Morgan Stanley
  • Wealth Management
  • Oct 29, 2019

A Closer Look at Alternative Investments

The era of private funds delivering double-digit returns may be ending. Other alternative strategies, some of which are available to a wider audience, may be better bets now.

One of the top performing asset classes of the past 10 years has been private equity. While only a small portion of investors can buy these private funds (to qualify, an investor generally needs an income of more than $200,000 or a net worth of at least $1 million), they garner outsized attention due to their high returns.

The top quartile of private equity funds has returned more than 20% a year for the past 10 years. This compares with U.S. stock market returns of more than 14% a year in that time. Private debt funds (which buy the debt of private companies), have also offered high yields relative to corporate bonds, making them a popular source of income. Since 2010, assets in private funds have more than doubled to $5.6 trillion. 

Now I think those glory days may be set to fade. While private equity funds will likely outperform public stock markets over the long run, the next 10 years are unlikely to result in the kind of double-digit returns some investors have grown accustomed to. Below are five reasons why:

  • Private equity funds are paying higher valuations (price relative to cash flow) for the companies they buy.

  • Private companies that are issuing the debt and equity acquired by these funds generally have lower credit quality—more debt, less cash flow to cover interest payments and weaker terms protecting investors.

  • The IPO and merger-and-acquisition markets may slow down, making it harder for private funds to exit their investments.

  • As competition rises for private deals, more funds are unable to deploy the cash from investors. Raised but uninvested cash in private funds is up to $2 trillion, an all-time high.

  • Private equity and debt funds are diversifying into venture capital, infrastructure and other kinds of investments. That may lower returns and add to volatility.

While I don’t think private investments have the same appeal going forward, other kinds of alternative investments can help investors broaden their portfolios away from pure exposure to public stock and bond markets.

Buying the stocks of publicly traded private equity and debt asset managers is one possible way. Another option is to buy funds that hedge some or all of their exposure to equity markets. These may be referred to as long/short or market neutral strategies.

Many so-called hedge funds (another kind of private partnership only available to qualified investors) use these and other hedging strategies. There are also some mutual funds that hedge and other alternative funds structures available to a broader audience. A Financial Advisor can help you find the right solution for your goals and risk tolerance.