Why Invest in Alternative Assets?

Bioverge
Bioverge
May 11, 2017 · 6 min read

Democratizing the Investing Landscape

Our mission at Bioverge is to democratize early stage investing in the $3.5 trillion healthcare market, while offering founders access to capital and an ecosystem of resources to help them push the boundaries of human healthcare.

To accomplish this, we aim to build awareness of innovative investment opportunities and provide investors the tools and resources necessary to make informed investment decisions.

Regardless of our focus on healthcare or the specific structure of any given investment, our fundamental product offering provides accredited investors (soon to be anyone) with the ability to invest in venture capital-style funds. Venture capital investments, in turn, are part of a larger asset class referred to as alternative investments.

The Case for Alternative Assets

There are a variety of benefits of including alternative assets in an investment portfolio, including:

· Enhanced return potential

· Diversification and hedging

· Reduced volatility

· Tax benefits

There’s been a ton of research on the benefits of including alternative assets in an investment portfolio (such as Blackstone’s white paper Patient Capital, Private Opportunity, The Benefits and Challenges of Illiquid Alternatives), so we’ll just briefly touch on three of them and focus our discussion around what matters most for the vast majority of investors: enhancing your return!

Diversification & Hedging

Alternative assets typically have a low or negative correlation with the performance of stocks and bonds (i.e. traditional asset classes), making them uniquely suitable for portfolio diversification. Certain alternative assets, such as gold and oil, may also provide a hedge against rising inflation.

Reduced Volatility

Alternative assets act to decrease overall portfolio volatility through diversification. Holding alternative assets will also help mitigate fear-based selling during broad market declines (since these holding are largely illiquid).

Tax Benefits

While upfront fees may be higher for some alternative assets, due to lower levels of turnover transaction costs are typically lower compared to conventional assets. In addition, investments held longer than 12 months are subject to a lower capital gains tax in comparison to shorter-term investments.

Enhanced Return Potential

The enhanced return associated with alternative assets is referred to as the illiquidity premium. The exact amount of this premium varies by the specifics of the underlying asset, but attempts to quantify this suggest it can be more than 3.0% annually. Moreover, the premium tends to increase with the degree of illiquidity in the asset.

Investment Returns Generally Increase with Degree of Illiquidity

Source: Blackstone. “Patient Capital, Private Opportunity. The Benefits and Challenges of Illiquid Alternatives.”

There are several underlying factors that are responsible for this illiquidity premium (infrequent transactions, better alignment of interests between investors and management, etc.), however, by far the most important and nuanced is the asymmetric flow of information. There are few rules or regulations that govern private market investing and certainly nothing to the equivalent of the public markets, so the advantages that private market investors have over one another may be substantial.

In fact, this ties in perfectly with statistics relating to the importance of devoting significant time to due diligence. Investors who spend on average >20 hours on diligence have a realized median exit multiple of 5.9x, compared to investors who spend an average of <20 hours on diligence who have a median realize exit multiple for 1.1x.

The Impact of Time in Due Diligence

Source: Kauffman, The Foundation of Entrepreneurship. “Study: Returns to Angel Investors in Groups.”

Here’s another look at the return of alternative assets, in this case specifically early stage venture investments, exactly what we offer at Bioverge:

VC Returns vs Stocks & Bonds: 30 Year End-to-End Pooled Returns

Source: U.S. Venture Capital Index and Selected Benchmark Statistics. Data from Cambridge Associates LLC March 31, 2016 U.S. Venture Capital Index® and Selected Benchmark Statistics Report. These indexes are not necessarily representative of the companies listed on Bioverge and do not reflect projected returns. Furthermore, past performance is no guarantee of future returns. In addition, early-stage venture capital investing has a higher rate of failure, volatility, and less liquidity.

And since we’re data junkies, here’s one final chart on the return profile of angel investors:

Distribution of Returns by Venture Investment

Source: “Study: Returns to Angel Investors in Groups

What’s the Right Mix?

Now that we’ve established alternative assets should be part of everyone’s portfolio, the next question we need to tackle is what’s the correct mix of alternative assets to include in your portfolio?

A good place to start our journey is with organizations that have been investing in alternative assets for a long period of time since they have a wealth of data to rummage through. And there’s no better place to start than with endowment funds.

Let’s start with one of the largest: Yale.

Yale’s endowment fund is one of the largest at ~$25 billion. The fund returned 8.1% annually over the 10 years ending June 30, 2016, surpassing results for both domestic stocks, which returned 7.5% annually, and for domestic bonds, which returned 5.1% annually.

Yale’s Endowment Fund

Source: Yale News. “Investment return of 3.4% brings Yale endowment value to $25.4 billion.”

Over the past two decades, Yale’s endowment generated returns of 12.6% annually, and has added an incredible $22.1 billion of incremental value.

While this approach works great for a behemoth like Yale, allocating 50%+ to alternative assets isn’t feasible for most individual investors (or institutions for that matter) given the cash flow needs of everyday life (mortgage payments, kids in college, your daily run to Starbucks, etc.).

During our research, we came across a great piece by Cambridge Associates which analyzed the performance of 174 endowment funds. What they found was that a major drive of better performance was the institutions’ allocation to private investments. They discovered a clear “15 Percent Frontier” that was not only consistent, but persisted across varies time horizons:

Range of Returns by Private Investment Allocation: Average Annual Compound Returns (Periods Ending June 30, 2015)

Source: Cambridge Associates. “The 15 Percent Frontier,” July 2016

The analysis indicates an outperformance by investors with high private allocations is persistent and consistent over 5, 10, 15 and 20 year periods. Over a 20 year period, the median return for institutions with >15% allocated to privates outperformed the median for the group with <5% in privates by a cumulative margin of 182 percentage points, or 180 bps per year.

So while an 50%+ allocation to alternative investments is almost certainly too aggressive for most, an allocation of ~15% is likely more reasonable and is supported by data indicating the potential for enhanced returns.

So What’s the Problem?

In spite of the opportunity to enhance portfolio returns, individual investors remain under-allocated to illiquid alternatives.

Most Investors Lack Portfolio Diversification with Alternative Assets

Source: Seeking Alpha. “AAII Asset Allocation Survey: Individual Investors Continue To Favor Equities In Portfolio Allocation.”

Furthermore, “only 3% of the total 8 million accredited investors in the U.S. are actively investing in private companies.” The major reason for this has been unless you were a venture capitalist or high net worth individual you generally lacked available deal flow and potentially the skill set necessary to properly diligence these types of investments. With the 2012 passage of the JOBS Act and Title II lifting the ban on general solicitation and Title III opening up Reg CF to all Americans, these barriers no longer exit.

Bioverge is here to enable this diversification with high impact and high growth investments in an area we all care about, our own healthcare and well being.

-The Bioverge Team

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Disclaimer: Bioverge is not a registered investment advisor and nothing contained in this blog is meant to be a recommendation on how to allocate your assets or is intended as investment advice. Returns presented here are not necessarily representative of the companies listed on Bioverge and do not reflect projected returns. This blog is meant for informational purposes only.

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