Alternative Asset Trust Quarterly Report: June 30,2017
The MacNicol Alternative Asset Trust is a multi-strategy, alternative investment platform designed to generate positive and uncorrelated returns against the public stock and bond markets. The Trust, through its underlying limited partnerships, is invested in private real estate and mortgages, private equity, high yield bonds and multi-strategy hedge funds. Combined, the Alternative Trust is invested in more than 150 separate real estate projects, mortgages, hedge funds and private securities. The advantage of combining different alternative asset classes and high yield investments into one Fund include tremendous diversification, enhanced liquidity, and a more predictable and less volatile pattern of returns when compared against the performance of the individual asset classes themselves.
Alternative Trust Review: The goals of the Alternative Trust are to generate positive “real” returns (after-taxes and inflation) each year, and to generate annualized nominal returns of 6%-8% over rolling five-year periods. We are pleased to report that as of June 2017 the Trust (E Class) has met its primary goals by generating positive calendar-year returns that have exceeded inflation, while delivering annual returns of 8.51% from inception.
For the past 6 months, the Alternative Trust (Class E) performed well in the face of fiscal policy uncertainty earlier in the year and currency head winds in May and June. Looking forward, we are anticipating positive returns and more liquidty from the Trust’s private equity holdings (see Emergence Fund commentary, page 8), as well as, cash flows from property realizations in the real estate fund.
Alternative Trust Quarterly Highlights
During the second quarter of 2017 ending June 30th, the Alternative Trust was essentially flat while remaining positive for the year. Currency headwinds were a factor in May and June while geopolitical and fiscal policy risk factors were more prevelant earlier in 2017. Additional investments in Canada and a normalization of the CAD/USD exchange rate are expected to benefit the trust in H2, 2017.
North American Private Real Estate
The Alternative Asset Trust invests in North American private real estate through the MacNicol 360 Degree Realty Income Fund. This fund focuses on value-added projects in the United States and Canada. The 360 Degree Fund also invests in mortgage funds through an expanding number of carefully selected operators and sponsors. All partners in the fund are chosen for their high degree of local knowledge and experience in deal sourcing, finance, construction, and property management. Diversification is achieved through partnership in multiple real estate projects across six North American asset classes.
Chart 4 highlights the regions of North America in which our real estate projects are located. The overall strategy is to invest in the fastest growing regions of the United States including Texas, Florida, Georgia, Phoenix, Las Vegas and California. More recently the fund has begun exploring opportunities in Europe as the outlook for the region continues to improve.
360 Fund Second Quarter Highlights: During the 2nd quarter of 2017 the fund experienced a strong pace of nearly sequential cash flows and several notable transactions, which we comment on in the Portfolio Activity section. With respect to cash flows, the fund received a distribution [interest, rental payment or dividend] almost once per week in the 2nd quarter. This healthy level of cash flow generation by the fund was expected and supportive of valuations at a time of currency headwinds as the Canadian dollar moved sharply higher in May and June. Moving into the second half of the year we expect cash flow activity to further optimize during the 3rd quarter before normalizing in the final three months of the year.
Commercial Real Estate Outlook (U.S.)
Commercial real estate market fundamentals remain stable across the United States and most of Canada. A resilient U.S. economy is leading to healthy tenant demand in all property types. Vacancy rates continue to fall and rents are rising modestly in most markets setting up conditions for what we believe will be sustained income growth in specific multifamily, industrial, office and retail spaces. Given the later phases of the
present market cycles the fund will avoid tertiary malls whose valuations reside primarily in land value or community support around re-purposing and certain big-box retailers. While the winds of change are blowing into the retail space, opportunities do exist and we continue to evaluate them on a case-by-case basis.
