Alternatives trickle into the mainstream

Where is it possible to find returns when interest rates are below zero and equities are considered expensive? For an increasing number of investors, the answer is alternatives.

Photos: / Graphics: Antti Sepponen

Equities and fixed income. That’s what a classic portfolio is made of. A classic portfolio also contains a pile of cash, waiting to be invested.

In recent years, a third asset class has risen up alongside equities and fixed income: alternatives. Alternatives already make up tens of per cent of the weight of major institutional investors’ portfolios and for several years, alternatives have made up around half of the biggest US funds.

Also in Finnish institutions’ portfolios, alternatives are starting to be mainstream. For instance, they account for 27 per cent of the Church Pension Fund’s portfolio. The pension fund started making alternative investments in real estate about twenty years ago.

“A decade ago, the share of alternatives was 12 per cent. We prepare an investment strategy for four years at a time. This autumn, the strategy will be updated again and I think the share of alternatives is set to rise,” says Chief Investment Officer Ira van der Pals.

The same trend applies to the majority of Finnish institutions.

“Fixed income–equities–alternatives, a balanced tripod,” van der Pals sums up the upheaval of her portfolio and the entire world of investment.

Earlier, alternatives were sprinkled into portfolios to add some spice, but now they are one of the main ingredients in the stew. Investors’ appetites have changed.

Earlier, alternatives were sprinkled
into portfolios to add some spice,
but now they are one of the main
ingredients in the stew. Investors’
appetites have changed.

REAL ESTATE, CORPORATE BONDS, PRIVATE EQUITY INVESTMENTS, RAW MATERIALS, infrastructure projects, forests, artwork and a bottle of wine. All of these are alternatives.

It is hard to define alternatives very precisely because there are so many different kinds and the terminology hasn’t had time to become established yet, especially among private investors.

Alternatives themselves can be old as investment products. What is new is their incredible popularity and classification into their own asset class. There is nothing alternative about, for example, real estate, let alone forests, from the viewpoint of Finnish investors. That is what they’ve always invested in. People who have grown up surrounded by the rustle of trees in managed forests may find it somewhat amusing that global financial publications are calling forests the new ‘alternative du jour’.

However, the reason why forests are so popular differs from traditional Finnish forest investments: globally they are interesting investments because, as a scarce commodity, investors believe their price will rise. Also the key role of forests as a carbon sink, and therefore a mitigator of climate change, adds to the demand for forest investments.

Nevertheless, real estate and forests can be classified as alternative investments based on their illiquidity. It is the main feature that sets them apart from fixed income and equities. Alternatives can’t be sold with a quick click like equities and fixed-income securities. A buyer may not show up immediately or the returns may be based on a long maturity: forests grow from tiny seedlings to long-fibred pulpwood, the return on real estate is based on years of rental income.

As alternative investments are not liquid, they offer a liquidity premium. This means that in order to attract investors, the expected return on alternative investments must be better than that of liquid investments with the same exposure. For instance, investors investing in a private equity fund expect to receive a larger return than those investing in public equity markets because private equity investments cannot be sold at just any time; instead they are typically exited when the company has been whipped into shape and sold onward.

Van der Pals describes investing in alternatives as a slow process. First they make an allocation decision and then start to look for investments. When they find them, they stick with them for a long time. After real estate, the Church Pension Fund has expanded its alternatives into private equity funds, infrastructure and forests.

“We have time to wait and see the investment through to the end and thus benefit from the liquidity premium. We can take it easy.”

This sounds nice and calm compared to the continuous commotion on the equity and fixed income markets.

INVESTMENT INSTRUMENTS ALWAYS SPRING FROM A NEED and are closely tied in with the surrounding society.

“They are a product of their time. The demand and supply always come from somewhere. Often the creation of alternative products is prefaced by a change in regulations or then a new inefficiency is discovered that alternatives utilise. Behind the current boom in alternatives is also a strong growth in demand. With interest rates close to zero and equities valued highly, investors find it difficult to know where to put their money. In this environment, everyone is looking for security in alternatives,” says Matti Suominen, Professor of Finance at Aalto University.

The alternative that is most clearly a product of its time is alternative fixed income investments.

The Church Pension Fund began making alternative fixed income investments systematically in 2016.

“Our thinking changed back then. We started wondering what alternatives we could find for traditional fixed income assets. Now they make up six per cent of the portfolio,” says van der Pals from the Church Pension Fund.

After the financial crisis, the weight of traditional fixed income, i.e. government bonds, was huge in the pension fund’s portfolio. They offered security in an uncertain situation.

