Speaking to investors every day, I often hear concerns about reaching portfolio return targets due to the low-interest-rate environment we find ourselves in.  Equity markets continue to hit new highs, but it’s been well documented that North American stocks have become frothy, and at some point, equities will suffer a correction.  

With the risk of high valuations, or paying too much for future earnings, many investors are considering allocating a greater portion of their portfolio to fixed income, despite the lower returns. Rotating into bonds is also known as a “flight to safety”, as bonds are less volatile and protect against the downside. However, should interest rates finally start to rise, a greater allocation to fixed income could be a drag on a portfolio. For investors who are considering reducing market exposure, but aren’t keen on today’s low bond interest rates, it’s a good time to consider adding private placements to your portfolio.

 


For investors who are considering reducing market exposure, but aren’t keen on today’s low bond interest rates, it’s a good time to consider adding private placements to your portfolio.


 

Private placements are investments in companies or in some cases, indirectly, in projects that are made (“placed”) by the investor and held privately without trading on any market or exchange. They offer unique investment opportunities that aren’t available through traditional investing channels such as online investing platforms, financial advisors or discount brokerages.

As with all investments, investors should take care in understanding all aspects of a private investment to determine if it’s compatible with their individual risk/reward tolerance.

For those investors who are interested in learning more about private placements, we’ve summarized the main considerations below.

 

Reducing Market Exposure

Investment strategists have begun to note that we may be reaching the end of the bull market cycle that started following the 2008 financial crisis. As the current cycle matures, growth opportunities for public equities are not as strong as they were five years ago. Many analysts note that stocks are currently overvalued based on a number of metrics, and yet most markets continue to reach new highs despite mediocre growth expectations.

 


Bank of America Merrill Lynch has suggested, based on their latest monthly survey, that global funds are displaying signs of “irrational exuberance.”


 

There will always be bearish experts, but the ones urging caution include some of the world’s most successful investment managers. David Swensen, chief investment officer of Yale’s $27 billion endowment, has now placed 32.5% of the Yale portfolio into uncorrelated assets, more than he had prior to the 2008 crash.

Ray Dalio of Bridgewater Associates manages $150 billion and believes that after eight years there are signs we’re reaching the late stages of a bull market cycle. Goldman Sachs argued in July that U.S. stocks are overvalued “on almost every metric” and Bank of America Merrill Lynch has suggested, based on their latest monthly survey, that global funds are displaying signs of “irrational exuberance.

We believe a similar sentiment extends to Canadian stocks which continue to reach new highs, most recently on October 30th when the TSX closed above 16,000 for the first time.

 

Diversification

Diversification is important for any portfolio from a risk perspective. You don’t want to have all your eggs in one basket, as the saying goes. The more diversified a portfolio is, the more baskets the eggs are in, the less of a setback it is if one basket breaks.

 


..having greater diversification in your portfolio can help smooth out the path of return.


 

Diversifying your sources of risk allows investors to diversify the opportunities for returns. Private placements don’t resemble the same risk/return profile of traditional investments such as mutual funds, ETFs, and stocks and bonds that trade on market exchanges. If an investment is composed of different risk and return profile, then adding it to your portfolio will provide diversification from your existing assets. Market or specific stock fluctuations will impact different areas of your portfolio at different times, so having greater diversification in your portfolio can help smooth out the path of return.

 

Liquidity

When an investment isn’t traded often or even at all, investors receive a premium called an illiquidity premium. This premium compensates investors for the inability to quickly convert the investment back to cash.

 


Capturing the illiquidity premium can be an attractive option...


 

 Many fixed income products, including municipal and smaller-province bond issues, have a liquidity premium based on the smaller amounts of capital they raise, as well as the fact that investors buy and hold or don’t trade them often. The smaller an issue is and the less it trades, the larger the illiquidity premium will be.

In our current environment where many investors are searching for higher-yielding products, capturing the illiquidity premium can be an attractive option. Investors should always make sure that their investment horizon matches that of the investment.

 

Unique Opportunities

Private placements can offer investors exposure to companies that don’t trade on public markets and indirect exposure to developed or developing projects. These can include smaller companies or smaller projects raising smaller amounts of capital than are typically seen in public market securities issuances, resulting in a greater breadth of opportunities.

Changes to financial regulations in early 2016 made it easier for the public to purchase securities offered by private companies. This regulation change could see a growing number of alternative investment options enter the market.

 

Limited or No Correlation to Public Markets

Private placements don’t trade daily like market securities.

Mutual funds and ETFs are made up of a portfolio of stocks or bonds, all which can go up and down depending on company-specific events but are also exposed to external market events. These external market exposures can include large macroeconomic events like Brexit or the US Presidential Election which favoured some sectors over others, or even sentiment-driven trading. The point is the value of a market traded security can sometimes be determined by factors outside of the company itself. 

 


The point is the value of a market traded security can sometimes be determined by factors outside of the company itself.


 

Private placements don’t have this market exposure, therefore it’s path of returns look very different than public securities. While some private placements can have slight changes in valuation due to the passage of time (depreciation, usage), these changes are independent of how the market is trading. For this reason, the path of returns for a private placement looks very different, and the less alike the returns are, the less correlation exists.

Adding investments with low correlation to the traditional market investments in your portfolio provides diversification.  It also means that when news headlines shock the market the value of private market securities aren’t impacted, making them one of the few Tweet-proof investments of our time.

 

But there are risks, too.

Like all investments for your portfolio, investors should research the product to make sure it meets their individual risk and return objectives. Many issuers of private placements can be smaller and their securities may not have a third party risk assessment such as a rating or a research report.

In addition, while public companies generally have continuous disclosure obligations giving investors transparency with respect to the company’s financial performance, outlook and current developments affecting the company, companies that offer securities on the private market generally have little or no continuous disclosure obligations.

These investments, therefore, require greater due diligence on the part of the investor to be fully aware of all the features, risks and fees associated with the investment.  Investors should read the private placement offering materials in detail before investing, and always make sure they are comfortable making and holding the investment for the full term.

 


Investors should always feel 100% comfortable with the risks they take as well as the timing of their investment horizon.


 

The illiquidity premium mentioned earlier can be a benefit for those investors who are comfortable not accessing their capital for the full term of the investment. However, if an investor is unsure of the timing of when they will need the proceeds of the investment, purchasing a product that can’t be sold or redeemed may not be a worthwhile risk to take. Even if there’s a chance an investor will need the capital, investing in market securities that trade daily may be a safer route to take. Along with this point, for most investors, it is important that a majority of their portfolio is not allocated to private placements, as liquidity considerations for a portfolio are important.

Investors should always feel 100% comfortable with the risks they take as well as the timing of their investment horizon.

For many investors who have the majority of their portfolio in traditional fixed income and equity allocations, a private placement is an investment that deserves consideration. With a long-term investment horizon and a majority of investments in liquid assets, a private placement can help diversify sources of return for educated investors.