“Those that fail to learn from history are doomed to repeat it.” -Winston Churchill
As laid out in Part 2 of this topic, our goal today is to convey the basic strategies of alternative investments that have been used on behalf of clients over the past several years, and – to Churchill’s point – hopefully, some important lessons learned.
Note: this is an excellent opportunity to add a bit of clarification. The holdings we’ll discuss relate to clients I have personally worked with for many years before my time with The Bahnsen Group. While there is some overlap with what TBG used before I joined the team in early 2020, there are also significant differences. Thus, please don’t extrapolate these particular holdings as applying to our broader team. I expect greater synergy of alts holdings for all of our clients in the coming years, as various strategies run their course, and proceeds need to be reinvested for the future.
They Call Me the Seeker
We were on a mission to find various strategies with improved characteristics vs. what we expected from daily-liquid investments; that difference would come in the form of less volatility with more income/total return and risk mitigation (ways of minimizing losses if things didn’t go as originally planned). In theory, this endeavor could provide a more consistent experience for clients through market cycles (“recession resilience”) while improving cashflow and long-term returns – especially in light of the (already at that time) low-rate environment in which we found ourselves.
Since not every client was a Qualified Purchaser, the goal was also to identify several alts that could be used for Accredited Investors or required no qualification. In addition, we needed to combine a variety of liquidity profiles to make the overall portfolio palatable. With this in mind – as we now explore each of these strategies – I will segment them by investor qualification, which will then loosely align with their liquidity profiles. Here we go.
No Qualification Required
Private Real Estate Fund-of-Funds
The appeal of this fund was that it could be used for all clients to help round out their allocations where needed. Or, for smaller accounts, it was a way of adding true private real estate exposure. While not as pure as a more illiquid real estate fund structure (we’ll get to some of these), we found that it had utility across all client types and sizes, and that was why the manager created it in the first place.
The fund invests in a diversified portfolio of other real estate funds (hence, a fund-of-funds), including some with decades-long track records and holding some of the largest, boringest (in a good way, and – no – that’s not a real word) properties in large cities. Because of the need for some degree of investor liquidity, the allocation must include some daily-liquid holdings – like publicly-traded REITs.
- Structure: Interval mutual fund, fund-of-funds
- Fund life / Access / Liquidity: Evergreen, with daily purchases and quarterly redemptions (subject to gating).
- Cashflow: Derives consistent cashflow from the underlying properties.
- Pros: Diversified, convenient, private commercial real estate exposure.
- Cons:
- “Fund-of-funds” means an extra layer of fees, although terms with underlying managers may be negotiated at more favorable rates than investing directly.
- The liquid part of the portfolio – along with the need for daily valuation of the mutual fund – can reflect more volatility than a fund holding only illiquid real estate.
- Where Are We Now?: Held very steady and continued paying income through the volatility of 2018 and 2020.
Direct Consumer & Business Lending
This fund was created to take advantage of the emerging opportunity in disruptive lending platforms, such as Lending Club, Square, SoFi, etc. While investors could go directly to these platforms and make loans themselves, they would also have to manage underwriting parameters and figure out how to make loans in a scalable/diversified way. The fund, however, could provide an institutional solution for advisors to use and incorporate additional risk management through owning whole loans, combined with greater diversification and redundant loan servicing.
When individuals lend, they would typically give only a portion of the amount requested by borrowers to achieve some degree of diversification. For example, if I’m going to lend $2000 via Lending Club, I could give $100 to 20 different borrowers (instead of all $2000 to a single borrower) to help diversify my risk. From the borrower’s perspective, their $20,000 loan may be composed of hundreds of small loans from hundreds of individuals, but Lending Club seamlessly coordinates the many loans to function as one cohesive loan. It then also collects payments each month and then pays each lender their rightful share of the principal and interest; this is known as “servicing,” which could become a problem if a given lending platform (Lending Club) is in this example) were to fail.
Simply because of scale, the fund could solve some potential issues. First, rather than fund pieces of loans, it would fund loans in their entirety (whole loans), which quells the complexity of coordinating servicing across hundreds of lenders for a given loan. It could then put contingent servicing in place in case a platform were to fail. In addition, significant resources could be dedicated to underwriting standards, and diversification could take place across hundreds of thousands of individual loans spread across multiple platforms, loan types, and borrowers.
These solutions appeal to borrowers, as the loans can help consolidate consumer/student debt but at far better rates and terms (non-revolving, set payoff schedule) vs. banks or credit cards. And, in the case of business loans through Square, loans can be seamlessly repaid (aka garnished) directly from business sales via order management software provided by – you guessed it – Square.
