The Case for Investing in Alternative Assets Through a Fund of Funds

Genevieve Signoret

(Hay una versión en español de este artículo aquí.)

Why Alternative Assets?

Private equity is hard to track as an asset class, because good data on it are hard to find. They’re scarce because valuations in private markets are not “marked to market”.

Nasdaq is an example of a public market. During Nasdaq trading sessions, I can find out what Apple is worth at 11:43 in the morning and then get an update a half hour later. Not so in private markets.

Think of your own company, your own home. You won’t know what it’s really worth until you sell it.

Whether an asset be publicly listed or alternative, to value it, you need a transaction. In public markets, transactions abound, because these markets are nonstop auctions wherein millions of bids and asks are listed continuously and in plain sight. Transactions in private markets, however, are rare. Hence their scarcity of good data on valuations and returns.

OK, so that’s the bad news. What’s the good news?

For many people, including many of our clients, watching a marked-to-market stock and bond portfolio can be a bit nerve-racking. TransEconomics delivers serenity. We find it promotes client well-being to allocate portions of wealth across alternative assets.

Also, in alternative assets compared with publicly listed ones, it’s easier for clients to be disciplined, to stay patient and keep their eyes fixed on the long-term horizon. In private markets, transaction costs such as those associated with attempting premature sales are so much more onerous than in public markets that people naturally tend to avoid them.

Additionally, when stock markets are down and therefore a bargain, (unpredictable) excess cashflows from alternative assets can be used to swoop up opportunities. And vice-versa: when stocks are frothy, clients can skim off profits to swoop up bargains in private markets.

But the best news about alternative assets is that a well-diversified, intelligently managed portfolio of them should pay an illiquidity premium: a return differential over stock market returns as a reward for an investor’s willingness to forego liquidity over a long period.

Why Any Fund?

Funds lower the cost of diversifying one’s portfolio across individual assets and allow you to do so inexpensively.

Also, in our view, people should manage actively only assets within their spheres of expertise and manage passively all others. So, for example, if I am the founder-owner of, say, a pharmaceutical company, I want to be hands-on. I know my industry and product better than anyone.

Do I want to take time away from this industry where I’m a pro at making money to learn to perform due diligence on a real estate deal in Chicago? On a venture deal in Silicon Valley?

Nope. I wouldn’t even know what I was doing. So much better to delegate to an expert.

Why a Private Equity Fund?

A private equity fund combines all pros of investing in alternative assets with all the advantages of a fund.

With alternative assets, recall, you get calm, discipline made easy, imperfect correlations with stocks, and higher expected returns.

With a fund: inexpensive diversification, passive management, and delegated expertise.

Why Venture Capital?

A great many of our investors are themselves entrepreneurs. Startups and family businesses are risky bets, especially in emerging economies where rule of law is weak and political risk is high. VC investing allows them to hedge their concentrated entrepreneurial bets by spreading some of their capital across dozens of other such bets in a developed economy.

The hedge, as you can see, is jurisdictional as well as entrepreneurial.

VC investing allows easy cross-border diversification. Why try to set up and operate a startup in a foreign country when instead you can bet on 100 visionary founders already living there and being financed and mentored intensely?

VC gives you access to exciting, edgy industries you do not operate in. Is your company way out on the cutting edge of science and technology? Probably not. And that’s fine! But through venture capital you can join the fun, finance the cutting edge.

Why Real Estate Private Equity?

Most of our investors are Mexicans with concentrated holdings of local real estate. All the diversification and hedging arguments we made above for VC investing apply to real estate private equity, too. And a few more.

Some of our Mexican investors manage their real estate holdings professionally—that is, real estate is their core business; they are Mexico Commercial Real Estate (CRE) pros. Most, however, do it as a side gig. (For that reason, usually they stick to housing. That’s what they “know”.) So, for example, they probably don’t use leverage optimally. Their site selection methods probably aren’t terribly sophisticated. And they lack the time and money to build and manage large portfolios.

And even the pros don’t operate in the United States. They lack access to the data and methods used by U.S. CRE fund managers to aid in site location. Not all can afford to hire sophisticated modelers. Operating in Mexico, they face higher financing costs. And their market is shallower and less dense that that of the United States. Finally, to invest by themselves in the United States, they would need to build relationships with brokers in every desirable city.

Why a Fund of Private Equity Funds?

Private equity funds have large minimum investment amounts, or “ticket sizes”. To build a well-diversified portfolio of such funds, you need tens of millions of dollars. A fund of funds gives you one-stop diversification for smaller amounts of capital.

A single real estate fund spreads your risk over several properties. A single venture capital fund over several startups. But neither will dilute your concentration in a single segment of real estate or in a single industry in VC. A fund of funds will.

No single fund can diversify exposure to one particular investment thesis or management style. A fund of funds can.

And do you really have access on your own to an entire basket of private equity funds? How many fund managers have invited you to partner with them lately? They prefer to work with people they know and who have well-established track records.

We’re not saying you could not develop those relationships or those track records. But do you really want to divert resources from your own job or business to do so? Isn’t your main job or business where you add the greatest value and generate the most abundant cashflow?

With a fund of funds, you need not manage scores of separate funds by yourself. It would require modeling skills, data, meetings with fund managers, hours and hours of due diligence, and complicated and costly legal consultation and accounting.

And then there is the filtering process. Our Tealta investors depend on our skills and methodologies for filtering deals. We are picky. We are discriminating. We are methodical.

Finally, if you invest in such funds through a wealth manager such as ourselves, your infrastructure is all set up for you. A wealth manager worth his or her salt will help you obtain your U.S. tax ID; find you the perfect cross-border tax strategist; set you up with just the right U.S. tax preparer; work with your Mexican tax preparer to make sure not only that he or she is complying but also that they’re doing so efficiently; hold your hand through the entire fund subscription process; and much, much more.

We hope this has opened your eyes to the advantages of alternatives as a class and to a fund of funds as a practical way to invest in it.