Exploring 4 potential high return alternative investments
Traditional investments, such as listed equities and government bonds, often form the major parts of a balanced investment portfolio. However, particularly during times of rising inflation, experienced private investors tend to search for ways to achieve superior returns via alternative routes.
As a result, a growing number of investors increased their exposure to alternative asset classes in recent years, particularly to assets that display potential to deliver more attractive returns than traditional investments. This has been reflected in the average alternative asset allocation of high-net-worth and ultra-high-net-worth individuals’ portfolios, which reached 26% and 50% in 2020, up from 22% and 46% in 2017, respectively (according to KKR analysis).
Though a wide range of alternative asset classes can often display high return potential, for suitably qualified UK-based investors, the following four specific alternative investment types are regularly highlighted as some of the most popular for delivering superior returns within a diversified investment portfolio:
- Venture capital investments
- Private equity investments
- Joint venture property investments
- Direct lending opportunities
Particularly for investors with considerable annual investment allocations, substantial tax liabilities or who have contributed their maximum annual allowances to ISAs and pension schemes, the following established alternative asset classes do not only display the opportunity to target higher returns, but in some cases can provide access to generous tax benefits and complement a wider tax planning strategy.
1. Venture capital
The form of private equity that deals with investment into early-stage businesses with high growth potential, venture capital (VC) is well regarded as one of the best performing alternative asset classes currently available. Often targeting superior investment returns, VC typically aims to generate between 5x and 10x money-on-money, though this figure can be considerably higher in some cases. Investors should note that returns depend on the investment route followed and, as with all investments, previous returns are indicative and not guaranteed.
The venture capital industry in the UK has grown substantially over recent years and is fast becoming a more crucial asset within many sophisticated investors’ portfolios. For instance, between 2010 and 2020, VC was identified as a top-performing asset class by independent market data firm, Statista, recording average annual returns of 15.15%, and the total value of VC investment in the UK reached over £30 billion in 2021 alone, in what proved a record-breaking year for the asset class.
Additionally, statistics from the British Business Bank show that 2021 saw the highest value of UK VC exited, reaching £21 billion – a significant amount compared to the £4.8 billion exited in 2020 (which was the third highest year on record).
For UK-based private investors, there are a number of ways to gain exposure to this asset class:
- By co-investing into venture capital opportunities via an online platform or private investor network, gaining access to a range of well-researched, carefully selected opportunities.
- Investing in professionally managed venture capital funds, some of which can offer generous tax reliefs, such as venture capital trusts (VCTs).
- Making direct investments, also known as deal-by-deal structures, can enable investors to construct a bespoke portfolio of individual early-stage private company investments, selected at their own discretion and without the involvement of an intermediary.
Whilst many venture capital opportunities can possess high return potential, VC often involves elevated risk levels due to gaining exposure to particularly young companies. These companies may not yet be generating a strong revenue stream or benefitting from a stable customer base at the time of VC investment. Subsequently, it can take several years for a startup company to develop its technology and market position to enable an early-stage investor to exit with a positive return.
Despite this potential for increased risk, some venture capital opportunities can provide scope for investors to maximise potential upside whilst minimising downside risk due to potential eligibility for tax-efficient wrappers, such as the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS).
Since being introduced by the UK Government in 1994, the EIS has attracted over £25 billion of private investment for more than 36,000 small and medium-sized enterprises (SMEs), in part due to the scheme’s generous tax incentives. The five main forms of tax relief available to EIS investors include up to 30% income tax relief, capital gains tax (CGT) exemption, CGT deferral on other assets, 100% inheritance tax exemption and loss relief.
The SEIS, on the other hand, was introduced in 2012 as the ‘younger sibling’ to the EIS and has since attracted more than £1.5 billion of investment for over 15,000 UK startups. This world-leading scheme has a similar aim to the EIS but places more emphasis on supporting particularly early-stage businesses, reflected in the scheme’s stricter eligibility criteria and more generous tax reliefs. The SEIS shares largely the same set of tax reliefs as its sibling scheme, with the exception of enhanced income tax relief (up to 50%) and CGT reinvestment relief, as opposed to CGT deferral.
Overall, some venture capital investment opportunities can be eligible for generous Government-backed tax wrappers, which can help to minimise investment risk and maximise potential returns. Particularly within an environment of rising taxation and high inflation, this feature, alongside the potential for superior returns, could position VC as an attractive asset class for investors seeking enhanced investment rewards.
