Unlisted assets have risen in popularity in recent times (as discussed in the first part of this series), in part due to their less volatile nature and the returns on offer. But with rising popularity often comes a rise in misconceptions and myths. Those myths can sometimes distract from the genuine risks.
In the second part of our series on unlisted investments, our three contributors each discuss a myth they’ve often encountered, plus a risk that’s unique to unlisted assets and how they manage it. Jamie Odell from Ellerston Ventures (JAADE) discusses venture capital, Tim Slattery from APN Property Group discusses unlisted property, and Rob Mead from PIMCO discusses private credit.
Part 1: Myths
Liquidity can be illusory
Tim Slattery, APN Property Group
People can get a bit caught up in how liquidity in markets works in practice. By comparison against unlisted assets, if a large number of investors wish to realise their investments in listed assets simultaneously, the seemingly ‘liquid’ assets can rapidly decline to a clearing price. In much the same way, accountants require independent valuations of unlisted funds’ assets to be undertaken, but these are of course subject to assumptions and it is often referred to as an art rather than a science. This is no criticism of valuers, however, they themselves would typically concede they have about a 10% margin of error. That’s why it’s not uncommon when you see a property sell that it can reach a price significantly above or below its NTA. Much like attending a house auction you think they’ve got a whopping price or a bargain!
The other thing we often explain to our investors is the price of unlisted funds relative to their asset backing (often called ‘NTA’ net tangible assets) – if the property is being bought by the fund at a much lower price than its independent market valuation it would be worth looking into this (as it’s rare for a vendor to sell at less than market value).
Finally, stamp duty on property purchases is a real cost – just like it is for residential property it is levied on commercial property in most states. This cost reduces starting NTA (e.g. at 5% stamp duty with no other costs a $100 property with 50% gearing and 50 x $1.00 units will have starting NTA of $0.90 per unit. If you do a similar NTA calculation to look at what happens to your equity on buying a house with 90% debt it may make you feel better at this starting NTA ($0.90 vs $0.50). Either way this leakage needs to be made up over the life of the investment (to get back to $1.00 per unit and hopefully more).
Liquidity is the price of higher returns
Rob Mead, PIMCO
While the private credit markets can seem relatively opaque, they are of course closely linked to the public credit markets. The ability to price and transition credit risk between these markets creates a rich opportunity; but there is no free lunch. To responsibly capitalize on this, we believe investors must both forgo some level of liquidity and accept some price volatility, while investment managers must invest significantly in specialist resources. Put simply, the illiquidity premium must be earned.
Private companies not as risky as you think
Jamie Odell, Ellerston Ventures (JAADE)
We often hear that many investors consider these private assets to be higher risk relative to listed equity. We respond to this by highlighting that we only invest in private companies with established revenues and successful business models, which we believe provide better value at entry point (we typically invest in companies at a 30-40% discount to listed peers), and the potential for greater compounding growth as we typically invest in companies growing at 25% plus per annum. That number is in strong contrast with the earnings per share (EPS) growth for industrials (excluding banks and REITs) in the 2020 financial year, of 0.6 per cent. Our most recent investment, SiteMinder, reflects these attributes, as we believe the company would trade at a significant premium if it were listed on the ASX.
Part 2: Risks
Make sure you’re being paid for the risks
Rob Mead, PIMCO
Alternative credit strategies can enhance portfolio returns, but investors should be extremely judicious when giving up liquidity.
Illiquid assets can’t be sold immediately without a potentially significant impact on price. Investors should therefore require incremental yield or an “illiquidity premium” for holding such assets. However, it is not easy to determine the level of illiquidity premium an investor should expect as compensation for having their capital locked up.
Simply comparing yields or credit spreads is appropriate if the underlying debt has similar credit and other risks. However, that is rarely the case; and even where credit metrics are comparable, underlying credit risk may still be quite different. For example, a large company may have similar leverage to that of a smaller one, but the earnings of a smaller business may be much more volatile, resulting in a significantly higher probability of default.
