June 28, 2022

Artwork, Anybody? The Case for Investing in Offbeat Alts

Alternative alternatives, such as lawsuit funding and pro sports, redefine non-correlated assets.

Reported by Larry Light

Art by Simone Virgini

Alternative investments are all the rage these days among allocators eager for assets such as infrastructure and commodities that don’t sync up with the customary fare, stocks and bonds—and offer prospects of decent returns and a degree of protection against inflation and interest rate risk. But within this alts framework is a niche that is even more outside the ordinary.

We’re talking about artwork, life settlements, litigation funding, medical royalties, and professional sports, to name just a few notable endeavors. “The underlying theme here is investors want alpha in their assets that are non-correlated” to conventional investment classes, says Stuart Katz, CIO of Robertson Stephens Wealth Management.

Thus far, only a smattering of institutions has taken positions in these alternative alternatives. One pioneer in this area is the Canada Pension Plan Investment Board, which in 2017 bought an 8% interest for US$400 million in WME-ING, a company that manages entertainers and athletes and also puts on events. The CPPIB’s documents indicate the holding was still in place as of last year. The pension plan couldn’t be reached to learn the size of the investment return.

But based on what evidence is available, the performance of these vehicles appears to be pretty darn good. Consider what may be the original alt alts foray: the British Rail Pension Fund’s 1974 investment in an artwork investment group, for $70 million. By the time the partnership dissolved in 1996, the fund had garnered an average 13.1% return, news reports said at the time.

Some non-mainstream alts are difficult investments to make, because they are hard to value, notes Chris Volpe, director of wealth management solutions at Informa Financial Intelligence. “Institutions need to value an asset, to know what to expect in 20 or 30 years,” he says.

A lot of these investments lack historical data to render good comparisons, he finds. Sport teams are easy to measure, as they generate cash flow every season, Volpe explains. On the other hand, artwork is more problematic, with each item’s worth determined only after many years, when it finally goes on the auction block.

More broadly, the impulse to branch out and try new things is robust among allocators. There’s an obviously growing institutional appetite for alts in general. Among public pension plans in 2021, alts made up 28.3% of allocations, a fourfold increase since 2001, by the count of Public Plans Data. In a 2020 study by Research Affiliates, standard alts—real estate, hedge funds, etc.—were projected to outperform stocks and bonds over the coming decade.

What about the offbeat alts subcategory? Alt alts have low correlations to the S&P 500, according to a study by David Mirabile, a Fordham finance professor, and they often outperform the stock index even more than regular alts do.

These “exotic alternative investments offer investors an opportunity to achieve many of the stand-alone and portfolio benefits that hedge funds and other types of more traditional alternatives often struggle to achieve,” he wrote in an article for the Chartered Alternative Investment Analyst Association’s journal. (He expanded upon this theme in a 2021 book.)

And they often are lucrative. A basket of such unconventional alts—litigation funding, life settlements, online sports and gambling, cannabis-based medicine—returned an annual 37.7% over a four-year period ending with the March 2020 market crash, he calculated. The mainstream alts such as hedge funds, private equity and real estate gained 7.9%, and the S&P 500 notched 14.3% (during an extraordinary bull market), his study concluded.

Let’s examine some of the more prominent exotic alts, to use Mirabile’s term:

Artwork. Paintings and sculpture have long been the province of the mega-wealthy, and this market now totals an estimated $1.1 trillion in global value, according to a recent CAIA study. That’s comparable to other privately held investment classes: private debt ($800 million) and private real assets ($1.6 trillion), per the CAIA study by Mike Parsons, a senior analyst at Masterworks, an art investing firm.

Lately, though, art has started to become securitized, and various paintings can be traded in blocks, some as private placements, some as public securities. Parsons likened this phenomenon to how property, via real estate investment trusts, and gold, through exchange-traded funds, have become easily tradeable. As the art market expands, securitization could solve the liquidity problem for these aesthetic delights.

The strongest demand is for “modern art,” defined as that produced since 1945. From 1995 through 2020, all art gained just slightly less than did the S&P 500, 9.0% to 9.5% annually, Parsons said. The modern works appreciated much better, at a 14.0% clip. The difference is perhaps a function of the greater availability of contemporary pieces, which a bevy of art galleries flog. The Old Masters often aren’t for sale.

