We’re often asked at SineCera Capital, “What percentage of my portfolio should be allocated to alternative investments?” To answer this, many capital allocators may turn to the “Endowment Model” as a guide. Made famous by David Swensen and Dean Takahashi while running Yale University’s Endowment, this model utilizes Modern Portfolio Theory to optimize a portfolio consisting of a large allocation to alternative investments including hedge funds, private equity, venture capital, and real assets, and a relatively smaller allocation to public market stocks and bonds.

While we are not major proponents of using Modern Portfolio Theory to determine optimal asset allocations for public market portfolios, let alone illiquid alternative assets (listen to how and why we are balancing portfolio bases on risk rather than asset allocation), we believe alternative investments add value to clients’ portfolios, both as a source of diversification and growth. Unfortunately, recent research has suggested that over the past decade alternatives have neither been a good source of diversification nor alpha (Ennis, 2020). Higher fees have had a role in hurting relative performance as has the enormous surge of capital flowing in these asset classes. As Richard Bernstein aptly notes many times, “return on investment is highest when capital is scarce.” With fees too high and capital too plentiful, it’s exceptionally hard to outperform the public market, especially when the S&P 500 has annualized +15% over the past ten years.

But all is not lost. As a supplement to a risk-balanced core portfolio of low-cost public market investments, we believe a diligently sourced collection of alternative assets still has the potential to benefit investors. Further, one may be able to avoid those above-mentioned shortcomings by seeking to prudently manage underlying fees, pursue deals in relatively capital constrained areas (i.e., avoiding the “crowded” trade), and partner with managers that have exceptional knowledge, skill, and unique investment philosophies (Read: The Art, Science & Accountability of Due Diligence).

The Endowment Model isn’t a one-size-fits-all solution to the problem we posed at the beginning of the post: “How much should one allocate to alternative investments?” The reality behind the Endowment Model is that it may be too reliant upon static “rules of thumb” and “practitioners’ lore” (Dimmock, Wang, Yang, (2021)), which is not helpful for the high-net-worth investor with unique needs and preferences. Still, a good “rule of thumb” is that, given their illiquid nature and long-term holding periods (often 10+ years), alternatives assets should not take away from capital that is essential to maintain one’s current standard of living. Rarely do these types of deals generate current income and those that do require long lockup periods of the original principal. Should unforeseen circumstances require that capital, expect to pay a steep discount on the original investment amount.

Managing Commitments is Easier Said Than Done

Unlike public market investments where you can quickly deploy capital, alternative investments require an active liquidity management strategy to balance target allocations. While that’s easier said than done, here are a couple of key points to consider:

Understand how long it will take to fully invest committed capital. Known as the “Investment Period,” alternative asset managers typically deploy capital over several years as they source deals. This means when you make a commitment in Year 1, all the capital may not be invested (“called”) right away unless the Fund Manager explicitly says that will happen.

• Review Fund Terms to understand how long an Investment Period may last, including potential “add-on” years, and whether consent from a majority of Limited Partners is required to approve any extension of the Investment Period

• Factor in that Fund Managers may not invest 100% of your commitment and instead reinvest proceeds from early investments to finance subsequent deals. It’s best to ask how a Fund Manager anticipates distributing early proceeds; they should also be able to share their historical data on invested capital relative to total commitments.

• Understand how many assets the Fund plans on acquiring within the portfolio, including expectations on how many deals per year and the range of invested capital per deal. 

Have a similar game plan when making direct investments. Investing directly—whether it be venture capital, private equity, real assets, or something else—is also likely to require a prolonged Investment Period. Without the help of an investment manager, reviewing direct investments will typically require additional time and/or resources to evaluate. Investors may also not be able to garner enough deal flow to hit their target allocation as many investments are reserved for institutional investors that have the ability to write larger checks.

Beware of Cash Drag

All this can be summed up with one warning: Beware of Cash Drag. Investing in alternative assets requires a long-term plan but may result in cash sitting idly on the sidelines if not managed well. Investors often fail to realize that those internal rates of returns (IRR) managers publish assume that distributions are re-invested at the same rate of return as the overall portfolio. However, just because the account statement says the fund achieved an X% IRR doesn’t mean the individual investor realized that same result. Investor-level returns may be lower if distributions are reinvested in lower returning assets, or worse, if the investor just sits on the cash received.

To help solve for cash drag, more sophisticated portfolios employ what’s known as an “overcommitment” strategy. For example, an overcommitment strategy of 150% would commit between 15%-20% if the target allocation is 10%-20%. This aims to accomplish two things: 1) accelerates the time it takes to hit the target allocation and 2) avoids the risk of falling below the target if 100% of committed capital isn’t called (for example, if you think only 80% of the capital will be called, commit 125% of the original amount). Obviously, the risk behind an overcommitment strategy is over-allocating, particularly if you are building a portfolio from scratch. More established portfolios that have already hit their target allocations are better able to manage this risk as distributions from older vintage assets are re-deployed into new commitments, smoothing out fluctuations in the target allocation. With realized gains typically getting distributed in Years 6-10, it’s typically best to spread initial commitments over several years.

There are also tools out there, known as “commitment-pacing models,” that help investors forecast capital call requirements and manage liquidity. These models rely on historical data of the underlying alternative asset classes as well as forecasts on the timing and amounts of the future cash flows. Oftentimes these models sacrifice accuracy for alleged peace of mind. In our view, it’s better to replace, or at least supplement these models with a customized game plan that accounts for your unique situation and liquidity requirements.

Fully committing to alternative investments requires a long courting process, and as noted, there isn’t a one-size-fits-all approach. As a fiduciary that always seeks our clients’ best interest, SineCera Capital is here to help make sure that shoe fits.

If you’d like to discuss further or learn more about SineCera Capital’s alternative investment process, please contact us.

Best Regards,

Adam J. Packer, CFA®, CAIA®

Chief Analyst | SineCera Capital