Author: French, Charles J; Dodd, Thomas H
Date published: April 1, 2010
Journal code: HFM
The past two years have been both traumatic and transformational for the financial markets. We are still in an extremely uncertain economic, financial, and political environment, and new terms are being coined to describe the future. (Perhaps you have heard of the new normal?)
To help dampen prospective volatility in their investable assets, many hospitals and healthcare systems have added alternative investments to their portfolios. Alternative investments are often misunderstood because of their breadth and complexity relative to traditional stocks and bonds. These investments are proven diversifiers of risk- and key elements of the investment programs of the best-performing hospital and healthcare systems. However, providers should carefully evaluate both the benefits and the risks of an alternative investment strategy to determine whether alternative investments are right for their organizations.
The Appeal of Alternative Investments
Defining alternative investments is not an easy task because there is no standard definition. In most cases, an alternative investment can be defined as a subset of traditional investments, like stocks or bonds. The alternative investment is created via a trading strategy that uses traditional stocks or bonds or derivatives of stocks and bonds in a nontraditional format (e.g., long/short equity hedge fund). In simple terms, an alternative investment is any investment that does not fit into the traditional buckets that are familiar to most investors (i.e., stocks/ equity securities and bonds/debt securities).
There is an appeal to investment returns that are not correlated. Correlation relates to how variables- or in this case, returns- move in relation to each other. The potential benefits are illustrated in the exhibit on page 72.
The average return shown in the exhibit is calculated by taking the sum of the three annual returns and dividing the total by the number of years (three). In contrast, the geometric return considers the ROI over time. Hence, an investment in Fund A would have grown 8.2 percent per year through 3009 (versus the average return of 8.7 percent). Risk, as depicted by standard deviation, is a measure of the volatility of the returns. As a rule, the higher the standard deviation of the return, the riskier the investment (and the bigger the spread between the average and geometric returns).
In the exhibit on page 7?, notice that when an equally weighted portfolio of Fund A + B is ere - ated, the geometric return of the combined fund is greater than the respective components. In addition, the risk of the portfolio goes down. This is the "magic" (or the "free lunch") associated with asset allocation using low correlated assets (in this extreme example, the correlation between Funds Aand B is -0.98).
In theory, combining risky assets that move independent of one another will reduce the overall risk in the portfolio. In general, alternative investments are not highly correlated with the stock and bond markets and their addition can dampen overall volatility. This interaction between low correlated assets is the foundation of asset diversification.
The three most widely adopted alternative assets in hospitals and healthcare systems are:
* Hedge funds and hedge fund-of-funds
* Private equity
* Real estate (private and public)
Hedge Funds and Hedge Fund-of-Funds
These alternative assets are investments in unregistered securities that often take the form of limited partnership investments. Such an asset is often the first vehicle that a hospital or healthcare system uses to gain exposure to alternative investments. Hedge funds consist of a wide range of strategies and vary in their risk profiles, as illustrated in the exhibit on page 78.
Some of the key characteristics of hedge fund investments include active management, limited licfuidity, management and performance fees in excess of those found in traditional investments, leverage, and absolute return benchmarks (e.g., return over a benchmark such as Libor plus 500 basis points). All of these characteristics differ from most traditional investments.
Ahedge fund-of-funds is a diversified approach to hedge fund investing. In a fund-of-funds, a general partner (fund-of-funds manager) accepts capital from the limited partners (investor) and allocates it to individual hedge funds in a pooled investment.
Some of the reasons hospital and healthcare systems choose to invest via fund-of-funds include the following.
Instant diversification. Investment with a fund-of-funds spreads risk among many different direct hedge fund managers and strategies.
Access to superior funds. By investing in a fund-of-funds, an organization may be able to access managers that have been closed to new investors. Additionally, the fund-of-funds investor is able to access managers and strategies with high minimum investment thresholds because the investor is participating in a pooled fund.
Decreased headline risk for the organization. Fund-of-funds investors have more protection than a direct investor in case of an underlying hedge fund manager blowup or fraud.
Ongoing due diligence. Hedge fund-of-fund managers earn their management fees by conducting extensive and continual due diligence on all underlying hedge investments. Hedge funds typically charge a management fee (i to 1.5 percent) and an incentive fee (15 to 25 percent). In a fundof-funds structure, the fund-of-funds manager charges an additional layer of fees, typically a ? percent management fee plus some type of performance fee based on returns over a hurdle rate. Hedge fund fees are high compared with the fees of traditional active equity managers, which typically are from 0.5 to 1 percent on an annual basis.
Private Equity Investments
Private equity investments are investments in the unregistered securities of private and public companies. Investors typically gain access to private equity investments through limited partnership investments. Private equity includes venture and nonventure capital. Venture capital is typically defined as investment in early-stage companies. Nonventure capital includes investment in late-stage companies, mezzanine financing, leveraged-buyouts, and private equity issued by publicly traded companies.
Prior to the 19805, private equity was not considered a prudent investment for hospitals and healthcare systems. However, as data evidencing strong returns with private equity and other alternative investments became available, perspectives on the prudence of private equity investment changed. Today, pension and endowment funds are the dominant private equity investors.
In a typical private equity structure, the investor makes a monetary commitment to a private equity fund of known size, but not timing. The general partner/manager of the fund draws down the commitment as investment opportunities are found. The goal of the general partner is to maximize the return of the invested capital via active management and by exiting the investment as soon as feasible via an initial public offering, sale to a strategic partner, or a secondary buy-out/sale to another private equity firm. The higher the internal rate of ROI, the higher the incentive compensation for the general partner. The incentive compensation paid to a private equity general partner is typically 20 percent over and above a risk-free return rate. Management fees are additional and are typically about z percent.