Life settlements. This investment is morbid to the tenth power: Investors buy life insurance policies of people with terminal conditions. The ailing insureds do this if they need the money for their remaining days, instead of bequeathing it to a relative or a charity. Returns to investors commonly are up to 9% of the death benefit.

Risks? Once they buy a policy, investors must then take over premium payments, which may not be for a long period—or may, depending on the health trajectory of the seller. Investors can get into life settlements through such firms as Oasis Strategy Group, RiverRock Funds, and Reliant Life Shares. For diversification, investors can select a large number of policies.

Litigation funding. On the surface, this is a risky business. It involves betting that the side you back will win, sort of like sports betting except there are no team stats to examine. As an attempted substitute, the investment sponsors have their own lawyers assessing winnability of cases. Investments in lawsuits provide cash to litigants or their lawyers, and investors get a chunk of the awarded damages if the case is successful.

Most of the action revolves around commercial lawsuits, especially contract breaches or patent infringements. Now, 47 companies offer these investments—LexShares, Juridica Investments, and Burford Capital are among the top players.

Downsides are the zero-sum nature of the investment—investors either win or lose—and the time money is locked up, typically for three or four years as suits wend their way through the court system. Often, investors are in several cases at once, thus lowering risk. Typical investments range from $1 million to $30 million, and annual returns over 10 years can be 15% or higher, wrote Tets Ishikawa, managing director at LionFish Litigation Finance, in a blog post.

Hedge funds and family offices are a big share of lawsuit investors, per Westfleet Advisors, which counsels law firms and plaintiffs on lawsuit funding. In its third annual report on the industry, Westfleet found that assets under management had increased by one third from 2019 to 2021, to $12.4 billion. The expense outlays resemble the most costly private equity firms, usually 2.5% for management fees and 25% of any profits. What the report didn’t say was the success rate of the suits.

Medical royalties. This is a rarified field where health care providers sell investments to tide themselves over while either seeking patents or, if they have a patent, struggling to get their products established. Investors take a cut of royalty payments that the providers’ drugs and medical devices create. The providers are small-fry, not pharma giants, and thus need capital to manufacture and distribute the goods.

Investors run the risks that the medical products won’t win a patent or will fail in the marketplace. A study by the Investments and Wealth Institute points out that investors must be able “to understand the complexities of a deal from both the scientific and financial standpoint.” Prominent players here include Royalty Pharma and HealthCare Royalty, best accessed by taking equity stakes in them.

If everything works out, the potential investor upside can be lucrative, with annual returns in the low teens, lasting the 20 years or so that a patent is in force, the study says. And sometimes, a drug will have another life. An example, says Christopher Zook, who heads CAZ Investments, which works in this space, is when “a pancreatic cancer medicine turns out to also work for lung cancer.”

Professional sports. Talk about a growth industry. Sports franchises are rapidly growing around the world. While attendances do slip during economic downturns—the Great Recession showed that—they also bounce back afterward and then some.

A bit of history: Team valuations have expanded beyond the point where there are enough sport-minded wealthy people to buy them, analysts say. Between 2002 and 2021, the value of National Basketball Association teams has ballooned 1,057%; Major League Baseball clubs, 669%; and National Football League squads, 558%, PitchBook data show. Those all handily beat the S&P 500, at 458%.

Enter private equity. Over the last couple of years, sports-centered PE firms have rushed in to purchase pieces of professional sports teams, both in the U.S. and elsewhere. The buyout firms laid out $51 billion in 2021, purchasing parts of sports teams worldwide, PitchBook says. The teams, even the perennial losers, boast very loyal fan bases and seldom have competition.

Last October, Arctos Sports Partners closed the largest first-time PE fund ever at $3 billion, then completed a second one in May, raising $1.1 billion. The group has stakes in more than 15 franchises, including the NBA’s Golden State Warriors and the National Hockey League’s Tampa Bay Lightning.

Other sports PE outfits are piling in behind Arctos, in particular RedBird Capital (Liverpool’s soccer club, hockey’s Pittsburgh Penguins) and Sixth Street Partners (San Antonio Spurs). This early in the new sports ownership trend, it’s tough to say just what these firms’ returns are. But one Arctos investor says these funds are clocking five times earnings before interest, depreciation and amortization, a healthy multiple.

All of which spells possible compelling opportunities for allocators. “Give institutions a story and a potential return,” says Informa’s Volpe, and despite a lack of historical comparisons, their interest may well be piqued in alt alts.