible for purchase on publicly traded markets. These assets are not frequently priced as assets on a public exchange are, and, generally, they also have liquidity restrictions, require notice to redeem and a minimum investment time commitment.

These constraints can help manage investor behaviour, because private assets are not as easily traded as a stock held in a direct trading investment account, and, therefore, irrational decisions can be avoided. Historically, private capital was for institutional investors and high-net-worth individuals, because high minimum investments were required to access. This has changed.

Some segments of private capital may include:

Mortgages : Private mortgage funds can provide capital preservation and a stable, high level of interest income. The loans may be secured first and second mortgages on income-producing properties. Public market comparable: mortgage investment corporations (MICs).

Private debt : These investments are made by providing debt financing to corporate entities through private transactions. Private debt opportunities are most often illiquid investments that generally need to be held until maturity. Investments seek a high cash flow (yield) compared to traditional fixed-income assets. Public market comparable: high-yield fixed-income products.

Hard real estate assets : Such real estate is often income producing and spread among different geographic locations and property types (for example, multi-family, industrial, storage, office, senior living and retail properties.) Public market comparable: real estate investment trusts (REITs).

Infrastructure and renewable resources : Investments made in infrastructure and other real assets include highways, water plants, communication, airports, wind and solar farms, farmland and timber. Public market comparable: publicly traded infrastructure firm securities.

Private equity : Investments made in later-stage private companies (companies not listed on a public stock exchange). Public market comparable: publicly listed small-cap stocks.

Venture capital : Similar to private equity, but investments are made in early-stage private companies. Public market comparable: publicly listed small-cap growth stocks.

There are some key advantages to having private assets in your portfolio. The first is diversification. Private assets offer exposure to corners of the economy that public investments don’t. In the past two decades, the number of public companies has declined and the number of privately held companies has increased.

“Investors may need access to these markets in order to achieve broader diversification into great companies,” said Bijal Patel, an industry veteran and chief financial officer at Nicola Wealth.

He goes on to explain that another advantage is lower volatility in performance returns.

“Private companies’ valuations are much more a reflection of their actual earnings versus extraneous factors which often influence public market valuations,” he said. “For this reason, they experience lower volatility in pricing.”

Patel also highlights that “by partnering with great sponsors who take activist roles in helping companies to achieve long-term growth versus chasing quarterly earnings, investors may get the opportunity for enhanced returns.”

Finally, in the current low-interest-rate environment, investors are finding typical fixed-income investments less attractive. Private fixed-income assets may provide an opportunity for good cash flow and target attractive yields and returns compared to public-market fixed-income assets.

Sounds great, so what keeps most investors from venturing into this market?

To start with, most private assets have high minimum investment thresholds. Many private funds require investors’ money to be committed for a set period of time, usually more than five years, giving the general partner time to invest, manage and finally divest the fund. There are often significant penalties should you need to sell sooner.

Furthermore, the management fees can be onerous. Investors generally have to pay for access to this world, because private markets demand specialized expertise from fund managers and deals largely come about on the basis of relationships.

I always aim to allow my clients access to the advantages of private investing while minimizing the disadvantages by using pooled funds and limited partnerships focused on infrastructure and renewable resources, private real estate holdings, private equity, venture capital, private debt and mortgages.

As an investor, you may want to work with an investment manager (your guide) who can invest on favourable terms with specialized general partners, participate directly in financings through co-investments, and maintain an evergreen fund structure that gives investors the ability to put funds in — and, if necessary, take them out — at times of their choosing.

Keep in mind that many private asset funds take years to deploy the capital that they raise, so choose one that does not implement minimums and can invest your money right away.

Having access to private capital enables investors to construct portfolios capable of transcending the limitations of stocks and bonds. Like a brave pioneer, you can’t discover all the opportunities available without exploring the offerings along the road less travelled.

Source: Financial Post