Multifamily: While capitalization (“Cap”) rate compression has improved the valuations of the multifamily space earlier this year, decelerating Net Operating Income (NOI) growth reduced total returns. Success in the multifamily space is about being strategic. The 360 Degree Fund’s exposures to multifamily projects are through its investments in Carroll Funds I and II of Atlanta, Georgia. The Carroll Funds primarily invest in Class “A” multifamily complexes in Tier I and Tier II cities in Florida, Texas, Georgia and the Carolinas. In the past quarter alone the Carroll group has evaluated 8 complex deals and consummated transactions in 3. While some of the Carroll properties classify as mixed use, the focus/targeting from a strategic perspective is suburban areas with favorable demographics that portend robust occupancy rates and elevated rent growth. To be sure, some areas are oversaturated and expose investors to the risk of “chasing” assets.
Industrial: We remain constructive on the industrial space as operationally industrial is a terrific place to park capital in an inflationary environment. Industrial assets mark-to-market their rent increases more quickly than other asset classes do and, once built, are comparatively affordable to maintain.
Office: With the recovery in the U.S. office market finally taking hold, the office sector is now at the point in the cycle where expiring contract rents will likely roll up to market which in combination with rent abatements burning down, will put upward pressure on income growth and valuations. The 360 Degree Fund is broadly exposed to the North American office space through its investments in the KingSett Income Fund of Toronto, Rockwood IX Fund out of New York and the Ameritus Real Estate Fund of Chicago. Given the timing in the market cycle, office is likely a single-digit return asset class for the foreseeable future with certain properties in key jurisdictions trading at premium multiples.
Retail. Although malls demonstrated resilient NOI growth in H1, 2017 the overall performance of the sector is expected to lag the other property types during the next five years. This under-performance for income growth is primarily due to the longer lease durations inherent for retail tenants (though mall leases allow for percentage rents that allow retail owners to capture higher retail sales growth). The 360 Degree Fund has several “value-add” retail investments with KingSett, Slate and a regional mall in Jacksonville, Florida, which is managed by the Sierra Building Group of Toronto.
Real Estate Portfolio Activity
During the second quarter of 2017, the 360 Fund expanded its investment in Slate Retail REIT price weakness. We believe Slate can expand rents from the present $11 per square foot level to $16 per square foot on more than 40% of their leases in the next four years. If this level of rent appreciation is realized, valuations should increase (along with distribution growth). Also during the second quarter of 2017 Monterone at Canyon Creek in Austin, TX was sold for an attractive valuation with the purchaser committing to pay the full mortgage prepayment penalty, which will be approximately $5M at the time of closing. Clearly demand for the right kind of asset still exists. The annualized pre-tax return on Monterone was 16.8% inclusive of monthly distributions.
In Florida, final closings at Central Parc (the North site) as well as ongoing closings at Manor Parc (the South site) continued the successful trend in the sunshine state for 13th Floor Investments. With the most recent closings at Central Parc, 252 homes within the program have closed with only 1 home remaining in inventory.
While Central Parc is largely “money in the bank” Manor Parc has been very active in the second quarter. To date, 116 [of the 239 homes have closed and we expect the remaining sold lots to close during 2017. In addition to the two Tamarac homebuilding sites 13th Floor continues to see ongoing proceeds from true ups at Hemingway (paid as DR Horton sells homes) and looks forward to final takedowns with DR Horton later this year.
Our core Canadian real estate investment continues to be with KingSett Capital of Toronto. KingSett management, led by Jon Love, are disciplined capital allocators which has led to above average inflation in rents at their properties. The KingSett portfolio is comprised of more than 50 Class A and Class B office, multifamily, retail and industrial properties across Canada. These properties include 2 St. Thomas of Toronto, the Bayshore Shopping Centre in Ottawa, 130 Bloor Street West retail/condominium complexes in Toronto, and the Cherry Hill apartments in London, Ontario. In late June, it was announced that KingSett agreed to acquire $1.5 Billion of real estate assets from DREAM REIT of which $750 million is for the remaining 50% interest in Scotia Plaza and the other $750 million for other commercial value-add assets.
