Do’s & Don’ts of Investing in Private Market Assets via Swiss Trust Companies: A Guide
Private market investments (PMA) have been experiencing strong growth for more than a decade. Assets under management now amount to around USD 12 trillion worldwide. PMAs differ from liquid investment funds in many respects. However, if you want to invest successfully and benefit from the high returns, there are a few important points to bear in mind.
Private equity, venture capital, real estate, infrastructure and private debt funds are experiencing a golden age. However, investing in private market investments has its own rules. There are five important aspects to consider.
1. Use benchmarks to assess performance.
Performance is often described by a multiplier or the internal rate of return (IRR). While the performance of most PMAs using these metrics is impressive, multiples and IRRs say little about performance. First of all, a multiplier does not take into account the time value of money. For example, it makes a big difference whether an investor doubles their investment over four years or alternatively over eight years. In both cases the multiplier is 2, but in the first case an IRR of 19% is achieved, in the latter one of only 9%, which makes a significant difference. Multipliers therefore say very little about the performance of an investment. Another key figure is the IRR. It takes into account the time value of money and is valued by many PMA investors as a measure of performance. Nevertheless, the IRR has significant shortcomings. Firstly, it is very sensitive to cash distributions in the early stages of an investment, making it relatively easy for fund managers to manipulate. Secondly, the IRR calculation is based on the implicit assumption that distributions can be reinvested at the same IRR. This so-called reinvestment assumption is particularly important for early distributions and leads to excessive IRRs. Thirdly, the IRR does not take into account the risk of an investment. Thus, higher IRRs can simply be the result of a higher investment risk. So, what is the significance of looking at IRRs? The performance of PMA should therefore be assessed on a risk-adjusted basis. The volatility of an investment can be used as the first measure of risk. It is striking that Swiss equities are more attractive than private equity investments in terms of the shape ration. A pure return analysis is therefore insufficient; risk adjustment is required. The latter should include a further step. PMA must generate an excess return compared to liquid assets in order to be attractive to investors. The easiest way to verify this is to use the so-called Public Market Equivalent (PME), also known as the public market equivalent. It shows the excess return of a fund compared to a benchmark market, whereby the cash flows of the fund are discounted with the discount factor of the benchmark and the present values of the net distributions are compared to the net payments. If the present value of the distributions calculated in this way is greater than that of the deposits, a fund has been successful after taking the benchmark into account. Alternatively, the direct alpha method can be used, which also estimates the risk-adjusted return. In addition, the Capital Asset Pricing Model (CAPM) can be used to determine the alpha of PMA. Depending on the method chosen, investors need the fund cash flows on the one hand and the quarterly valuations on the other to calculate their own risk-adjusted returns, as well as a suitable methodology to adjust the typically smoothed quarterly valuations and returns. The performance of PMA can therefore only be verified by assessing the PME, direct alpha or CAPM alpha.
2. A close look at the ‘black box’ is essential.
After an initial, mostly performance-oriented fund selection, it is important to understand in detail the investment policy of an asset manager. For example, there are significant differences between venture capital, buyout, growth, turnaround and secondaries funds. Private debt strategies also differ greatly and include, for example, direct lending, mezzanine, special situations, distressed debt and venture debt. The differing risk and return characteristics must therefore be evaluated. In short, each individual fund should be part of a comprehensive due diligence process. Professional funds provide serious investors with comprehensive documentation and information. This allows an accurate (and recommended) look into the black box of private market tailored due diligence. Ideally, this allows the investor to understand the investment activity of a fund and the resulting historical risks and returns and to better assess the expected risk and return structure of a fund.