There are drawbacks to private equity investments. For example, the investor has very little input on the liquidity of a private equity investment. Although there is a developing secondary market, the discounts necessary to liquidate a position make selling unattractive. Further, it is generally expected that the private equity investment will be unprofitable in the early years as the general partner sources opportunities and incurs expenses without any corresponding income.
One of the key factors to successful private equity investment is access to the best performing private equity managers. As proof, recent studies have shown that the median return of private equity funds is much lower than the mean (average) returns of the same funds.
A second factor to a successful private equity investment is the vintage year (defined as the first year the private equity fund makes an investment) . The ultimate returns for private equity funds are often dependent on the economic environment that exists when the general partner makes the investments as well as when the general partner exits the investments. As with wines, there are good vintage years and bad ones. Therefore, it is often advisable to diversify across several vintage years. As depicted in the exhibit on page 76, there have been good vintage years following a recession.
Real estate constitutes investment in property. Hospital and healthcare systems gain exposure to real estate via one of two broad vehicles: private real estate, which refers to direct ownership of property or investments in commingled funds (open-ended or closed-ended) that have direct ownership of property, andpublic real estate, which refers to investments in real estate investment trusts (REITs). Although most REITs are publicly traded, privately held REITs also exist.
Institutional interest in real estate increased significantly after the high inflation environment of the 19705 and early 19808 (particularly 1978 to 1981). Today, institutional investors commonly cite four reasons for investing in real estate.
Potential inflation hedge. Real estate valuations tend to rise as prices of goods and services rise. Commercial properly rents also traditionally rise with inflation, as owners attempt to pass on their higher expenses through increased rents.
Consistent income. A significant portion of commercial real estate returns is derived from rents, which are typically connected with long-term leases. The stability of this income is expected to provide a cushion against price declines.
Potential diversification benefit. Real estate has a relatively low correlation with other asset classes. Adding real estate to a diversified portfolio is thought to lower the overall volatility of the total portfolio.
Return and risk characteristics. Real estate returns consist of both a bond-like component (stable income) and an equity- like component (potential capital appreciation). Private real estate, in particular, displays a low standard deviation relative to other asset classes; however, this volatility is artificially diminished due to the use of appraisal data.
The downsides to private real estate investment include a long investment horizon (10+ years) and limited liquidity. In addition, the credibility of data in private real estate can be questionable. Performance measurement also can be difficult, as reliable valuation data are only available when properties are sold.
Several of these drawbacks are not present in publicly traded real estate. However, publicly traded real estate has a higher correlation to equity, reducing the potential diversification benefit.
Recent Industry Trends
Alternative investments did not perform as well as anticipated in 2008. With a few exceptions, the returns that were supposed to be immune from overall market conditions were severely affected by the forced reduction of leverage, mass liquidations, and the flight to safety. Valuation of all but the most liquid assets also became a concern. Diversification benefits disappeared as correlations converged.
Still, hospital and healthcare systems that had a higher allocation to hedge funds, private equity, and real estate investments had smaller investment losses when compared with their peer organizations that maintained traditional stock/bond allocations. In this regard, alternative investments did help portfolios reduce losses.
The alternative investment industry has become more investor-friendly in light of investors who experienced significant losses in 2008. In the interest of raising capital, many funds have reduced their management fees (but not their incentive fees). Many managers have reduced their initial investment minimums, thereby allowing access for smaller institutional investors. In some instances, the more unfriendly provisions within the limited partnership agreements have been relaxed. Investor transparency of manager trading positions has also improved. Today, it would be rare for an institutional investor to participate in an investment where the assets were not audited and held in custody by a third party. There is a view that reduced competition, reduced leverage, and increased transparency has created a more stable environment for alternative investments.
Determining Whether Alternative Investments Are the Right Approach
The decision by a healthcare provider to implement and monitor an alternative investment program requires careful consideration and planning. An organization should keep several points in mind when making this decision.
Begin slowly. Keep in mind that the expertise necessary to create, implement, and monitor a program is different from the expertise needed to manage traditional asset classes. Although your organization's asset allocation model may indicate that a 20 percent allocation to alternatives is optimal, you may want to "step into" this allocation in 5 percentage point phases, completing each phase sequentially rather than allotting the entire 30 percent at once. If your organization is new to alternatives, this gives the organization appropriate time to complete comprehensive due diligence on each phase.
Consider access and liquidity. Most alternative investments have liquidity constraints. Make sure that your organization's liquidity needs are adequately addressed before the organization invests in alternatives. Also, most alternatives have high minimum investment amounts ($5 million or greater). If your organization has a small fund, make sure the organization creates a diversified portfolio of alternatives and meet the minimum investment requirements.
Don't "force" the investment to fill a target allocation. It may be more optimal to create one broad alternative investment category with an overall allocation target, rather than create separate targets for hedge funds, real estate, and private equity. Manager selection and strategy choice are more important in alternatives than traditional asset classes. By creating separate allocation targets, your organization may feel compelled to fill each alternative "bucket" with managers or strategies that are not appropriate. Be careful not to force the filling of a bucket just for the sake of implementing the allocation. Let the opportunities come to you. If what the market presents is not appropriate foryour organization, don't invest. Be patient and wait.
View an alternative investment as an "opportunity investment. "This follows from the preceding comments. Look for opportunities that the market presents. Market environments change, strategies come in and out of favor, and managers open and close products. Be wary of limiting your opportunity set. Stay flexible and nimble.
About the authors
Charles J. French, CAIA,
is a consultant, Stratford Advisory Group, Chicago, and a member of HFMA's First Illinois Chapter (email@example.com).
Thomas H. Dodd, CFA, FSA,
is president, Stratford Advisory Group, Chicago, and a member of HFMA's First Illinois Chapter (firstname.lastname@example.org).