An alternative approach to alternatives

How nonprofits can benefit from new ways of investing in alternative assets

In the not-for-profit world as elsewhere, the benefits of investing in alternative assets are well documented. Alternatives can diversify portfolios beyond public equities and bonds, provide lower overall volatility, and offer a measure of inflation protection. They also bring the potential for higher long-term returns, an especially valuable attribute at a time when many nonprofits are facing rising costs and uncertain funding.

But while most organizations today understand why alternatives belong in their portfolios, many still struggle with how to invest in them effectively. Traditional approaches may deliver some of the benefits above, but these benefits may be partially offset by high costs, operational burdens, or other drawbacks. Fortunately, newer approaches to alternatives are emerging that may allow nonprofits to capture many of the advantages while avoiding some of the disadvantages.

Traditional approaches to alternatives

Historically, many nonprofits have used funds of funds, which provide access to a diversified basket of underlying managers, to invest in alternative assets. Another common approach has been to invest in a super-diversified portfolio of alternatives. Under this model, an institution may maintain dozens, or even hundreds, of line items across private equity, hedge funds, real estate, and other asset classes.

These approaches may be effective in providing diversification and professional oversight, but they come with challenges. Operationally, administering a large number of line items can be cumbersome and resource-intensive, particularly for nonprofits with smaller investment teams. Illiquidity is another concern, as many alternative structures lock up capital for years. Fees can also be high, especially with funds of funds, where investors may pay multiple layers of management and performance fees. Tax considerations, too, can complicate reporting and cash flow management for certain institutions.

For organizations that are increasingly reliant on their investment portfolios to help sustain their missions, these drawbacks may undercut some of the very benefits alternatives are supposed to provide.

New approaches offer distinct advantages

Newer ways of investing in alternatives aim to address many of the traditional challenges. One way forward is to use an outsourced CIO (OCIO) to make primary investments in funds while maintaining an open-architecture, customizable approach. Another option is to use evergreen vehicles that provide ongoing exposure to alternatives with simplified capital calls and liquidity features. Evergreen funds can be specific to a specific asset class or across multiple private market asset classes.

These strategies provide several advantages. First, they can simplify both investment oversight and operations, reducing the administrative burden on nonprofit staff. They also offer greater portability, meaning an organization is not locked into paying fees to a former OCIO or fund-of-funds manager after transitioning to a new provider.

Perhaps most importantly, these approaches allow for customization. Each nonprofit has different risk/return targets, liquidity needs, and mission-driven considerations. A modernized approach to alternatives can be tailored to reflect those factors rather than forcing organizations into rigid, prepackaged structures. In some cases, this shift may also bring cost reductions compared to traditional approaches.

Transitioning to new approaches

Shifting from legacy approaches to newer ones is not an overnight process. For most nonprofits, the transition will be gradual, unfolding over many years as existing commitments wind down and capital is redeployed.

A thoughtful way to manage this transition is through a “path forward” pacing model. This model blends the organization’s legacy portfolio with new investments in a way that helps maintain alignment with allocation targets while gradually modernizing the alternatives program. Through careful portfolio construction, nonprofits can minimize concentration risk in asset types, sectors, vintages, and managers while improving liquidity management.

It is important to recognize that there are no quick fixes. However, over time, adjusting the approach to alternatives can deliver meaningful benefits. These may include lower overall costs, streamlined operations, improved alignment with mission-driven objectives, and enhanced ability to generate the diversification and return potential that make alternatives so valuable in the first place.

Contact the State Street Not-for-Profit Team to learn more about how investing in alternative assets can benefit nonprofit organizations.