Managing your alternatives portfolio in a distressed market: Five things institutional investors should consider

Institutional investors are facing challenging conditions related to both returns and liquidity demands against trust assets. Interest rates are expected to be higher for longer, as the real economy continues to adjust to a potential “soft landing” scenario, and concerns about inflation remain common. Companies are facing the tightest loan markets in recent history and corporate bankruptcies are back on the table. Private investments are particularly exposed to these risk factors.

At the same time, a whole generation of managers now exist that have never confronted a serious, prolonged period of market stress without the comfort of the Fed (f/k/a Greenspan) put.

The new economic environment also means new pressures for institutional investors as fiduciaries. The obligations of investment fiduciaries include the duty of care, which requires the fiduciary to exercise the reasonable care and skill of a prudent person in a similar circumstance. Although the exact contours vary on a state-by-state basis, this duty typically requires fiduciaries to (i) consider all material information that is reasonably available to them prior to making a decision and (ii) exercise appropriate oversight and care with their portfolios.

Generally, this duty does not require fiduciaries to have perfect information before acting, but it does require fiduciaries to exercise due inquiry and act upon reasonable information. Even if an institutional investor employs outside managers, fiduciary obligations cannot be outsourced.

The following are suggestions to help institutional investors navigate pitfalls that can arise in this novel and challenging environment.

Proactive monitoring

Effective and open communication between manager and investors is the foundation for navigating a distressed situation. Institutional investors should expect (or be proactive in requesting) enhanced engagement with the manager or limited partner advisory committee (LPAC). It is critical for institutional investors to understand the emerging risks that the portfolio may be facing and the manager’s strategy for addressing those risks. Conversely, institutional investors should interpret radio silence from managers addressing distress in their portfolio companies as a potential red flag.

Attention to valuations

The accuracy of valuations, particularly interim valuations, has been a matter of debate in the trade press for years. Today, however, the issue is no longer academic – alternatives now make up over 20 percent of the average portfolio. But many trusts are now facing increasing liquidity demands, while simultaneously confronting major headwinds in alternatives markets. A fiduciary faced with an emergency decision regarding which assets to keep and which assets to liquidate cannot make that decision within the requirements of the duty of care if it does not have reasonable interim valuations – or, even worse, does not know that the last reported valuations are reliable. Institutional investors need to understand how fund assets are being marked.

Understanding the impact of leverage

The end of zero-interest-rate policy has a material effect across the different classes of alternative investments. For example, on average, private equity fund portfolio companies are leveraged at 50 percent of asset value and real estate fund portfolio companies are even higher, at an average of 65 percent of asset value. On top of this, institutional investors also need to account for the growth of leverage at the fund level. Strategies that may have been efficient in a low, stable interest rate environment may now be potential sources of significant risk. Institutional investors need to understand leverage points and liquidity risk across the entire fund structure.

Maintaining alignment

The standard management fee/carry structure ensures interest alignment in the good times. But when investments fall into distressed territory — and the incentive provided by carry disappears — the economic interests of investors and manager may no longer be fully aligned. Institutional investors need to adjust their expectations, consider the impact on the fund, and potentially address the need for alternative structures.

Developing an action plan

When a distressed situation emerges, decisions may need to be made on an expedited basis. An institutional investor may have only a few short days to make a decision with tens or hundreds of millions of dollars on the line. Don’t get caught flat footed. Institutional investors should think through how to react to distress in different parts of their portfolio and develop policies and guidelines to facilitate an effective response.

For more information

If you have any questions, please contact the authors or your usual DLA Piper contact.