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The long and short of investing in unlisted assets

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A perception in the market exists that if an asset is listed on an exchange it is safer than investing in an asset that is unlisted.

Investors in South Africa have minimal exposure to investments in unlisted assets and this is purely because the listed market is well known, well understood and has received high coverage over the years.

There are real risks when investing in any type of asset, the trick is in having mitigants in place while ensuring that the return earned is commensurate with the risk that is being taken on.

Matching a portfolio’s investment horizon and risk tolerance level to the types of assets in which investments are made should always be a key consideration. Furthermore, diversity in an investment portfolio is important and a key protection against the returns earned being wiped out due to the underperformance of any one asset.

In times of uncertainty, such as that being experienced in the South African market currently, perhaps casting the investment universe net wider could enhance diversification and provide some protection against volatility.

So what sets investing in a product that has unlisted assets apart from a product that has listed assets?

Liquidity

Investors often think that if an asset is more liquid it is less risky. If you were invested in African Bank shares or bonds you would know that liquidity does not take away business risks and that liquidity would only be beneficial in exiting an investment before it completely sinks and probably doing so at a deep discount.

Whilst unlisted assets might not be liquid, investors can have more insight into the business on a regular basis. Equity holders in an unlisted business may request management accounts on a monthly basis and may also have Board representation to keep appraised of the business’ activities and performance. In the case of investors that provide debt funding directly in the unlisted market, protections for investors (an example is taking security over the asset being funded) can be negotiated.

Investment Horizon

Investments in both unlisted and listed assets require a relatively long term view; more so on the unlisted assets because of the often illiquid trading market. When making the decision whether to invest in traditional or alternative asset classes, clients’ income needs as well as the level of risk tolerance need to be carefully considered.

Types of Assets

The entire market has access to listed assets on an exchange and access to investments in specific economic sectors is limited to what is available on the exchange.

The unlisted market can give investors access to a wider selection of assets across various sectors. Some of these businesses can be in a niche market, difficult to replicate and have little competition. Futuregrowth has invested in many sectors not accessible to the listed market such as renewable energy, toll roads and abalone farming.

Availability of information

In the listed market, all information is publicly available and this has an advantage in the sense that all market participants have equal footing in assessing an investment. This could also be seen as a disadvantage as you as an investor would not really have a competitive advantage over your peers.

In the unlisted market, information is not readily available and not as easy to gather. Analysis may even take longer as you may need to consult with experts if the industry being considered for investment is unfamiliar. For example, when buying a direct stake in a property, extensive financial and economic analysis needs to be done. In addition an investor needs to:

  • obtain the tenant leases from the owner,
  • perform a structural engineering assessment,
  • check title deeds,
  • check zoning and occupancy certificates,
  • check fire and electrical compliance, and
  • perform a building-specific due diligence.

The advantage, in this instance, of a direct property investment is that a portfolio can gain exposure into a segment of the property market that the listed property companies may not necessarily focus on.

Risk and Return on Investment

The risk and return assessment on a listed asset versus an unlisted asset would be no different. The only difference would be a higher liquidity premium that would be added for the unlisted asset, which could result in a higher required rate of return over the life of the investment.

Valuations

Listed assets on an exchange are deemed to be efficiently priced with a daily price available. We find that from time to time, based on our experience, the South African corporate bond market is not efficiently priced and the pricing on the listed exchange may not be reflective of the current market situation. It is also not the most liquid segment of the bond market, despite it being listed on an exchange.

Futuregrowth applies its own credit valuation methodology on unlisted assets and the same for listed assets if we believe the last published price is not reflective of our own assessment of the inherent risks.

Shares in companies can trade on a stock exchange at a premium or discount to the net asset value. When investing in unlisted companies via equity, the value of the equity is based on the net asset value which is derived from market-based valuation techniques.

Application of investing in unlisted bonds

Let’s look at an unlisted loan facility made available to a property company building an affordable housing rental development. Where the property company (“ABC Properties”) is the borrower and the entity advancing the loan (“XYZ Lenders”) is the lender.

A loan facility of this nature would be made available to ABC Properties for a certain period of time. The uses for this funding would range from land and/or building acquisition, construction costs, legal costs and other costs required for the development. As one would expect, the repayment of this loan would be predominantly through the rental income that the building tenants would pay on a monthly basis to ABC Properties. This kind of facility would also have a predetermined maturity date by which any amount outstanding needs to be repaid to XYZ Lenders.

As with any loan, the lender charges the borrower interest for the money being advanced. The rate charged is adjusted based on the assessment of the risk being taken on. Some of the factors considered in assessing the rate charged are construction risk, industry risk, legal/regulatory risk and this ensures that the rate being earned is commensurate for the risk.

Further mitigants to protect the investment would be in the form of covenants; which restrict the company’s ability to do certain things which may impair the credit quality of the investment over time. These include but are not limited to the following being maintained at a level agreed to by both the lender and borrower:

  • loan-to-value ratios,
  • debt service cover ratios,
  • maximum vacancy ratios and maximum tenant arrears ratios.

The security package is another integral part of the structuring of a deal, and in the case of ABC Properties this would include things like a mortgage bond, and rights to the tenant rental cashflows.

It’s quite evident that having the leeway to negotiate the terms of a loan facility is very valuable instead of taking a bond instrument that is listed on an exchange that may not provide adequate protections for lenders. Having the ability to negotiate terms of a loan facility is a great tool to have when trying to mitigate risks and to protect the value of an investment.

Investing in unlisted assets can appear to be more risky than investing in traditional listed assets, but there are a number of tools at the investor’s disposal (some of which we’ve highlighted) to ensure that a portfolio gets rewarded for the risk being taken. It is important to note that an investment in an unlisted asset can be protected by having numerous “belts & braces” in place, which the borrowing company would need to comply with over the life of the investment.

Investing in unlisted assets is complex due to the additional layers of work that require highly specialist skills. We recommend that investors who choose alternative assets as part of their portfolio mix, always invest with partners that have a proven track record in managing investments in this asset class.