“Now, I think their share is close to zero at most institutions,” van der Pals estimates.

Ilkka Tomperi, Varma

In terms of interest rates, we are
living in extremely strange times.
Investors are actually paying for
Germany to slide into debt.

In a world of negative interest and expensive stocks, alternative fixed income is added to the pot more and more often, to thicken an otherwise thin stew.

“In terms of interest rates, we are living in extremely strange times. The mood will remain subdued for a long while. Investors are actually paying for Germany to slide into debt. Meanwhile, equities have become more expensive,” says Ilkka Tomperi, Varma Mutual Pension Insurance Company’s Investment Director, Real Estate Investments, on the negative impacts of interest rates.

ANOTHER REASON FOR THE GROWTH taking place in the private debt markets emerged from the financial crisis: the banks’ capital requirements and the sector’s regulation were tightened so that banks could no longer become the hotbed of risk that they were during the financial crisis. The political pressure to tighten regulation was also significant as the governments saved the banks. A lot of tax money was squandered and political crises were ignited. On the other hand, the central banks flooded the markets with cash to prevent a credit recession.

Due to tightening rules, banks can no longer give out loans to companies as before, which means that companies are looking for their money elsewhere, i.e. on the private debt markets. The private debt markets now make up a significant share of the world’s financing system.

Demand created supply. One of the parties offering loan money is David Allen, CIO and Partner at AlbaCore Capital Group.

“The popularity of the market is based on the fact that companies need loans but banks are no longer granting them,” he explains.

In the United States, the birth of the private debt markets received a boost from the consolidation of banks. The banks have merged and grown to be so large that they are no longer interested in lending 50 million dollars to SMEs. Businesses therefore go straight to investors when they need a loan. Europe still has smaller banks, but due to capital requirements and regulation, they cannot provide corporate loans as before.

Allen looks for large companies, market leaders, that don’t seek loans from public debt markets, whatever the reason. AlbaCore, with 2.8 billion euros of assets under management, offers loan solutions tailored to these companies.

“There aren’t many companies of this kind, but we have time to wait for the right ones.”

Allen gives us an example.

“Many shy away from the retail trade because many of the sector’s businesses have gone bankrupt and the Amazon effect is making its mark. However, our biggest investment at the moment is a loan to a retail operator. The company owns and runs petrol stations, which also accommodate Burger Kings, bakeries and other shops. Steady returns, no e-commerce risks,” Allen points out.

Nevertheless, a company could have trouble securing a loan on the public markets as so many investors have categorically filed away all retail in their ‘no thank you’ folder. A company might also avoid the syndicated loan markets because it does not want to or does not have the opportunity to attract investors at roadshows. Or because it doesn’t want to take a reputation risk if it fails to get the loan. Or because it doesn’t want everyone to know about the loan.

Allen describes finding these types of loan deals as similar to private eye work and as challenging the consensus. Sometimes, just driving along the coast of California with his family can spark an idea.

“My family consists of my wife and three kids. We stop and take a lot of breaks. I noticed that there are a lot of people at rest areas. People travel, so this retail sector is not impacted by the internet,” says Allen, explaining how yet another family break at a rest area sparked the idea.

As the company cannot receive a loan from elsewhere, Allen can negotiate good terms for the money he lends and a good interest, even if the loan’s exposure is not very high. Good terms can also be negotiated when a company needs money quickly.

The method sounds simple, but in practice, the arrangements can take a lot of time, and negotiating billion-dollar loans is finicky and hard work.

Allen’s AlbaCore is a tailored private debt special product. Another way to invest in the private debt market is to put money in funds that lend to mid-cap companies, that provide high risk loans or that finance M&As. The options are endless.

In the USA, private debt funds are also available to private investors. It pays to remember, however, that they do not have deposit insurance and that the loan market is unregulated. The loan investments may thus evaporate if the possibly major risk materialises, and the investor lacks the security offered by bank deposits.

The same kind of steady flow of
returns as from real estate is also
offered by infrastructure investments.

THE POPULARITY OF ALTERNATIVE INVESTMENTS IS BASED also on their good relative return as, in investments, the return on one instrument is always compared to other instruments.

“If, for instance, you have expected a return of 5–6 per cent on real estate, 4–5 per cent may now be a reasonable expectation on the same investments. Corporate bonds may offer interest of one per cent, but the rental income from a property leased to the same company can be 4–5 per cent,” says Ilkka Tomperi, Investment Director, Real Estate Investments at Varma, as an example of a change in the net initial rate of return.

