The Illiquidity of Alternative Investments and a Comparison to Public Markets

Record low interest rates following the 2007-2008 global financial crisis were unprecedented and caused many distortions in the global economy. In the investing world, record low interest rates pushed investors to look for alternatives to cash and high-quality fixed income (bonds), which yielded close to zero in North America and negative in Europe. Locking in very low single-digit or even negative returns was understandably unappealing for investors and, as a result, investors preferred equities and alternative investments. Alternative investments are non-traditional investments that do not fall into the category of equity or fixed income. Alternative investments are usually structured as Canadian mutual funds such that investors subscribe into the fund, which in turn holds the underlying private investments. Some examples of alternative assets include residential apartment rentals, residential mortgage lenders, residential and commercial construction lenders, and private equity.

Further boosting the impact of record low interest rates over the last decade, investors could borrow cheaply during this period and invest in asset classes with relatively higher expected returns, like equities and alternative investments. As we know now, too many dollars were chasing these asset classes during this period. The 2021 ‘meme-stock’ slash unprofitable tech bubble is a case in point. Cheap money piled into these speculative areas of the equity markets. As soon as it looked like the spigot of cheap money would go away, money flowed out and the bubble popped. While it is less clear if and where the excesses lie in the alternative investment space, there have been recent events where pension funds and other investors rebalanced their holdings simultaneously, which has highlighted the illiquid nature of alternatives.

Investors in alternative investments tend to be more long-term oriented than speculative equity investors as many alternative investment strategies aim to generate sustainable distributions and not sky-high returns over short periods. This is reinforced by the fact that many alternative investments charge a fee for redeeming/selling your position with 6-24 months of your initial investment. That said, it is likely that many investors who greatly increased their allocations to alternative investments during the low interest rate period are reconsidering their asset allocation now that interest rates provided by fixed income and GICs are four to five times higher than they were for much of the 2010s. Additionally, because equities and fixed income greatly underperformed alternative investments (on average) in 2022, many investment managers – portfolio managers like us, pension funds, insurance companies, etc., – are looking to rebalance portfolios back to their original asset allocation, requiring the partial sale of alternative investments to add to equities and fixed income.

The pressure of investment managers’ rebalancing, and more attractive fixed income yields, has caused some alternative fund managers to “gate” (i.e., restrict redemptions of) their funds. This means that an investor who submits a redemption request may not be able access their funds for quite some time, or only receive a portion of their redemption request on each redemption date. Some large alternative fund managers who have gated their funds include Blackstone (gated a US$69 billion fund) and Romspen (gated a CAD$3 billion fund). The risk of “gating” is a common risk that many may have overlooked when initially investing in these funds but is a risk that savvy investors are well aware of and must consider when constructing portfolios. That said, it should be made clear that gating does not necessarily mean you will not be able to access your money in future. In fact, gating the fund helps prevent the alternative fund manager from selling part of their private asset portfolio quickly to accommodate redemption requests. Because private asset portfolios typically consist of illiquid securities with few ready buyers, not gating could come with low sale prices, pushing the value of the fund lower, which is likely not in the best interests of the fund’s investors.

While some may view gating and the illiquidity of alternative investments as outright negatives and reasons to avoid alternative investments, we have a more nuanced view. If an alternative fund manager gates their fund, this is to protect the owners of the fund. If the alternative fund manager did not gate their fund, this could result in a fire sale of private assets, likely at a time when other funds are holding fire sales of their private assets, possibly resulting in poor transaction values for all sellers. This is the equivalent of selling during or just after an equity market crash, locking in significant losses. Having liquidity can be a curse for those who are not disciplined in their investment strategy. When stock markets fall precipitously, as they do on occasion, it may be tempting to jump ship and lock in the losses in your equity portfolio. This is only enabled because of the liquidity of individual equity and equity mutual fund holdings. One of the core responsibilities of a financial advisor is to coach clients to not panic when many others are panicking. An alternative fund manager gating their fund is similar in that it prevents its investors from panicking and locking in poor sale prices.

At Steele Wealth Management, we perform extensive due diligence on all alternative investments that meet the needs for our clients. Part of this due diligence is assessing the risk of gating, and therefore losing the ability to redeem a position for some time. We prefer funds that have a low risk of gating (i.e., the duration of the fund’s assets and liabilities are well matched) as this provides us the ability to rebalance when market conditions change and rebalancing can add to portfolio returns over time. While some funds we own on behalf of clients and recommend may be gated at some point in the future, this is the nature of alternative investments. Remember that alternative investments are meant to be long-term holdings, which complement equities and fixed income and provide more frequent rebalancing opportunities. We only allocate long-term capital to these securities where it is appropriate based on factors such as your individual risk tolerance, asset allocation and liquidity needs.

News and our views

• U.S. Regional Banking Crisis and Financial Sector Doubts in Europe. In mid-March, Silicon Valley Bank and Signature Bank were closed by U.S. regulators. The banks were the 16^th and 19^th largest banks in the U.S., and their failures marked the second and third biggest U.S. bank failures in history (by assets). The banks failed due to rapid withdrawals by depositors, which caused a short-term funding need, and the fact that these banks held mostly long-term assets, which had declined in value since purchase. A classic asset-liability mismatch. The U.S. Federal Reserve stepped in to provide short-term liquidity to these and other U.S. regional banks with similar issues. Days later, this doubt about banks’ asset-liability mismatches found its way to Europe’s ailing banks, primarily Credit Suisse, which received Swiss government support and was subsequently acquired by UBS after its shares fell to all-time lows.

Our Take: While government support of U.S. regional banks helps soothe short-term concerns, the current support program may not be enough to prevent deposits from moving from regional banks to “too big to fail” U.S. banks, which are seen as more stable as they have an implicit government guarantee. Deposits moving from regional banks to large U.S. banks may cause lending activity to slow as a higher cost of capital at U.S. regional banks will impede their ability to lend. Concerns about a higher cost of capital for European banks may shrink lending activity across the continent as well. We see large institutions in the U.S., Canada and around the world benefitting from investor concerns about smaller banks as more deposits at big banks mean a lower cost of capital. Depending on future interest rates, this period of lower lending activity may make a soft landing for the economy a bit more difficult and certainly increases the odds of a more traditional recession in many economies around the world.

• Oil Prices Hit 15-Month Low amid Bank Turmoil. Oil prices have been steadily trending lower since U.S. inflation peaked in June 2022. The recent banking issues in the U.S. and Europe pushed oil prices down as much as 15 per cent in March in response to a weaker economic outlook and possible de-risking on behalf of banks that may hold energy assets on their balance sheets.

Our Take: Lower oil prices will help counterbalance the negative economic effects of the financial sector turmoil as consumers and businesses will see their energy costs fall. Lower oil prices may also keep a lid on the Canadian dollar going forward, making the U.S. dollar and U.S. dollar investments relatively more attractive.

Just for fun

• Which countries get the most paid vacation days? The answer may surprise you! The top five are Iran (53), San Marino (46), Yemen (45), Andorra (44) and Bhutan (44). North American nations are among the countries with the fewest paid vacation days – Canada (19), United States (10) and Mexico (14). Lots of freedom in North America, but apparently we have to work for it!
• Although St. Patrick’s Day is now behind us, we thought you might be interested in this tried and true recipe for beef stew, courtesy of the New York Times. It will stick to your bones! For extra richness, we recommend swapping beef consummé for beef broth.
• If you’re a golf fan, it may be worth checking out the new Netflix TV series Full Swing. The show gives a behind-the-scenes look at the players and tournaments of the PGA tour.