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Setting the Stage
y bank statement arrived a few days ago, and I was frustrated to see my interest rate was just 0.01 percent. To put that in perspective, a $1,000 account earns just 10 cents of interest annually.
For people in retirement, today’s low interest rates present an enormous challenge. Long gone are the days when a retiree could simply put their money in the bank and live off the 5 percent interest that would give them $50,000 a year on a $1 million balance. Today, that same $1 million yields just $100 a year at my bank or $20,000 a year in relatively secure corporate bonds.
So what is an investor to do? First, don’t panic. A 5-percent total return is within the range of reason for a balanced account of stocks and bonds.
Some investors, however, want to know what alternatives they have outside of traditional stocks and bonds. These “alternative investments” include choices such as private equity, venture capital, oil and gas partnerships, mezzanine financing, private debt and others. More broadly defined, alternative assets are simply investments that do not trade on a public exchange like the NYSE.
Historically, many alternative assets have beaten the performance of the broader stock market for two primary reasons. First, private markets tend to be less efficient than public markets. Think of this concept as “buying wholesale and selling retail.” For example, private equity managers often purchase companies for four to eight times the company’s annual earnings (wholesale). If the manager can acquire 12–20 companies in the same industry, she can likely take it public for 10–20 times earnings (retail).
Second, these managers tend to be active in their investments. They have control levers to improve the company’s results such as expanding into new markets, broadening the product line, reducing costs or better aligning the incentives of the senior executives.
As difficult as it is to find quality income investments in the public market, the exact opposite is true on the non-public, “alternative” side—conditions have seldom been more attractive. Two examples include:
Cash flow-oriented private equity funds: These funds tend to yield 8–12 percent per year. They invest in old, boring recurring revenue industries such as landfills, frozen food storage and land leases under cell phone towers or billboards. Compared to the risks of high-yield bonds delivering similar yields, “old and boring” sounds delightful to most investors.
Private debt: Banks have pulled out of lending to all but the largest and strongest of companies. The effect for private lenders has been reduced competition, greater demand, higher-quality borrowers and the ability to charge higher interest rates. This is a nice combination if you are the lender. These funds generally target 8–12 percent annual yields as well.
While these are attractive returns, investors are well advised to exercise a great deal of prudence. Like publicly held stocks and bonds, one must choose alternative investments wisely and diversify. Unlike most stocks and bonds, alternatives tend to be difficult to sell. If you choose unwisely, you could be stuck for many years with an underperforming investment, or worse, you could lose your entire commitment.
Another challenge is that most funds require investors to commit at least $1 million, making it difficult for all but the wealthiest of investors to diversify. Also, these funds typically take five to 10 years (or longer) to completely pay out. Yes, investors may be receiving attractive income checks each year, but the ability to completely exit is minimal at best.
Finally, most alternative investments require participants to be “accredited investors,” which broadly means that investors must have a net worth of $1 million or more outside of their home, or earn more than $200,000 per year. The SEC’s definition for accredited investors can be found at http://www.sec.gov/answers/accred.htm.
One effective way to solve several of the challenges associated with alternatives (high minimums, difficulty in diversifying and the need for rigorous research) is to invest in a “fund of funds” (FOF). Under this structure, the FOF manager leads the research efforts and selects the underlying funds that become part of the FOF’s portfolio. By accepting commitments from a multitude of investors, the FOF can meet the relatively high minimums and still provide a diversified portfolio to each investor in the FOF.
Long gone are the days that retirees could simply put their money in the bank and live off of the 5 percent interest. However, a 5-percent return, while not guaranteed, is still possible with a combination of stocks and bonds. Accredited investors may also want to consider adding some exposure to alternative investments to help achieve their goals.
Touch base with your financial advisor and discuss whether adding some exposure to alternative investments is right for you. If you don’t have a financial advisor, give Albion a call. We are currently accepting new accredited clients and would be honored to talk with you.