The alternatives market has evolved dramatically in recent years. Here’s what your clients need to know.
Several years ago, the average investor may have recognized the value of diversification but felt some hesitation about alternative investments, particularly the non-traded versions. Others saw alternatives as opaque investments with a narrow focus on real estate or income-generating strategies. But alternatives have changed, and some financial professionals and retail clients are now giving the category a second look.
Part of the change is due to a maturation of alternative investments. Products have evolved beyond the original private placements, LLCs and real estate investment trust (REIT) offerings of even several years ago. New regulations have also come along to drive increased transparency and updates to client statements.
As a result of this evolution, the perceptions that many investors hold about alternatives may no longer be accurate. With that in mind, let’s look at some other ways non-traded alternatives have changed.
An Expanding Range of Options
In the past, non-traded alternatives for everyday investors were limited to a few asset classes, primarily real estate. Then the industry transitioned into private debt investment offerings. Today, those options are still available, but investors also have access to a much wider set of asset classes in different structures, including infrastructure, energy, and private equity and private capital. These new options are helping change the misperceptions that non-traded alternatives offer only income. In fact, they offer income, growth or a combination of the two.
In addition, investors can access these asset classes in new ways. Most recently, private equity has even become an option for some retirement accounts. In June 2020, the U.S. Department of Labor issued a letter clarifying that select 401(k) plans could now include certain types of private equity among their options for employees.1
Increased Transparency & Share Class Options
Alternative investments registered as public companies have always had to publicly report information—such as quarterly company financial statements—but the amount of information disclosed has increased.
In the past, net asset valuation (NAV) methods lacked industry standardization. At the same time, early in an investment’s life cycle, client statements reflected purchase price without accounting for upfront fees and commissions. In 2016, a rule from the Financial Industry Regulatory Authority (FINRA) went into effect that affected certain public non-traded REITs and other direct participation programs (DPPs). The change required an initial valuation no later than 29 months into the program’s life cycle and then at least annually thereafter. This estimated NAV replaced the purchase price on client statements. It is important to note that the estimated NAV is not a guarantee of final value at liquidation but a directional indicator as to how the investment is performing.
The non-traded alternatives industry has further responded by creating multiple share classes that, depending on an investor’s intended length of hold, offer varying commission structures and durations. Fee-based options have been taking on a greater role in recent years, and other share classes offer different ways to pay the commission on these types of products. In 2018, the Institute for Portfolio Alternatives (IPA), an alternative investment industry organization, gathered the industry’s leaders to collaborate with federal regulators on a way to standardize performance across share classes. The change made it easier to compare investment opportunities side by side.
Historically, alternative asset classes were only available to institutional investors. Private placements and limited partnerships—selling securities to a smaller group of investors—marked the first wave in the democratization of alternative investments. In subsequent waves, non-traded REIT and business development company (BDC) structures and other DPPs allowed certain everyday investors to access commercial real estate, oil and gas and private debt.
Structural innovations have further expanded the options. Some options also provide more liquidity opportunities than early non-traded alternatives, either by virtue of their structure or through quarterly redemption programs. Examples of these types of structures include interval funds and NAV REITs, among others.
Although improvements have been made, the products are still considered long-term, higher-risk investments. Programs for redemption or repurchase of shares are not guaranteed. Redemption programs can be suspended, modified, or terminated at any time by the board of directors. The long-term nature of alternative investments also comes with some benefits. It disincentivizes investors from making impulse sales driven by fear or attempts to time the market. This allows the management team to hew closely to their strategic plan without having to meet demands to fill redemptions quickly and potentially at a loss.
Better Customer Experience
Like many industries, non-traded alternatives continue to evaluate their customers’ experiences and make improvements to streamline key processes. For example, many sponsors simplify the paperwork process for financial professionals by offering e-signature and partnering with fintech firms. In addition to delivering a better customer experience, fintech solutions can deliver benefits for financial professionals, such as increasing productivity, reducing the administrative workload, saving operational costs and increasing compliance.
Over time, fee compression for non-traded alternatives has occurred. The fees and sales load have often decreased by 150 basis points or more. As mentioned above, there are a variety of options (similar to mutual funds) offered on how to pay this, including upfront or trailing commissions that spread costs across an investment’s multi-year life cycle. Additionally, some of the ancillary origination and acquisition fees that were charged in the past have been removed.
Finally, greater alignment has occurred by ensuring the sponsor’s performance bonus kicks in only after investors achieve increased value. Many sponsors also seed funds to help acquire initial assets more quickly. In other cases, some investment strategies will only invest in companies whose management teams are partial owners, furthering the alignment with all stakeholders. It is expected that more of these types of investment strategies will continue evolving over time.
To be clear, even with all the changes, non-traded alternatives are not the right fit for all investors. They are complex, illiquid, high risk and have higher fees than traditional investments. But for some clients, non-traded alternatives offer the potential for diversification.
The non-traded alternatives market has evolved—and it will likely continue to evolve. For that reason, financial professionals should keep alternative investments on their radar for clients who may benefit from options beyond traded stocks and bonds.
1 Information Letter, U.S. Department of Labor, June 3, 2020.
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