Questions clients are asking – The Challenges of Alternatives Investments
Q: “We’re a very large client with substantial capital to deploy. What challenges might we face in designing, implementing, and monitoring a private markets program?”
A: There are significant challenges in building and managing a successful private markets program, but the potential for additive return to the overall plan as demonstrated by the performance of private markets over the past several years warrants the effort.
One challenge that applies through all phases from program development into program maturity is achieving and maintaining the targeted allocation. While investors can control the commitments they make to private markets funds, the actual drawdowns are determined by the respective fund manager and are made over the life of the fund. As a result, the actual exposure can vary significantly from the sum of the commitments. Similarly, distributions from private market funds are made at the discretion of the fund manager and are often correlated with public market performance, although in recent years, distributions from private markets funds have been strong while public markets have been relatively flat. For mature programs, the uncertainty of both drawdowns and distributions requires a substantial investment in resources to properly manage the portfolio. A key aspect of this is to maintain close contact with the private markets fund managers so that any large cash flows, positive or negative, are anticipated.
“For mature programs,
the uncertainty of both drawdowns and distributions
requires a substantial investment in resources
to properly manage the portfolio.”
Another related challenge is accurately measuring allocation. While there have been improvements in the valuation of private market assets, the reported valuations still do not reflect actual transactional data whereas the valuation of public market assets typically represents the trading activity of numerous market participants. The lack of private market transactional data creates additional uncertainty as to the true exposure to private market assets. Again, for mature programs, this issue can be somewhat attenuated by maintaining a consistent investment pace so that there is a balance across vintage years. The older vintages will be later in their value-creation cycle and carry their assets closer to fair market value while the younger vintage funds will tend to hold their assets closer to cost.
Finally, a challenge that is more significant to mature private markets programs is the possibility of over-diversifying a portfolio. As numerous studies have shown, there is wide variation in the performance of individual funds within the various private market sub-asset classes. This large differentiation in performance offers the benefit of earning significantly higher returns if top-performing managers are identified and included in the portfolio. However, if below-median managers are resident in the portfolio, their performance can significantly dilute the better-performing managers and result in an overall private markets portfolio performance that may not achieve the anticipated risk/return payoff. Thus, it is imperative to impartially evaluate the performance of fund managers already in a mature portfolio relative to the pertinent opportunity set. If it is not clear that an existing private markets fund manager offers a compelling investment opportunity, replacing that manager should be considered.
By Pavilion Alternatives Group™