Family offices load up on alternative investments: Here's what to know

Key Concepts:

• Family Offices: Privately held companies that manage investments for wealthy families.
• Alternative Investments (Alts): Investment assets that are not stocks, bonds, or cash. Examples include private equity, private credit, venture capital, hedge funds, real estate, and infrastructure.
• Private Equity (PE): Investments in companies that are not publicly traded.
• Private Credit/Debt: Loans made to companies that are not publicly traded.
• Illiquidity Premium: The additional return investors expect to receive for investing in assets that are difficult to sell quickly.
• S&P 500: A stock market index that tracks the performance of 500 of the largest publicly traded companies in the United States.

Family Office Investment Trends

• Growth in Alts: Family offices are increasingly allocating capital to alternative investments. The number of family offices investing in alts has increased by over 500% since 2016, according to data from Kraken. This growth surpasses that of wealth management firms, sovereign wealth funds, and endowments. There are now over 4,000 family offices with alts investments, up from 650 in 2016.
• Preference for Private Credit: Within the alts space, family offices are showing a preference for private credit. Blackrock reports that 39% of family offices plan to add or make new investments in private credit/debt this year, while 29% plan to increase investments in private equity.
• Portfolio Allocation: Private credit currently represents a relatively small share (around 5%) of total family office portfolios.
• Concerns about Fees and Returns: Family offices are expressing concerns about higher fees and potentially lower returns in the private credit space, given the significant capital inflows. 72% of family offices identify high fees as the biggest challenge to investing in private markets.

Rationale for Investing in Alternatives

• Diversification: The argument is that relying solely on the public stock market (e.g., being "pegged to an Nvidia stock") can be risky.
• Access to Private Companies: 80% of American companies with over $100 million in annual revenue are private. Investing in private markets provides broader exposure to the economy.
• Illiquidity Premium: The idea is that investors are compensated for the illiquidity of private investments with higher returns.

Counterarguments and Concerns

• Exclusivity: One perspective is that the rationale for investing in alts is simply to access investments not available to the average investor.
• Return Compression: The influx of capital into private credit and private equity is expected to compress returns and potentially lead to lower fees.
• Private Equity Stock Performance: The stock performance of some publicly traded private equity firms (e.g., KKR, Apollo) has underperformed, with some even being down this year.
• Exit Challenges: There are concerns about whether private equity firms will be able to exit their investments in portfolio companies (currently valued around $3 trillion across 30,000 companies) at the same or better prices than they entered.
• "Hot Potato" Scenario: There is a worry that as more investors allocate to private markets, a "hot potato" scenario could develop, where investors struggle to find buyers for their illiquid assets.

Notable Quotes:

• "The argument is that when the entire American retirement system is pegged to an Nvidia stock, that could be risky."
• "The rationale is I'm rich, I'm special. I should have access to something better than the average American can get access to through the S&P 500, right?"
• "72% of family offices say high fees are the biggest challenge to investing in private markets."

Conclusion:

Family offices are increasingly allocating capital to alternative investments, particularly private credit, seeking diversification and potentially higher returns. However, concerns exist regarding high fees, potential return compression due to increased capital flows, and the ability of private equity firms to successfully exit their investments. The long-term viability of expanding access to private markets to a broader investor base is also questioned, with the potential for a "hot potato" scenario if liquidity becomes an issue.