InvestmentsSep 18 2019

The power of the alternative

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The power of the alternative

Some things just go well together – Lennon and McCartney, gin and tonic, toast and butter.

It is a similar situation with investment companies and illiquid assets. Ten years ago, the amount of money invested by investment companies in illiquid, alternative assets, including venture capital trusts, was £33bn. 

That has more than doubled to £85bn today.

It’s not hard to understand the reasons behind this growth. Assets like infrastructure, property, specialist debt and renewable energy have been offering high levels of income in an era of ultra-low interest rates.

Investment companies’ closed-ended structure, where managers have a fixed pool of money and do not have to worry about inflows or redemptions, makes them a natural home for these types of assets, which can take months to buy and sell.

The growth of investment companies investing in illiquid assets does not show signs of slowing down yet either.

Key points

  • Illiquid assets have become very popular in recent years
  • Investment companies are suited to holding illiquid assets
  • Open-ended companies suit illiquid assets less

The first half of 2019 saw all existing investment companies raise £4bn, the highest ever amount in a six-month period.

This was powered by alternative assets, with more than £1bn raised by investment companies investing in renewable energy infrastructure.

The second and third investment company sectors that raised most money were also alternatives, namely Property – UK Commercial, which raised £587m and Infrastructure, raising £291m.

However, the attraction between investment companies and illiquid assets is not just an income story. Investors are increasingly using the investment company structure to target illiquid growth opportunities too.

Unquoted target

Data from Pantheon International shows that the number of North American and European listed companies in 2017 had decreased by 29 per cent since 2008, from 20,326 to 14,393.

The investment company industry has a well-established private equity sector, but against the backdrop of businesses choosing to stay private for longer and the number of public companies shrinking, more investment companies are turning their attention to unquoted companies to access growth opportunities.

This ranges from well-known companies like Scottish Mortgage, which can now allocate a portion of their portfolios to private companies, to new investment companies launching specifically to target unquoted opportunities.

The trend is clear looking at recent launches.

2018 saw the launch of Augmentum Fintech, investing in unquoted fintech companies; Merian Chrysalis, targeting later stage private companies across Europe; and Baillie Gifford US Growth, which can hold up to 50 per cent of its portfolio in unquoted companies.

The theme has continued this year too with the launch of Schiehallion to institutional investors, which will make minority investments in later-stage private companies globally.

To reflect this trend, in May the Association of Investment Companies launched a new Growth Capital sector. Separate from the existing Private Equity sector, Growth Capital is home to investment companies that generally take non-controlling stakes in unquoted companies with high growth potential.

So what are advisers meant to make of all this?

Well, investment companies can offer a way for clients to gain exposure to illiquid assets that would be hard to access elsewhere, either in pure form, or blended with mainstream equities.

But they are also highly relevant in the direct property sector, where an open-ended alternative exists and there is a clear choice between the two fund structures.

The open-ended issue

The problems with open-ended funds investing in direct property have been shown all too clearly.

When assets cannot be sold quickly enough to meet investor redemptions, funds are forced to suspend trading and investors are trapped.

You only have to think back to the EU referendum or the financial crisis to remember when large parts of the open-ended property sector were forced to close the gates.

Such measures are ostensibly put in place for the benefit of investors, but the reaction to the suspension of LF Woodford Equity Income has shown that this does not make suspensions any more popular and managers may have to work harder to defend them in future.

One answer is for funds to hold ever larger cash buffers and as FTAdviser reported in July, the proportion of cash held in UK property funds doubled between January and June this year from 10 per cent to 20 per cent.

Investors are not only charged fees on this cash, they also pay a price in terms of performance.

Over the past 10 years the average open-ended fund investing in UK direct property returned 78 per cent, versus 109 per cent for the average investment company, according to Morningstar.

This is not to say that investment companies are immune from market stress.

During the financial crisis and the Brexit vote, investment companies fell to big discounts, but as listed companies they could continue to be bought and sold, and investors saw share prices bounce back when sentiment improved.

Investment companies did not have to sell properties from their portfolios – unlike open-ended funds.

To deal with the liquidity mismatch between daily-dealing funds and bricks-and-mortar properties, the Investment Association has unveiled proposals for so-called long-term asset funds.

These would aim to offer investors exposure to illiquid assets via a semi-open-ended structure, with daily dealing replaced by redemption periods that are monthly, quarterly, or even less frequent.

Locking up investors’ money for longer periods may appeal to asset managers, but the benefits for investors are less obvious, especially when investment companies offer a well-established vehicle for illiquid investments with superior performance and no lock-in periods.

Despite the significant growth of investment companies investing in illiquid assets in recent years, it is important to remember that alternatives still represent less than half of the investment company industry.

The majority of investment companies still invest in mainstream equities and for many advisers this is where clients are seeking core exposure to achieve growth, income or a mixture of the two.

And in this area too, the structural features of investment companies, such as the ability to gear and use of the revenue reserve, help to deliver important benefits such as strong long-term performance and rising dividends.

Elmley de la Cour is communications manager at the Association of Investment Companies