We sat down with Tim Godin, Senior Associate, to discuss his current role at Altera, why he believes Altera’s investment offering differentiates the firm from others in the industry, and what he feels is his most notable achievement so far at Altera.
Is it possible to get a mid-to high-single digit annual yield in publicly traded fixed income or real estate investments? Yes. Further, are public options less risky compared to private fixed income or real estate? The answer to that second question, at least at a high level, generally appears to be no.
Whether referred to as income or yield, the notion of relying on a portion of a portfolio to generate recurring cash flow has become increasingly unreliable. At its core, yield is a product of an asset’s operating income (e.g., a portfolio of rental properties or the coupon payments on loans), which can be modeled with a fair degree of confidence. What is harder to account for, is the ongoing impact of changes in interest rates, the creditworthiness of borrowers, and the relationship an investment has with other assets, particularly if those assets are traded in the public markets. Each of these traits affects the level of investment risk and begs the question of whether seeking yield at the expense of adding what may be disproportionate risk is worth it or necessary.
What distinguishes yield-seeking investments in public markets versus those in private markets?
There are plenty of public debt instruments and real estate investment trusts (REITs) that advertise high yields (in some cases high single- to low-double digit annual yields). However, those yields are often tied to undesirable characteristics such as higher leverage multiples, lower quality borrowers, less secure or unsecured loans, and fixed interest rates at prevailing market rates.
Public yield seeking investments introduce varying levels of exposure to these characteristics while also presenting investors with a related dilemma. As most of these investments are tradeable on the public markets, the impact of changes to interest rates or credit downgrades may make investors uncomfortable and susceptible to abandoning a position. This behavior is all too common in public markets, creating a decision point of whether there is more value in exiting a position to preserve capital, or in being patient so as to realize the potential associated yield over the long term.
By contrast, private market investments seeking yield are not often subject to the same behavioral risks, in large part due to illiquidity. In isolation, illiquidity is a polarizing concept, where some investors view it as a risk and others as a benefit, but it does remove the ability for investors to abandon a position and allows sponsors to build a high yielding portfolio over a long term, which is typically a net benefit to all parties involved. Further, private market debt instruments and real estate typically include investor protections that public markets typically do not, such as conservative leverage multiples, capital stack seniority, collateral, and robust covenant packages. These protections further enhance investment in assets with durable operating cash flows. Collectively, these allow private credit and real estate sponsors to generate attractive yields on an absolute basis (high single- to low-double digit annual yields), as well as on a risk-adjusted basis.
As an investment firm focused on identifying private market investments offering differentiated sources of return in the lower- and lower-middle market, Altera views private yield-producing assets as highly desirable with a risk/return profile that perhaps may be more easily understood.
The Wall Street Journal recently reported that an increasing number of accredited investors are seeking to invest in private markets. Historically, these investors have only allocated approximately 2% of their investible assets to private markets, which is considerably lower than the programmatic, double-digit allocations across institutions like pensions and endowments.1 This spread in allocations to private markets stems from differences in these investors’ structure and time horizon, as well as their respective approaches to decision making and evaluating risk.
Pension plans and endowments are generally considered perpetual vehicles, maintaining their investment programs to meet a prospective book of liabilities (either short or long term) or provide capital for strategic programs several years in the future. They can afford to take an extremely long-term perspective on markets and individual assets and view the illiquidity in private market investments as an acceptable risk and return proposition. Over the last decade, this approach to aligning views and capital goals has been adopted by a wider cohort of investors, including high-net-worth individuals. People, of course, are not perpetual entities, and invest in accordance with certain goals they have in their lives.
Across high-net-worth individuals, differences in investment goals should warrant differences in approach and risk and return expectations. Illiquidity can be considered as one factor in an investor’s approach, typically as a premium (i.e., greater expected returns than liquid assets) or an opportunity cost (i.e., committing capital for several years precludes investors from deploying that capital elsewhere in the interim). Another common factor to consider is an investment’s size, which we can assess through several lenses (e.g., size of the market, size of the underlying asset, size of the transaction, etc.). All these definitions would allow investors to draw distinctions between larger and smaller deals, which each have their nuances, but the size of the underlying asset is the most common.
