Alternatives -- that is, private credit, real estate, infrastructure, private equity and venture capital -- have historically attracted mammoth institutional investors like pension and sovereign wealth funds. However, sophisticated retail investors have been slowly entering this territory in the hunt for that holy grail of investing: yield.
According to consultancy Deloitte’s Luxembourg-based partner Arnaud Bon, alternatives offer an important combination of both long-term investment performance and lack of correlation with the stock markets. There’s also an important psychological component.
“An investor in stocks has no impact but alternative investment gives you a feeling of being involved,” said Bon, referencing private credit investments in smaller companies and private equity. This increasingly conscious approach to investing is part of a wider trend and is well reflected in the growth of demand for ESG investments.
Bon’s assertions are backed up. The yield in private credit according to analysts S&P Global reached 100 basis points more than syndicated loans in 2020, and European buy-outs, the largest segment in private equity studied by European private equity association Invest Europe in their Benchmark 2020 report, delivered an annualised return of 15.06% since inception to end-2020, compared with the 5.48% achieved by the MSCI Europe index over the same period.
However, these funds are not as easy for sophisticated retail investors to access as those in the public market. “There’s a huge demand from high-net-worth-individuals [broadly defined as those with more than $1 million in investible assets] for alternative investment – but the offer can’t meet the demand and both sides are very frustrated,” said Deloitte’s Bon.
A greater number of individual investors
According to Leon Volchyok, managing director in real estate at global investment firm Blackstone, HNWI represent a gargantuan investor opportunity. “We estimate that HNWI is a $80 trillion market, but only single digits of that amount are currently flowing into the alternatives space,” he said.
Europe has been keen to capture this investment opportunity using the European Long-term Investment Fund vehicle, a structure that makes it possible for professional and retail investors in the European Union to invest in illiquid companies and projects formerly available only to institutional investors.
But supportive regulation like Eltif is only part of the challenge. According to market participants, alternative investment funds and their corporate services providers will need to overhaul rusty operating procedures to have any hope of processing a new investor pool.
Bon explains. “The alternatives fund market has typically admitted big-ticket institutional investors capable of investing in the tens of millions to be locked up over at least five years or more. However, the challenges of processing 15-20 institutional investors is very different for hundreds or thousands of HNWI.”
The know-your-customer processes and the anti-money-laundering processes in particular explode in volume when applied to a larger and more granular investor base.
The answer is not to recruit a bigger back-office team. “There are already issues in attracting the right talent to Luxembourg, and, in any case, the potential market is larger than the number of people the market is able to recruit,” said Bon. But there are a few solutions in the works.
The size of the HNWI market in Luxembourg is undefined, but private banking customers are a reasonable estimation of the market size. According to market development institution Luxembourg for Finance, Luxembourg’s private banking market has €466 billion in assets under management.
“While fundraising for institutional investors was typically a one-on-one exercise, we’re seeing wealth managers with private banking clients partnering with fund managers and setting up a feeder vehicle into alternative assets,” said Bon. These feeder vehicles can hold 70-80 high net worth investors, thus greatly reducing the processing headaches for the alternatives fund managers.
“The number of investors per feeder fund is growing all the time,” said Peter Wilson, managing director at ScalingFunds, a technology provider to the alternative fund industry that uses distributed ledger technology to streamline operational processes in alternative investment funds. “Historically 99% of alternative investment funds were owned by institutional investors, such as pension funds and family offices, but now you are looking at many individual investors with over €1 million in cash investing via feeder funds into alternative investment funds.”
Private banks are now seeing the opportunity of feeder funds to offer their clients exposure to alternative assets. Some are going as far as to create their own feeder fund structures, said Wilson. “It’s a more fluid, fast-to-market process,” he said.
Outside of private banks, start-ups have also captured the opportunities made available by feeder funds.
Moonfare, a Germany-headquartered fund-management platform, channels private-investor commitments to private equity through its Luxembourg-based feeder funds. The pooling of individual investors into a feeder vehicle allows for significant reductions in terms of operating and trading costs. A larger portfolio also enables economies of scale which can result in better options in terms of services and prime brokers.
In Moonfare’s case, enabling individual investor commitments to start as low as €100,000, according to the platform’s website.
Although feeder funds go some way to consolidating the investor base, there remains another problem according to Bon: valuation timelines.
"Valuation of assets is always a greater problem in alternative investments because there isn’t a market to value assets. You can only realise the value when you sell,” explains Bon.
In a closed-ended fund this is less of an issue as investors do not enter throughout the life of a fund. But for an open-ended fund, which is more and more popular structure for private credit, investor subscription and redemption requires ongoing asset valuation.