3 Portfolio Theory also applies to private market assets. Since the introduction of modern portfolio theory in the 1950s, institutional and professional investors have paid strict attention to their portfolio diversification and portfolio risk. The latter depends on how strongly individual assets in a portfolio correlate and the weighting with which they are represented in the portfolio. A lot of attention is paid to portfolio diversification and risk management when investing in liquid asset classes. When investing in PMA, however, they are often forgotten for no good reason. After carrying out comprehensive due diligence, it is possible to determine historical correlations between individual PMAs. The same principle applies as for liquid investments: do not put all your eggs in one basket, aim for a low expected correlation between the returns of individual funds.
4. Consider various term structures.
The J-curve effect is well known in private equity (PE). It describes the interim returns of a PE fund in relation to its life cycle. PE funds generate negative cash flows at the beginning of their life cycle and negative to low interim returns in a subsequent phase. Only in the harvest phase, when the values in the underlying investments develop and these can be successfully sold or listed on a stock exchange, do the units in a PE fund record a positive performance. Private debt (PD) funds differ fundamentally from PE funds in terms of their interim returns. In contrast to PE funds, they have very high returns at the beginning of their life cycle and significantly lower returns in later phases. Simplified PE and PD funds have opposite maturity structures in terms of their returns. In view of the J-curve effect with PE, investors should be interested in investing relatively late in the fundraising phase.
5. Flexible but regular capital allocation
Investors should also be aware of at least two other special features: Firstly, they should think about their approach to asset allocation. Today, PMAs are usually allocated to alternative investments. However, it would be interesting to consider whether the allocation should first be made according to risk characteristics in a specific asset class (equity, debt, inflation protection) and only then should a distinction be made between private market investments or those in the public and liquid markets. Such an approach would make it possible to allocate according to liquidity criteria and, for example, assign private debt to the debt asset class. Depending on the liquidity needs of the investor, such an asset allocation rule would leave significantly more room for investments in PMA. Secondly, capital efficiency must be ensured. The time lag between capital commitments by an investor and the capital call by the general partner presents a challenge. 2023 appears to have been a particularly attractive year for an investment in private debt. However, if an investor commits capital today, it may only be called up and invested over the next two years. The capital efficiency of the committed capital is therefore low. Various studies indicate that this problem can be countered with an always ‘steady and slow’ strategy. This refers to the regular allocation of PMA in constant amounts or portfolio shares over a long period of time. Such approach and strategy are said to achieve the best results over time.
Irrespective of your investment-experience, strategy, approach to risk, planned returns, portfolio diversification or preferred asset classes and investment horizon, a common thread brings all the ‘savvy investors’ to a common denominator.
While the return on investment may be the single paramount factor of any investment decision, parallel factors such as investment security, safety and tax exposure are also of primordial importance of any successful and well thought-through strategy. In simple terms it boils down to two aspects; the investment or custodian vehicle (the structure used for holding and investing your assets) and the subsequent tax exposure (hence the jurisdiction and the amount of tax levied on your investment and how these affect your returns or profits). It is no secret, but rather common knowledge amongst the affluents of this world, that Swiss Financial & Vintage Trust Companies are not only the world’s most secure, sophisticated and sought-after business vehicles but also the catalyst to accessing a secure investment in virtually all asset classes, while enjoying a full tax exemption on any capital gains. That is not a mistake, you read this correctly, investments made through Swiss Trust Companies are fully exempted from any capital gain taxation.
This ‘almost too good to be true’ setup allows the beneficiaries of such vehicles to fully enjoy the security, protectionism and versatility of the Swiss financial realm, all while taking advantage of the most modern banking solutions known to men and without having to worry about any taxes being levied on the gains. Tax optimization that leads to securing greater gains and protecting your capital in time. If this has caught your interest or captured your imagination and you would like to learn more, how a Swiss Financial or Trust Company can benefit you in 2024 and immediately contribute to your security and financial stability, contact a trusted fiduciary and a leader in the field of Swiss Trust Companies worldwide. First Fidelity Trust AG will have the distinct pleasure to advise, provide all the necessary information and create a curated solution tailored to your specific needs. Our team of professional consultants and advisors is just one click away.
