An Equation for Non-Traded Alternatives: Potential Growth Along with Income
Pigeonholing alternative investments into the “income only” category ignores some of the potential gains from asset appreciation.
Sept. 27, 2021 - Many financial professionals have long considered non-traded alternative investments as an option for income-focused investors. Non-traded alternatives can also offer potential diversification for portfolios centered on traditional asset classes, such as stocks and bonds. The universe of alternative assets has grown and so has the range of investment approaches that can incorporate them. In addition to income potential, alternatives today can generate growth opportunities through increased value in the underlying holdings.
In other words, non-traded alternatives don’t have to be lumped together as a single tool with the purpose of generating income. Instead, there are many tools within a toolbox, with different options to meet the needs of your clients.
Income Versus Growth in the Stock Market
In the stock market, the income-versus-growth dichotomy is well-established. Income-oriented investors may tend to choose fairly conservative, reliable stocks, often in categories like utilities or non-discretionary consumer goods. These stocks aren’t likely to see a big run-up in stock price (though some rise is always possible). Instead, they’re chosen because this type of stock may offer quarterly dividend payouts1—the regular income that this group of investors seeks.
Growth-oriented investors, in contrast, usually don’t care as much about generating regular income. They often choose stocks that may not offer a dividend at all—meaning the investment pays nothing until the stock is ultimately sold. But these stocks can offer the potential for capital appreciation through bigger increases in the stock price.
There’s no right or wrong answer; either approach can work as long as investors are clear about their goals and can make an informed decision about which holdings can best help them get there. In addition, the division between income- and growth-oriented investments isn’t always so defined. Many investments include both, with relatively more or less of each component.
Growth Through Non-Traded Alternatives
Non-traded alternative investments have traditionally focused primarily on the income side of the equation. That’s because the earliest options tended to offer similar distributions (and some today still do).
However, non-traded alternatives offer a broader set of objectives: Growth instead of (or along with) income. They typically offer lower distributions, identifying assets that can be purchased at a lower price with the goal of selling them for a higher price, ideally after fund managers have invested time, effort, and capital to improve those assets in meaningful ways. In that way, they offer a potential total return, rather than a predefined stream of income.
In private capital, for example, the goal is not simply to buy an existing business and maintain the status quo. Instead, fund managers identify specific improvements to increase the company’s profitability, and ultimately its value, and in order to register a gain for investors when the business is later sold. (To be clear, some growth-oriented alternatives also offer income levels that can be attractive relative to bonds.)2
The Underlying Elements of Growth
Where does capital appreciation come from? Every non-traded alternative investment will have its own approach, and there are no guarantees that the investment objectives will be met, but growth may come from a variety of strategies:
- Investments in high-growth markets can capitalize on broad momentum: A rising tide lifts all boats.
- Price dislocations, sometimes in inefficient markets, allow investment managers to identify good opportunities: High-quality assets at attractive valuations.
- Some payment mechanisms, such as royalties and warrants, allow investors to benefit from rising valuations of a business in line with improved performance. For example, a company receives royalties that can increase depending on production at the underlying project.3
- In real estate, developing (or redeveloping) a piece of property can cause its valuation to increase.
- Operational improvements to existing businesses—such as reducing costs, investing in a new product line or service, or expanding into new geographic markets—can increase the value of a business.
The Appeal to Investors
There are several reasons why an investor may prefer to focus on growth rather than income. Perhaps the biggest are their own goals as an investor—if they do not need income (or can access it through other investments in their portfolio), they may find the growth element more attractive.
As mentioned above, growth-oriented alternatives can offer diversification to investors who may be heavily concentrated in public equities. Major stock indices in the U.S. are currently at or near all-time highs, and some indications suggest that they may be overvalued.
In addition, growth may be desirable because actively managed investments charge higher fees. Passive investments typically track major indices—they do not require anyone to make decisions about which assets to hold or when to buy and sell. But active investments require a manager who can assess market conditions, identify opportunities, and choose specific investments. That level of hands-on management contributes to higher costs of doing business. (Fees may be charged regardless of gains or losses on the investment unless associated with a specific return hurdle.)
Investors also have tax implications to consider. Distributions from an income-oriented investment are taxed as income, while those from long-term capital gains are often taxed at a lower rate. (All investors should consult with their tax advisors before making any investment decisions.)
Last, some investors may want to diversify their portfolios of alternative investments. If they already hold some income-oriented investments, they may want to consider others that may complement those positions. After all, just as it may make sense to use non-traded alternatives for diversification within a portfolio that includes traditional holdings like stocks and bonds, it makes sense to diversify among alternative holdings themselves. The logic is the same—investors want a basket of assets that move up and down independently, which can help reduce their downside exposure.4
Alternatives can carry higher risk, higher fees and expenses, limitations on liquidity, and other challenges compared to traditional investments—they are not suitable for everyone.
As a financial professional, your job is to help investors understand the full range of options for their goals, objectives, and risk tolerances. Increasingly, that means looking beyond the traditional mindset of non-traded alternatives as a tool for providing regular cash flow for income-focused investors and considering how they might provide growth potential as well.
Represents CNL’s view of the current market environment as of the date appearing in this material only. There can be no assurance that any CNL investment will achieve its objectives or avoid substantial losses.
1 Dividends are subject to change and are not guaranteed.
2 There can be no assurances that any of the trends described herein will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results.
3 “Streaming and Royalties in Mining: Let the Music Play On,” McKinsey & Company, April 2021.
4 Diversification does not guarantee a profit or protect against loss. There can be no assurance that any investment will achieve its objectives or avoid substantial losses.
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