Using the closed-ended structure for alternative investment

David Prosser takes a look at illiquid assets.

As Neil Woodford’s new Patient Capital Trust increases the size of its initial public offering in order to accommodate investor demand, it’s worth pointing out what an enormous fund launch this is for the sector by recent standards. If the trust raises the full £800m it has now said it will accept, this single IPO will generate around a third of the £2.5bn raised in total by the 17 or so investment companies that came to market during 2014.

However, Patient Capital does have one thing in common with many of those new issues. Eventually, much of its portfolio will be held in relatively illiquid assets – particularly unquoted smaller companies. Last year, more than 60 per cent of money raised by the sector went into closed-ended funds planning to invest in illiquid assets of one kind or another.

In particular, the growth of alternative investment – infrastructure, commercial property and private equity, for example – has become an increasingly important theme for the investment company industry as a whole. So much so that alternatives now account for around 36 per cent of the sector’s assets according to a recent analysis conducted by Winterflood Securities.

As Simon Elliott, head of investment research at Winterflood, pointed out in a recent interview with Investment Week magazine, this is essentially a case of investment companies playing to their strengths. “The listed closed-ended structure suits illiquid and other income-generating assets,” he argues.

Why so? Well, in an open-ended fund, which ebbs and flows in size as investor demand waxes and wanes, fund managers need to be able to buy and sell assets quickly and cheaply, as new money comes into the fund or as redemptions are made. If they’re investing in assets where that isn’t possible, they need to hold a large cash buffer for these operational demands, which reduces the extent to which the fund can fulfil its mandate.

Closed-ended fund managers, by contrast, do not have to contend with the same frustrations. With a fixed pool of assets, there are no inflows and outflows to worry about.

However, investment companies aren’t launching more alternatives funds simply because their structure is a good way to offer such exposure. This issuance also reflects the changing needs of investors. “There has been strong institutional demand for alternatives,” adds Elliott.

This is partly because asset classes such as commercial property and infrastructure have been strong performers in recent times, but also because of the type of return they offer: their yield, in particular, looks attractive during this ongoing period of super-low interest rates.

For financial advisers pondering the same challenges as institutional investors – where to find income-generating assets in a climate of low inflation – these asset classes are becoming increasingly important. And for them, the collective fund route is the best option: few advisers have either the expertise or the scale to invest direct in alternatives.

Looking forward, Woodford’s fund notwithstanding (it’s not an alternatives fund in the usual sense of the word, even though it will hold illiquid assets), we can expect alternatives to continue to dominate the investment company IPO scene. Demand remains buoyant and the ability to offer alternatives exposure is a valuable point of differentiation for the investment company sector.

More choice, meanwhile, is good news for advisers looking for new solutions for their clients.