2016: The Year to Think Small

Family Office Alpha Report

By Phoebe Outerbridge & Keith Danko

December 11, 2015

For 2016 there is a simple message: Less is more.

The most promising bets for the new year are those that require a little zooming in—deals whose smaller size may preclude larger institutional investors from taking the time and resources to investigate, but whose IRRs command as much attention as or more than the bigger players. Think emerging and newer hedge funds, direct PE deals below $150M, real estate in non-gateway cities and other real assets, and smaller VC.

Thinking big has worked for this bullish period since the financial crisis of 2008-2009, with the stock market exceeding most investors’ expectations and with favorable interest rates and historically low oil prices reducing headwinds. But it’s less likely that equities, large PE funds, and gateway city real estate can unabatedly continue to sustain reliable, positive (let alone uncorrelated) returns for investors in the new year.

In a period marked by significant market volatility as well as anemic returns from the larger hedge funds, family offices and institutional investors may wonder which way to turn in 2016 to attain meaningful, uncorrelated investment returns from alternatives.  The average hedge fund returns were up less than 3% YTD (through November), with some of the biggest funds posting double-digit negative returns. There is a huge standard deviation in the overall performance of private equity funds, implying that the squeezing of efficiencies out of larger businesses may have well run its course. And many wonder if the abundance of capital and strong investor demand in gateway cities has driven commercial real estate prices in those locations far beyond their actual values.

While they may require more time to source and structure, many alternative investment opportunities still wait to be seized by the right investor.

Secondary City Real Estate Market

Look beyond the salty shores of New York, Los Angeles, and Boston: the most growth opportunities in commercial real estate right now are in secondary city markets where favorable demographics, job growth, inventories and rents have intersected to create healthy return-generating investments.  These non-gateway cities, also known as “18-hour” cities, are seeing more moderate cap rate compression and thus better yields, and typically offer the benefits of larger cities at a lower cost. Some of the hottest cities to watch include Dallas, Austin, Charlotte, Denver, Nashville, and Raleigh-Durham.

While each market will vary by city and asset type, commercial real estate cap rates remain reasonable. And the growth of these cities is outpacing gateway city growth in every class but central business district (CBD).

Given a heightened level of investor sophistication and increased access to data on asset characteristics, neighborhood statistics, and demographics, investing in secondary market commercial real estate is more transparent and accessible than before. Also, when leverage and an ability to execute swiftly are necessary, multiple sources of real estate financing (including private equity real estate funds) are available, especially with the current low interest rates.

Emerging Fund Managers

Emerging fund managers continue to warrant increased attention.  While larger pension funds, endowments, and institutional investors may be forced to assume a more cautious approach by allocating to larger, name-brand funds, family offices and individual investors have the advantage of selecting from among a huge spectrum of smaller funds in a variety of specialized strategies. Emerging hedge fund managers and younger firms tend to have outsized ambition and performance to match, themselves being more nimble in the market given a lower AUM (countless studies point to the negative relationship between hedge fund performance and size). Finally, in their quest to attract early capital, many emerging hedge funds are likely to offer more attractive management and performance fee packages than the typical 2 & 20.

Direct Investments in PE and Real Assets

Making direct investments in privately held companies or real assets (other than real estate) has been a prudent way to diversify assets and minimize correlation to the equity market, and the overall trend toward disintermediation supports this. Given the high market volatility experienced in 2015, this investment tactic could be even more advantageous going forward into 2016.

The lower-middle market (under $150M) deals are likely to provide the most robust IRRs to investors, especially when under the guidance of experienced operating partners who provide a layer of due diligence, industry perspective and expertise.  The relative lack of liquidity of direct investments is offset by potential superior gains and large multiples that can be realized within a relatively short (3-5 year) time frame.

While the definition of “real assets” continues to evolve to include such esoteric commodities as oil from exotic trees, an asset that warrants further attention is shipping. An often overlooked sector that shares little correlation to other investments, the global maritime trade is the engine of capitalism, responsible for moving 90% of world trade.  While investing in ships like dry bulk carriers, tankers, and cargo vessels can be subject to cyclical market forces, this unique investment provides an exciting, long-term yield by way of “day rates” or charter fees as well as through asset appreciation. Values of secondary market ships are currently still depressed, offering a robust opportunity for the right investor.

With a new year come new resolutions. Investors can continue to have great expectations for strong investment returns in 2016—they just need to think on a smaller scale.