Private Equity – MacNicol Emergence Fund:
The investment objective of the Emergence Fund is to generate capital gains and income by investing in a portfolio of fast-growing public companies and private equity funds. The Fund seeks opportunities in private equity where capital exit strategies are clearly
defined, and are likely to occur within a 3-5 year time frame. The Emergence Fund invests in established private equity funds with a focus on companies with defensible franchises, high growth profiles and proven management. Investments will largely focus
on profitable companies with high levels of proprietary technology addressing large target markets.
The Emergence Fund achieves its objectives by investing in well-respected and managed third-party private equity funds including the Georgian Partners Funds I and II, Northleaf Secondary Private Equity Fund and the Northleaf Private Venture Catalyst Fund. Applied artificial intelligence, conversational business and security continue to form the bulk of the fund’s focus from a strategic business perspective.
The tools and platforms for implementing applied artificial intelligence solutions continue to become commoditized and easier for companies to access and adopt. In March, Google made a number of new announcements at its Google Next event including a new cloud-based video intelligence service that allows software developers to find objects in video content. Google also announced at the event that its machine learning service “Google Cloud Machine Learning” was generally available.
Also in March, IBM and Salesforce announced that IBM would offer consulting services across both its own AI platform, Watson, as well as Salesforce’s “Intelligent Customer Success” platform, Einstein. Acquisitions around AI continued in the first quarter with the announcement that Microsoft was acquiring Canadian AI-startup Maluuba, a company that was using deep learning and reinforcement learning, to improve the understanding of human language and to perform common sense reasoning. Also in Canada during the quarter the open source machine learning database ‘MLDB’ was acquired by Element AI. The platform is to be continued to be developed as an open source alternative for implementing machine learning applications. And in March, Google confirmed that it was acquiring the data science community Kaggle that is known for hosting data science and machine learning competitions. Finally, in late March the Toronto-based Vector Institute launched with the goal of building on the already deep pool of artificial intelligence research and talent that Canada has produced. Clearly, interest in applied artificial intelligence, conversational business and security continues to ramp up and the march towards a fully digitized age continues. We expect ongoing M&A in H2, 2017 and into 2018 which should be supportive of leading private company valuations.
Hedge Funds – Absolute Return Fund
The investment objective of the Absolute Return Fund is to generate positive returns under most market and economic conditions, and to have little or no correlation to the US and Canadian stock markets. In order to achieve its objectives, the Absolute Return Fund invests in several value-added strategies managed by experienced and successful Canadian, US and U.K. hedge fund managers.
Most of these investments are not available in the public market and are typically not accessible to individuals and smaller institutions because of high minimum investment thresholds, often in excess of five-million dollars.
The long/short Equity strategy was the 3rd largest contributor to performance in absolute terms. This strategy underperformed its net exposure to equity markets generating negative alpha as markets rose mostly on multiple expansion rather than company fundamentals. The rally in U.S. corporate credit extended further into May and high yield credit spreads tightened by 7 bps in the United States and 20 bps in Europe. The event driven/credit strategy was marginally positive for the month. Performance in this strategy was driven predominantly by the exposure to event driven strategies such as bankruptcies, M&A or corporate spinoffs. The macro strategy detracted from the fund’s performance and was the only detractor for the month of June. Negative performance in this strategy came both from the discretionary sub-strategy and systematic macro trading sub-strategy. The underperformance of this strategy was driven mainly by the sharp declines in Brazilian rates.
We are pleased with the stability of the private equity, real estate and hedge fund components of the Alternative Trust in the face of currency risk, geopolitical uncertainty and potentially higher interest rates. Importantly we are also pleased that the trust remains well diversified which will allow it to act as a shock absorbed to short-term risks in traditional stock and bond markets.
The trust remains open to new investors and is available for purchase on a monthly basis.
MacNicol & Associates Asset Management Inc.