Tomperi is not exactly convinced that real estate should be classified as an alternative.

“It is after all the oldest asset class. In terms of returns, real estate lies somewhere between fixed income and equity investments. Volatility may be higher than in fixed income, but so are the returns,” Tomperi says.

According to Tomperi, low return levels can be acceptable, but the quality and location of the investments needs to be assured. By quality, Tomperi does not mean ‘the most expensive and shiny’ state-of-the-art buildings. What matters is, for example, that a grocery store property may be a better investment than a shopping centre because people need to buy food even during a downturn.

“When the shock hits, we can separate the wheat from the chaff. If you haven’t compromised on quality, the investments suffer less. The risk-return ratio of real estate is good in this interest rate environment and a sudden surge in interest rates seems unlikely. Still, it’s good to remember that we are at the tail end of the traditional real estate cycle,” Tomperi says. Usually, the traditional real estate cycle follows the general economic cycle. The record-long economic growth has started to slow down and is already showing signs of future decline.

Recently, Tomperi has thought hard about the characteristics of different real estate classes: commercial premises correlate with the GDP, while flats and senior housing, ­not so much.

“People need to live somewhere even when the economy shrinks,” Tomperi points out.

The same kind of steady flow of returns as from real estate is also offered by infrastructure investments. Builders of roads, power plants and other major projects need loan financing.

To the Church Pension Fund, investing in infrastructure means, for example, clean energy projects. The fund invests responsibly, but according to van der Pals, renewable energy projects are also a very viable option because of their returns.

Renewable energy projects are a good example of how the risk involved in an alternative investment product can be low even though, at first glance, it may be considered high.

“The price of technical solutions for renewable energy has fallen and projects are no longer as dependent on subsidies and tariffs. The return expectation is attractive and the counterparty risk is moderate thanks to long-term agreements and a public counterparty,” says van der Pals.

The growing pressure to mitigate climate change has increased governments’ commitment to the projects.

ALTERNATIVE INVESTMENTS ARE ALREADY so popular that securing them is not always a sure thing.

The managers of alternative funds can pick and choose their investors. One criterion is typically a large enough sum of money. Or the investor needs to know the right people.

“Sometimes, not everyone who wants to is allowed in. Or then the manager announces that we can’t invest the sum we want to,” explains van der Pals.

For instance, there is so much cash being offered to private equity funds that it’s not so simple finding good investments.

There is so much cash being offered
to private equity funds that it’s not
so simple finding good investments.

Mandatum Life offers its customers co-investment opportunities, i.e. it assembles groups of Finnish investors with whom it invests in the same targets. A group of investors carries more weight than a single investor.

“We invest in the funds of third-party portfolio managers. We meet with many candidates. When we find a good candidate, we start a process in which we review the investment and its terms and conditions extensively,” describes Jussi Tanninen, Mandatum Life’s Director of Alternatives.

WHAT KIND OF STEW WILL INVESTORS COOK UP when more and more of the flavour comes from alternatives? There is no sure answer to that, but financing styles and financial instruments always impact society in some way.

“Hedge funds established in the 1990s have given equity market trade a boost, startup funding in the 2000s was born from an acute need, private equity funds have made many companies more productive,” lists Professor of Finance Matti Suominen.

The impacts can also be unpredictable. This is what happened in the United States when the subprime loan bubble triggered the financial crisis.

Alternative investments may not
revolutionise the world on their own,
but during their rise, the world has
been revolutionised.

Some people think that the risk comes from the lack of transparency on the alternative investment markets compared to public markets. On the other hand, precisely this opaqueness, i.e. a lack of efficiency, makes it possible to achieve bigger returns than on public markets. Transparency is improving all the time, as the sector’s practices and processes become established.

Alternative investments may not revolutionise the world on their own, but during their rise, the world has been revolutionised. This is why it would be strange if new strategies and return targets were not sought out on the financial markets in a world of central bank financing, increasing regulation, economic policy developments, the increasing debt of states, climate change, AI and more dynamic trade.

“Something is going on,” as James Bullard, president of the St. Louis Federal Reserve described the state of the global economy at the annual international central bankers’ meeting at Jackson Hole in August. In his interview with the Financial Times, Bullard alluded to the era of low interest rates that started from Japan a couple of decades ago, to the trade war threat and to general uncertainty.

Turmoil always creates opportunity, but Ilkka Tomperi from Varma is also puzzled by the new situation.

“We have to really consider whether the world’s economic system has changed. It’s not wrong to conclude that we are in the same boat as Japan, with the aging of Europe’s population,” Tomperi concludes.