Investment size is a large driver behind differences in portfolio composition across institutions and individual investors. Larger institutional investors are generally incapable of considering lower- and lower-middle market opportunities as most have concentration limitations embedded in their investment policy agreements. For example, a smaller fund targeting $400 million and investing in companies with less than $25 million in EBITDA would be inaccessible to an institution seeking to invest $100 million, if they have a concentration limit set to 20% of commitments. It would make much more sense for this institution to target investments in larger funds (>$1 billion). Further, this limitation is why many institutions have extremely large, diverse portfolios, invested across several funds, or establish pooled “emerging manager programs” to invest in smaller opportunities.
Conversely, it’s more challenging for high-net-worth individuals to invest in larger funds, since capacity is largely consumed by institutions, and investment minimums are significantly more than most individuals can afford on their own. However, strides have been made recently to provide access to large funds through technology-based allocation platforms, such as iCapital or CAIS. These services allow large funds to target wealthy individuals and registered investment advisors (RIA), two cohorts of investors that they wouldn’t traditionally approach. The benefit for large funds is that they’re able to diversify their LP base away from institutional capital, in which allocations are defined by investor policy agreements and have little flexibility. The benefit for investors is that large funds are typically managed by reputable and successful firms (e.g., Blackstone, Carlyle, KKR, etc.), and many perceive that these funds are less risky than smaller funds. However, individual investors have greater flexibility and evolving priorities, and their decision to allocate to private markets could be meaningful. In such cases, smaller, differentiated investment options could have a material impact on an individual’s livelihood, either positively or negatively. While lower- and lower-middle market opportunities should outperform their larger peers2, there are thousands of investments to choose from, which can be daunting for many investors. This is where an investment platform like Altera may add value to qualified investors and RIAs seeking investments in private markets.
Altera is a private markets investment firm and institutional due diligence platform focused exclusively on the lower- and lower-middle market. We believe that qualified investors should have access to best-in-class investment opportunities in private markets, and by providing clients with a frictionless investor experience, lower investment minimums, proprietary market research, underwriting guidance, and access to differentiated solutions across private equity, private credit, and real assets, Altera helps to bridge the gap between high-net-worth individuals and institutions.
1 “Wealthy Investors Pile Into Private Equity to Escape Stock Volatility” https://www.wsj.com/articles/wealthy-investors-pile-into-private-equity-to-escape-stock-volatility-11653561000.
2According to the NAICS Association, there are over 200,000 companies in the United States with revenues >$5M, which presents a broad universe of potential investment opportunities for lower- and lower-middle market sponsors. Generally, if there is less competition for a deal, a sponsor can acquire an asset for less, which provides a downside margin of safety and potential multiple expansion if sold at a comparable price to larger assets. It’s important to note however, that this is a guideline for expectations – every transaction is different, and sponsors can deploy many different investment strategies, some of which may not align with this framework.
We sat down with Tim Partridge, Managing Director, to discuss his current role at Altera, when his passion for private markets started, and why he feels the way Altera works with its clients sets the firm apart from others in the industry.
In the current market environment, with swings in interest rates from historic lows to pre-pandemic levels, and global equities roiled by the Russian invasion of Ukraine, there are few reliable sources of return. In an evolving economy, investors have been challenged to maintain the status quo, particularly as it relates to their historical capital market assumptions or expectations across asset classes. In search of yield or uncorrelated sources of return, many investors have turned to private markets to supplement their investments in public markets.
Within mainstream private market investments, investors have poured into the largest offerings. The global private equity industry held nearly $1.8 trillion in dry powder at the end of 2021, of which the top 25 largest firms held a quarter1. This presents an interesting opportunity for investors seeking to maximize the potential impact of their private market portfolio, particularly through the lower- to lower-middle market. Altera focuses on this space exclusively and believes that smaller opportunities present the greatest potential upside for investors equipped to navigate the space.
WHY NOT MAINSTREAM PRIVATE MARKETS?