As outlined above, there are reasons this is a good solution, but it’s not perfect. For one, loans are generally issued at fixed rates, so interest-rate movements can affect the NAV (net asset value) of the fund. Importantly, however, these are private loans, so – while the value of the loans may fluctuate in the short term along with rates – when a loan is repaid, investors achieve precisely the return they were expecting when the loan was made. Also, these loans are unsecured. Unlike many of the other strategies we’ll discuss, there is no asset to take ownership of in the event of default. Risk is mitigated solely through underwriting and diversification. Last, there is no “cherry-picking” of loans/borrowers. The fund can set criteria, and then will receive loans at regular intervals that meet the criteria (e.g., every 5th loan with credit score above 750 and debt-to-income ratio below 25% will go to the fund). It’s perhaps the one disadvantage vs. what individual investors can do on their own, but it’s also an important factor in scalability.
- Structure: interval mutual fund
- Fund life / Access / Liquidity: Evergreen, with quarterly purchases and quarterly redemptions (subject to gating).
- Cashflow: Derives income from the underlying loans.
- Pros: Whole loans, diversification, reasonable yield, the influence of underwriting and servicing.
- Cons: typically fixed-rate loans, unsecured, no cherry-picking of borrowers.
- Where Are We Now?:
- Exhibited surprisingly good stability through the 2020 volatility.
- In a one-off situation, the fund held a small private equity stake in one of the platforms it lent through, which recently went public and benefitted shareholders (this aspect will not be replicated going forward).
Reinsurance
Reinsurance is essentially insurance for insurers. If I’m an insurance company that provides you with flood insurance on your home, I need to pay you if a flood occurs and you sustain certain damages covered by the policy. If I don’t want to assume all of that risk, I could transfer some of it to a third party. That practice is known as reinsurance (just what it sounds like!), and it may be the most significant business you’ve never heard of (or at least until the past 5 years or so). If interested, here’s a list of 2019’s top 50 reinsurance companies.
Some of the largest reinsurers are easily identifiable by their names alone, e.g., Swiss Re, Munich Reinsurance, Hannover Re, even if you’ve never previously heard of them. At the same time, you may be surprised to learn that Berkshire Hathaway rounds out the top 5 of the world’s largest reinsurers. And if Warren Buffett is willing to be involved so significantly, it would stand to reason that there’s a pretty good business case for it.
As laid out in this Investopedia article, there are several reasons why reinsurance exists. However, the most obvious is to help insurers manage risk – particularly that of insolvency in the case of widespread natural disasters that trigger an excessive number (and/or value) of claims. Thus, insuring against natural disasters (e.g., fires, floods, hurricanes) is a vital part of the reinsurance business.
There is a lot of work that goes into determining appropriate premiums for those types of policies, and it is tricky because hurricanes, fires, and floods vary so significantly from year to year. It boils down to charging an amount that allows insurers/reinsurers to cover losses and profit over the long term (in theory). But the premiums also fluctuate constantly to help adjust for reality, typically getting more expensive after a year with more claims than average (“market hardening”) or cheaper after a year with fewer claims than expected (“market softening”).
A hurricane nearly missing Florida or wildfires running rampant in the western US has absolutely nothing to do with what the S&P 500 did yesterday, and therein lies a certain beauty: reinsurance is an alternative investment that has essentially no correlation to anything else. The fund we selected created a passive approach to the reinsurance market. By partnering with reinsurers, they could take a pro-rata slice of the reinsurance business they underwrote. As an example, if Swiss Re added $100 million of reinsurance to its balance sheet, the fund would take 10%, or $10 million of that exposure – receiving premiums and assuming the risk that comes along with it. By coordinating the amount of investor capital commitments with many reinsurers, the fund was able to construct a sort of reinsurance index approach and allow investors to sit in the seat of reinsurers.
This was the first less-than-daily fund we invested in. At the time, there were few other (non-reinsurance company) players in the space, and it was the first interval mutual fund we had access to. Notably, we invested in this strategy prior to our broader journey of seeking income-oriented alts with more stability, but I felt it is worth including in this overview, as it was an important experience in shaping our perspective on other strategies to look for.
- Structure: interval mutual fund
- Fund life / Access / Liquidity: Evergreen, with quarterly purchases and quarterly redemptions (subject to gating).
- Cashflow: Highly variable, as it is dependent upon premiums received.
- Pros: Non-correlated diversifier.
- Cons: Can be very volatile and adversely affected by extreme conditions, including certain changes in climate.
- Where Are We Now?
- Many other investors entered the space after we invested, and this changed the market dynamics, resulting in less market hardening after a couple of difficult years for reinsurance (hurricane/flood/fire-related). It was simply a matter of supply and demand, with greater demand for investment in reinsurance forcing more competition for premiums and, therefore, lower premiums.
- The variable income may present a challenge for investors if consistent income is an objective (which it is for many of our clients).
If there’s one consistent motif found throughout alt.Blend, it’s my impressive (not in a good way) ability to have topics run WAY longer than I initially anticipate – resulting in my having to spread ideas over a series of posts. As we’ve only covered three funds today and already exceeded 2000 words, I find myself once again at that crossroads. With eight funds to go, my best guess is this topic will ultimately be a 5-part series, but bear with me, and we will persevere!
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