For the fund manager, the valuation is either performed internally or delegated to an external valuer. This is a time-consuming process, requiring a methodology and data modelling. The process is subject to an independent review prepared by the fund manager or third party to make sure it falls within an acceptable range.
For the fund administrator, there need to be administrative and accounting procedures in place, as well as remedial procedures for incorrect valuations. Service providers such as depositary banks need to be aware of the valuation methodologies and conduct their own periodic reviews.
All-in-all, the valuation timeline in the alternative asset space can be at least two months, said Bon. Throw in the buying and selling of a greater number of individual investors and the operating pressure is compounded.
“A lot needs to be done to streamline valuation in alternative assets,” said Bon.
Distributed ledger technology
Certain technologies propose to relieve the operational burden on alternative investment managers. One of these is DLT.
“These work in two ways,” said Bon. “They reduce the processing load by automating it through the ledger and automating participants in the ledger.” For financial services, this would mean in particular that companies can operate more efficiently, as internal processes are simplified, cases of intra-system arbitrage are minimised, and the verification of transactions and thus assets becomes much easier.
ScalingFunds is one such asset servicing provider offering technology to enable a digital shareholder registry. The software allows for faster and more efficient capital raising along with streamlined fund administration capabilities.
“DLT also tokenises units of funds which strongly facilitates the secondary trading of alternative products,” said Bon. At present any secondary trading of alternative products is done over-the-counter, i.e. between two parties and not via a central exchange.
According to ScalingFunds’ Wilson, DLT will allow for real-time secondary market transactions without the need for the trader-broker counter parties in a classic OTC trade.
For Martin Engdal, chief commercial officer at ScalingFunds, general partners in investment funds are starting to expect more from fund administration.
“Research shows around 50% of GPs rotate fund administrators when they change funds due to dis-satisfaction in the service provided,” he said. “When you look at the onboarding time – the average onboarding for a legal entity is 90-100 days, then a fund administrator who can offer technical solutions, that delivers efficiencies and increases client satisfaction, really has the edge.”
Luxembourg has, in general, shown itself to be welcoming to DLT in financial services. The so-called ‘Blockchain laws’ of 1 March 2019 and 22 January 2021 recognise DLT and its use in financial services.
In January 2022, the Luxembourg financial regulator CSSF produced a white paper Distributed Ledger Technologies and Blockchain, technological risks and recommendations for the financial sector, to further guide the industry on the use of DLT.
Luxembourg’s investment fund association Alfi has seven working groups within its digital and fintech forum focused on digitising the asset management value chain.
“We find Luxembourg the most progressive jurisdiction in the DLT sphere compared with competing jurisdictions,” said Engdal.
Regulation must keep apace
According to Volchyok, Luxembourg has a regulatory environment conducive to individuals accessing alternative investments. However, this does not necessarily translate to the rest of Europe. “Luxembourg has a great structure, regulatory oversight, enhanced reporting. Now let’s extrapolate that to the rest of Europe,” he said.
Europe is in the early stages of making alternatives’ access simpler through the European Long-term Investment Fund, a structure and regulation aimed at alternative investment fund managers who want to offer long-term investment opportunities to institutional and private investors.
The vehicle has been through various revisions since 2015, most recently in 2021, to improve its flexibility in terms of eligible assets, portfolio composition, distribution and authorisation.
However, certain elements of the Eltif still need to be tweaked. “The Eltif structure only applies to closed-ended funds, which doesn’t work well for individual investors that need some liquidity features, and its leverage requirements are set low, which doesn’t suit stabilised real estate,” Volchyok said.
A number of alternative funds in private equity, infrastructure and debt are venturing into new products that can offer the liquidity desired by smaller investors, said Bon. Products like a fund of alternatives funds, diversified by vintage means that fund redemption creates liquidity out of a pool of illiquid assets over time.
For assets that generate an income, such as infrastructure or real estate, there is a way of matching liquidity needs to projected inflows. However, Bon concedes “this is not a precise science. There are not necessarily the deep data to model this.”
A third model is listed alternatives funds. However, the listing process is cumbersome, and reporting obligations such as acquisition price does not necessarily suit the alternatives market.
As a result, most global managers launch open-ended funds or feeder vehicle to collect new investors.
“Most individual investors prefer not to have capital calls. They want the investment to be fully funded so that they can invest their money immediately,” said Volchyok.
“We know what an individual investor needs from an alternatives’ allocation. We just need the regulation to support it across markets in Europe.”
Like Deloitte’s Bon, Volchyok believes that the subscriptions and operations process for investors into alternatives funds needs to be streamlined. However, the operational gains on their own cannot solve the regulatory issues. “The real hurdles [to alternatives investment] are the regulation,” said Bon. “The revamping of Eltif could be the real accelerator.”