Mainstream private markets can generally be defined as the largest, well capitalized opportunities across the industry. In recent history, we’ve seen demand for private market funds increase dramatically, without a comparable increase in the supply of underlying investment opportunities. This supply- and demand-driven price appreciation has an inverse effect on return expectations – in the traditional valuation sense, purchasing an asset for a higher price erodes the upside expectations an investor should have, relative to comparable assets. Further, the historical success of mainstream private markets has garnered the attention of investors with distinct investment requirements, and in many cases, these create structural impediments that impact mainstream private market funds and their respective approaches to allocating committed capital.
With respect to the challenges facing mainstream funds today, consider the following:
Large funds primarily raise capital from large institutions. The primary pool of limited partners for large funds consists of institutions, namely pension funds, insurance companies, or endowments. These investors build holistic portfolios and allocate capital across all asset classes, informed by a book of liabilities, or return requirements. Due to the volume of capital they manage, they tend to make sizable investments ($10 million+) into underlying funds. From the mainstream fund manager’s perspective, it’s more lucrative and cost effective to focus on these large LPs, rather than raise the same amount of capital from multiple smaller sources.
Mainstream fund managers then must deploy a large amount of capital. Funds that have hundreds of millions, or billions, in committed capital are expected to invest most of it (90%+). This is a point of convergence with the lower- to lower-middle market and the factor that makes accessing this space a challenge for larger funds. For example, depending on the fund’s strategy, it would be less likely for a $1 billion fund to make hundreds of $5 to $25 million investments into portfolio companies with EBITDA ranging from $2 to $7 million. Each portfolio-level investment requires a substantial effort in sourcing, diligence, and execution. Working on that many deals wouldn’t make sense from a cost, or human capital perspective. Conversely, it is more practical for this $1 billion fund to identify 10 to 20 investments that are larger in size.
Larger portfolio companies have less “low-hanging fruit.” Generally, the larger the company, the more sophisticated its financial, operational, and managerial procedures. The lower- to lower-middle market is defined as being a much less efficient market. There is a greater likelihood that smaller companies have gaps in critical areas (e.g., fragmented operations, obsolete technologies, less experienced management, lack of financial oversight, etc.), and these gaps present opportunities for fund managers to step in and generate substantial economic value on day one. These inefficiencies translate to opportunities for skilled managers and prospective outperformance for investors.
LOWER-MIDDLE MARKET ALTERNATIVES
Fund managers that focus on the lower- to lower-middle market generally avoid many of the issues that impact mainstream fund managers. There are hundreds of thousands of small businesses in the United States with revenues in excess of $5 million2, and generally, these tend to have flexible capital needs. This allows for greater access across smaller investors, and fund managers can execute on niche strategies, take advantage of “low hanging fruit,” and generate substantial value for their stakeholders. Investments tend to be for smaller amounts into companies entrenched in local economies – supporting Main Street as opposed to Wall Street. Such private market investments are more likely to generate positive outcomes for all parties involved and are inherently less correlated with public markets.
Altera has established its own niche investing in the lower- and lower-middle market. Since our inception in 2018, we’ve developed an institutional due diligence platform targeting this segment of the market across all asset classes: private equity, private credit, and real assets. Through our network of independent and fund sponsors, we’ve cultivated strong deal flow that offers our clients the opportunity to allocate across lower- and lower-middle market investments, however it makes sense for them.
We welcome the opportunity to discuss how our approach may serve as a complement to your existing allocations.
1S&P Global Market Intelligence; Another PE dry powder record set; VC rounds in US fintech surged in 2021, February 11, 2022.
2NAICS Association, Business Lists, Counts by Company Size, February 2022.
Predicting the future in financial markets is like trying to pick the winner of the Super Bowl in the preseason, unless maybe you have a copy of Gray’s Sports Almanac from Back to the Future. Surely, the confluence of issues relating to global supply chains, COVID-19, monetary policy, and fiscal stimulus, along with the current geopolitical landscape have stirred capital markets. With that, market participants have cause for concern across many things, especially inflation, overheating equity valuations, and the looming possibility of a recession.
With no shortage of issues to navigate, there are two questions that remain top of mind for investors:
While answers to these questions have a dependency on point in time and relative market fundamentals, as it turns out, we feel private credit investments are well positioned to deliver both strong risk-adjusted returns and a meaningful yield.