For this reason, we think it’s essential that investors adjust for the underlying credit risk or anticipated losses when comparing prospective returns from both more and less liquid forms of credit risk.
In private credit also, the lender must be prepared to be much more hands-on in order to maximize a loan’s recovery. Effective recovery depends significantly on how close the investor is to both the loan and the underlying collateral. While some directly originate private loans to borrowers, others source exposure indirectly from banks in some form of risk transfer. From a recovery perspective, being one step removed from the loans and dependent on the bank’s servicing or workout capabilities can materially diminish effectiveness, while potentially creating conflicts of interest. This must be factored into the initial assessment of the price of the asset.
Illiquidity – both a feature and a risk
Jamie Odell, Ellerston Ventures (JAADE)
The number one key unique risk when compared to publicly traded assets is illiquidity. Many investors within this asset class are locked into a fund between 5-10 years, and unlisted equities are typically considered to be illiquid because they are not traded on the listed share market. Recognising this, to improve the liquidity profile for our investors, we offer quarterly liquidity after September 2021 within an open-ended structure. We don’t lock our investors in for 5-10-year periods with is common amongst many VC/PE Funds available in Australia.
Do your homework before you invest
Tim Slattery, APN Property Group
Like a lot of investments there’s a good number of ways you can lose money in unlisted property funds – pay too much to start with in buying the property, buy a property in the wrong location with exposure to high vacancy risk or with weak tenants on short leases are all important considerations as well as the usual risks that apply to most investments, from interest rate fluctuations, legislative changes and economic downturns.
In addition, like all industries there are great operators and dodgy operators so choosing a good manager that you trust is really important. As the manager will typically be making the investments on your behalf, I’d speak with them and be doing your homework on how the people there operate before you invest.
As with every other asset, the price of commercial real estate can go up and down. The supply of new buildings, the quality of older ones, tenant turnover and demographic change are just some of the factors that can influence supply and demand, which then feed into price. This also ties into revenue risk. If a tenant goes belly up there’s a chance the rent won’t be paid. What sort of security do you have? A guarantee from a bank or a multi-billion-dollar parent is going to be much better than a personal guarantee from the now bankrupt founder. Paying close attention to the lease here is critical – from everything to who’s guaranteeing it, to what the annual rent increases are to who is responsible for fixing the roof if it starts leaking. All these things are very much manageable by experienced investment managers but can make a very big difference to your hip pocket over the life of the investment. Frequently some of these things are in the fine print of the offer document – along with the fees and upfront costs which can also make a big difference to returns.
APN seeks to manage those risks by, amongst other things, ensuring the property remains attractive to tenants (e.g. new end of trip and bike facilities, upgrading the café facilities for the buildings’ tenants), maintaining good relationships with the tenants (our key customer partners!) and signing longer lease contracts. We are also very particular with what we buy and what we pay for the properties we purchase on behalf of our investors for all the above reasons. For every commercial property we say ‘yes’ to, there are more than 20 ‘nos’ and we are OK with the FOMO (Fear of Missing Out!) on this front given we are planning to be here for the long term! We also typically invest ourselves as the manager in the equity – so we have alignment ‘skin in the game’ with our investors.
Finally, there’s liquidity risk. If a fund can’t sell a building at the end of the investment term, investors don’t get their money when they expect to. That may require refinancing, which introduces more risk. Such situations are rare but potential investors should not ignore them – in particular the level of debt in your property fund is critical – at 50% each dollar your property increases or decreases in value will mean $2 of increase or decrease in the value of your equity investment (amplifying your profits or your losses). If you are not careful you can lose control of the investment if market conditions deteriorate – if bank terms are breached and a refinancing or a cash injection is required, this can dilute returns significantly. Some investors in the GFC lost the majority or all their equity in some property investments and this reason was a key culprit – thankfully the majority of managers have learned this lesson well (for now at least)!
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