2. Private equity
Private equity (PE) involves investing into unlisted companies in return for an equity stake but, unlike venture capital, focuses on investment into more mature, well-established firms.
Highlighted by KPMG analysis, the UK’s private equity market facilitated 1,545 deals in 2021, worth a total £159.2 billion, up from 1,117 deals in 2020 and 1,246 in 2019.
More specifically, KPMG outlines that 803 mid-market private equity deals, worth £46.8 billion, were completed in the UK in 2021 – the highest level to date – with multiples remaining consistent at 10.4x earnings. Additionally, KPMG’s study noted that, while disruptions caused by COVID-19 made 2020 a unique year for dealmakers, the levels of activity observed in 2021 surpassed pre-pandemic levels, with deal volumes up 20% and deal values up 15% compared to 2019.
Today, private equity returns have reached near-record levels, with 42% of investors reporting lifetime portfolio annual returns of over net 16%, as highlighted by Coller Capital’s most recent Global Private Equity Barometer. With a pooled IRR of 27% in 2021, private equity was once again ranked as a high-performing private markets asset class.
For UK-based investors, a number of routes are available to access private equity opportunities, including:
- Co-investment platforms that enable investors to allocate capital to thoroughly researched PE opportunities and invest alongside a number of other investors, pooling capital together with the aim of generating a significant financial return.
- Private equity funds, which are controlled by a fund manager who decides where to allocate investor capital in exchange for fees, could prove somewhat less risky than venture capital funds, such as VCTs, as the companies being targeted are likely to be at a later stage of development. Although, investors in PE funds would not be able to benefit from the same tax benefits offered by VCTs or, potentially, the same level of investment growth.
- Direct investment could provide a useful opportunity for investors seeking full control over PE investments and possibly seeking to adopt a more active role within the company – though is generally only an option for experienced investors and members of business angel networks who are approached by private companies raising finance to scale up.
The ability to handle reduced liquidity and tolerate a high degree of risk can be necessary for PE investors as, in some cases, returns can take several years to materialise.
Although, some of the risks associated with PE could be mitigated by carefully selecting opportunities offered by a sophisticated co-investment platform, or investing via a fund, with a wealth of experience in thoroughly researching and sourcing high-quality private equity opportunities for investors.
As a whole, PE has consistently established itself as an alternative investment option with high return potential for investors, though generally not targeting as considerable returns as VC or offering the same extent of tax reliefs, but instead possessing reduced inherent risk levels than the aforementioned route, primarily due to later-stage companies being accessed.
3. Joint venture property investments
The alternative asset class of property, as a whole, is one of the oldest forms of investment still at the disposal of investors today and has consistently proven an important addition to many portfolios. Displaying a history of stable demand, capital growth, and offering a variety of routes to suit differing investment goals, property has long been a popular route for investors to access favourable returns, particularly as the average UK house price rose by 68% between June 2012 and June 2022, from £170,049 to £286,397.
One specific form of property investment, known as a joint venture (JV) property investment, has proven to be an increasingly popular option for investors targeting superior returns in recent years without the capital, resource and expertise requirements of traditional routes, such as buy-to-let.
Enabling investors to combine their capital with the industry expertise of property developers, joint venture property investments involve two or more parties working together to fund and build much-demanded property projects, offering investors a more indirect route into the alternative asset class of property.
JV property investing has the potential to provide significant financial returns for investors, particularly when compared with traditional property investment routes, largely due to the lack of additional costs. When investing equity into a JV opportunity, base case returns can usually stand at around 1.5x money-on-money (or 50%), although this does vary depending on the project.
Notably, the ability to gain exposure to this asset class whilst not being directly involved with the physical construction, renovation and/or maintenance of property can be highly attractive for experienced investors who may prefer a more ‘hands-off’ role.
Embarking on a joint venture enables investors to partner with professional property developers, which, in turn, can help to mitigate much of the downside risk associated with the investment and potentially improve the chances of success.
Due to JV property investments existing across a range of tenures and geographies – from regional residential developments to large scale commercial developments – this form of property investment can further contribute to a diverse portfolio.
With demand for property in the UK still markedly exceeding supply, investors could access the opportunity and not only benefit from superior growth potential, but also generate positive social impact by helping to tackle the UK’s chronic housing shortage.