Fundamentally, private credit is a form of fixed income, but in many ways it’s markedly different from public fixed income. Even before interest rates began their current upward mobility (the 10-year treasury is approaching 3.00% for the 3rd time in the last 10 years1) and the effects of inflation began to reverberate through consumer wallets and corporate coffers, the case for private credit was strong. Now it is even stronger.
Private credit is typically structured as floating rate debt (generally in the form of loans) and very often includes extensive protective covenants for lenders, which present key advantages to investors. As highlighted in Altera’s recent perspective “IS PRIVATE CREDIT THE ANTIDOTE FOR WHAT AILS FIXED INCOME?”, private credit can deliver both yield and capital preservation. Effectively, investors are getting the benefit of a more favorable interest rate profile relative to higher-quality, fixed-rate public debt, and a more favorable risk profile relative to floating rate public debt.
These differences were two of the primary drivers behind Altera’s launching of a private credit offering in the current market environment. Further, we selected a sponsor with an extensive track record, experienced team, and thorough investment process. This sponsor is conservative in how they underwrite the businesses they lend to, has the ability to structure loans to provide attractive income with capital preservation, and also adds the possibility of capital appreciation through equity in their investments.
On a risk-adjusted basis, we believe private credit is poised to perform well relative to other assets beyond just fixed income. The combination of structured yield, downside protection, and ability to capitalize on equity upside makes for an “all-weather” strategy. We continue to operate without a crystal ball to predict the future, but we also see the role of private credit in investment portfolios becoming more and more of a benefit. I wonder what Marty McFly is seeing in the Almanac…
[1] Board of Governors of the Federal Reserve System (US); www.fred.stlouisfed.org/series/DGS10.
We sat down with Julie Newman, Partner and Managing Director, to discuss her current role at Altera, her 12 years of experience in the industry, and why she feels Altera’s team is its most differential factor.
We believe asset allocation and a disciplined evaluation of risk and return are hallmarks of an effective investment process and critical within the current environment. Read how adding a diversified sleeve of alternative investments to investors’ portfolios can reduce expected volatility and increase expected returns.
With tax season now in full swing, we wanted to remind you to file an extension on your taxes due to delayed reporting with private investments. Extensions are very common when investing in private placements. The deadline for filing an extension is the standard tax deadline of April 18, 2022. We strongly encourage you to coordinate with your tax professional to plan to file these each year.
Partnerships are taxed as “pass-through entities”, meaning they do not pay taxes on their own, but instead pass any income, deductions, or credits to the various partners. Partnerships file Form 1065 with the IRS and then issue a Schedule K-1 to each limited partner that details their share of the financial results. Each limited partner is required to report this tax liability on their own tax return. This takes time running through each of these channels and oftentimes results in delayed reporting. In addition, Altera is a Registered Investment Advisor, and is therefore required to audit its holdings, which in turn further delays the turnaround time.
The below outlines some of the reasons why accounting for alternative investments takes longer than the standard filing:
Complexity: Determining the results from a portfolio of private companies requires financial reporting by each of the holdings (think corporate Annual Reports multiplied many times over). Corporations are expected to report their income to the IRS by April of most tax years, but a very large number do not meet this deadline.
Timing: Fund documents can only be prepared once all parties have filed.
Other LLCs: When a partnership invests in an entity that is also an LLC, the pass-through challenge is magnified. The filing is then about more than gains, losses and net income. It is also about tax credits, deductible expenses and other items. And as previously stated, the fund cannot file until all the LLCs in which it invests have filed.
Fund-of-fund accounting: A partnership investment is often held within another fund as a means of gaining diversification. This structure adds another layer of accounting that must be completed before tax documents can be generated, pushing the final K-1 to weeks after receipt of documents from their holdings.
Industry Bottleneck: The accounting industry is, unfortunately, charged with providing all financial statements, audits, and tax documents around the same time each year. Inevitably, some are completed more quickly than others.
Please note, it is common for investors to see their K-1s delivered as late as September but filing a tax reporting extension can make late reporting less of a concern.
Private markets in general are experiencing a strong tailwind due low yields, high inflation and uncertain markets. Check out our latest perspective from Q1 2022.
