How to Discuss Alternative Investments with Investors

Private securities— also known as“exempt market securities” or “alternative investments”—  have a unique impact on a client’s portfolio and their resulting experience with an advisor.

Although the diversity within private market securities can meet a wide range of investment objectives (from high-growth speculative investments to comparatively less risky pools of income-generating secured loans), alternative asset investments are generally considered “high risk” in comparison to public stocks.

This is for two key reasons:

1. Private securities have less and sometimes no secondary market liquidity
2. They are subject to lower ongoing reporting and post-trade transparency rules

Registered advisors have a fundamental duty to act in good faith when advising their clients, which include staking a balanced approach to discussing private securities. This ensures that investors not only know how private securities might fit within their portfolio, but also that an allocation to private securities is right for them.

To help with this balanced approach, we’ve provided a summary of pros and cons for each of these systemic risk features:

Less Secondary Market Liquidity

The key positive: Since private securities are not traded on an exchange, the “market value” of these securities aren’t being struck on a minute-to-minute basis.  This can insulate them from excess volatility caused by investor sentiment that doesn’t reflect fundamental analysis and the true value of the security. Excess volatility can influence behavioural trading patterns based on the emotional influences of market exuberance and fear (ultimately harming an investor’s long-term objectives). An allocation to private securities is sometimes described as having a“smoothing” effect on the client’s overall portfolio, because they can’t be traded easily and aren’t repriced as efficiently as public stocks.

The key negative: Without secondary market liquidity, valuations often come with a degree of uncertainty because they rely so heavily on the firm’s processes and expertise to validate both initial and ongoing valuations.  They can’t simply rely on the daily trading patterns of secondary market buyers and sellers to agree on what something is worth (however rational or not).  This can result in under or overstating of the total portfolio value at any given time. In addition, without liquidity, investors may not be able to realize the value of their investments if they need them for the planned and unplanned expenses that life can throw at them. For this reason, ensuring a sufficient liquidity reserve not tied to private securities for any short-term needs is important and often unique to each investor.

Less ongoing reporting and formal transparency

The key positive: With less ongoing reporting, fewer formal transparency rules and no stock exchange listing requirements, investment issuers may be able reduce expenses by reallocating traditional “reporting issuer” costs toward operations for the purpose of profit. For small to medium-sized companies in particular this can be a material amount of capital being used to generate income, revenue or growth rather than being creating regulatory reporting.  

The key negative: Lower transparency increases investment risk at the time of purchase and reduces opportunities for a client to evaluate an investment after it has been purchased.  Even when market valuations or dividend income remains consistent, the absence of formal reporting and certain governance oversight can prevent an investor from assessing whether the company is being managed effectively and is positioned to withstand future risk.  It’s important for firms to have strong ongoing relationships with the issuers so that they can monitor the investment over time and ensure that income, redemption and other quantifiable metrics are kept up to date.  There is also a significant burden on the firm’s know-your-product and due diligence processes because they must obtain information directly from issuers rather than relying on public source materials.

Much like portfolio construction itself, discussing private securities with a client requires balance.  Advisors who put in the work to provide their clients with unique investment opportunities are rewarded with access to certain benefits that aren’t available for those with limited product shelves.  However, those same benefits come with systemic risks, making it important to ensure that private securities are right for your client. Through careful evaluation of private securities and consideration of investment objectives, advisors can help their clients navigate alternative investments with confidence and clarity.

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Conducting due diligence and making balanced recommendations about alternative investments to clients can be complex and time consuming. Built and designed for private security investments facilitated by high-quality advisors, Raisr’s solutions streamline compliance and increase the efficient communication between dealers, issuers and advisors. By connecting issuers, dealers, advisors and their clients through a comprehensive technology platform, advisors with private security shelves can focus less on administration and more on delivering the high-quality advice necessary to get the most out of alternative allocations for their retail clients. Learn more about how Raisr supports advisors here.