Whilst this route can be desirable for investors who may prefer a more indirect approach to property investing, joint ventures can be associated with a number of risks that every investor should be aware of.
As with all investments, the risk of losing capital is present. But the possibility of this eventuality could be minimised, to some extent, by ensuring the property investment team have a proven track record and the necessary expertise for the project to be successful, and by researching the feasibility of the project itself. Sufficient due diligence should be carried out by investors to fully understand the risk/reward profile of the opportunity under question.
Due to no secondary market currently existing for the exchange of JV property investment shares, this opportunity can display a lack of liquidity. In addition, investor capital is typically required in a JV property development for up to two years (with the average payback period for most JVs being between 18 and 24 months), so investors would need to be willing and able to experience reduced liquidity for the estimated investment timescale.
Furthermore, unexpected events occurring on a local, national or international scale, such as regulatory changes, political uncertainty or global supply chain issues, may result in construction delays, possibly increasing the time taken and cost of completing the project. A longer project duration and higher costs could adversely impact the internal rate of return (IRR) of the investment.
Ultimately, joint venture property investments could display a significant opportunity for investors keen to target considerable returns, invest in property without the burden of additional costs and regulation, and diversify their portfolio against an increasingly fluctuating economic landscape. Though, it is crucial that investors consider the potential risks of this type of endeavour in an equally balanced manner. To help with this, considering the overall risks and benefits of JV property investments could formulate a clearer outline of how to approach this type of investment.
4. Direct lending opportunities
Direct lending is a form of private debt, in which lenders (other than banks) provide loans to businesses (often SMEs), individuals, or property development projects. This type of alternative investment can offer interest rates that are often considerably higher than those provided by traditional savings accounts.
Further enhancing the reward potential of direct lending, in April 2016 the UK government introduced the Innovative Finance ISA (IFISA), recognising the importance of the alternative finance sector – particularly peer-to-peer and direct lending – and allowing investors to receive tax-free returns on certain investments.
One example of a specific type of direct lending opportunity is a property bond (or property loan note). This financial instrument involves property developers raising capital from investors in the form of a loan. Bonds are usually issued for a fixed term, generally two to five years, and are used to aid in the development of residential or commercial property projects.
At the end of the fixed-term, if the project has gone to plan, investors will see the return of their original capital as well as any interest accumulated (unless they opted to receive interest payments on a monthly, quarterly or annual basis, which can be possible, depending on the provider).
Interest rates currently offered by UK property bonds can range between 4% and 15%, suggesting that this alternative property investment has the potential to generate inflation-beating returns for UK investors in 2022.
Although, it must be noted that property investments, particularly loan notes, can carry a considerable amount of risk and, as with all investments, returns are not guaranteed.
The primary risk associated with property bonds is the event of a borrower defaulting on their loan. However, property bonds will typically be secured by way of a first or second charge over the assets (properties or land), offering an element of downside protection for investors.
Furthermore, property bonds can be held within an IFISA, making any potential returns tax-free and helping investors to maximise potential upside and benefit from the tax reliefs on offer.
Unlike commercial bank loans, direct lending opportunities can sometimes lack regulation, which means that increased risks can be taken, and deals may be pursued that larger entities would avoid. This emphasises the need for investors to carry out thorough due diligence when considering direct lending opportunities.
Superior return potential of alternatives
The examples listed above represent just four particularly effective routes that investors may look to for achieving superior returns, and it should be noted that a number of different routes could be followed in pursuit of this aim. Ultimately, alternative asset classes – especially VC, PE, property and direct lending – could provide investors with the opportunity to target superior financial returns.
Generating positive returns are often the primary goal of any investment, and a factor of increasing significance for investors during times of high inflation and increased volatility of traditional listed equities. The return potential of alternative investments – venture capital in particular – can be enhanced by utilising generous tax-efficient investment schemes, helping to maximise upside whilst minimising downside risk.
And whilst many alternative investments can offer significant returns and tax benefits for investors, these potential advantages are accompanied with a number of risks that investors need to be equally aware of.
Overall, certain alternative investments may be more suitable for investors with relatively higher risk tolerances in place. Thorough due diligence into opportunities, platforms, and investment providers should be conducted to help with mitigating the likely risks of the opportunity, fully understanding the terms of the deal, and working to maximise confidence in the project along with the potential financial upside.