As a Portfolio Manager, one is constantly searching for investments that seek to generate positive expected returns but are not correlated with each other. The problem is that most investments are actually correlated to some degree to the global equity market or interest rates. Therefore, during times of falling equity markets, equity investments will typically decline and during times of rising interest rates fixed income holdings will typically fall. The good news is that these two macroeconomic factors don’t always move hand in hand. Even with these two important levers at the Portfolio Manager’s disposal it is still important to research the marketplace regularly in search of alternative opportunities where the risk involved is either not correlated or has a low correlation with equities or interest rates.
The Funding Dilemma
Currently divorce proceedings in the US are prohibitively expensive.1 It is an unfortunate reality that some people will have their marriages break up and end up divorced. These individuals will usually have significant legal needs and higher living expenses than before the divorce proceedings. In these instances, it is also possible that assets are tied up until the legal proceedings end and often there is a property that is one of the most valuable assets in the family but which may take time, or be difficult, to sell making it a fairly illiquid asset. Sometimes, one of the individuals is not working and access to capital for legal and living expenses is constrained. Most traditional financial institutions will not lend to people in this situation and capital is hard to come by.
Often when there is a demand and supply funding mismatch, the private market steps in to fill the gap. As Divorce Finance is a small, niche market, there are few industry participants.
As a result of this funding shortfall, small firms set themselves up using private capital to provide financing to individuals who require immediate access to capital. Often the firms will use the legally encumbered assets, including property, as collateral against the funding made to the individual. Typically, no interest or capital is required to be repaid until the divorce is settled. After the divorce is settled, the proceeds from the divorce are used by the divorcee to pay back the loan and interest.
This Alternative Income strategy is very niche and typical investors who fund divorce funders have seen net returns have ranged been between 7-10% per annum.2
Risks of the Strategy
Like all risks these are managed, but the correlation to traditional sources of return (equities and bonds) is low. From a portfolio management perspective, one of the risks of investing in a pool of divorce loans is that the divorce proceeds may not cover the borrowed amount and the interest accrued. If this happens the return on the funding will be lower than expected. Also, the timing of divorce proceedings is unknown and therefore, it is unknown when you can expect to be paid back by the divorcee.
There is also often real estate risk as the largest assets collateralizing the loan is often the family home. If the property market falls during the divorce proceedings, the value of the property may decline and its subsequent sale may not raise sufficient funds to pay back the loan. Another risk factor of this strategy is illiquidity. After the loans are made there is usually a limited or no secondary market for these investments and the maturity/term of the investments depend on the timing of the divorce proceedings. This asset class therefore will not appeal to those who demand liquidity or to those who believe they will demand it in the near future.
As with all portfolio management, diversification is important. Ensuring that there are an adequate number of investments in the portfolio and they are adequately diversified will reduce the idiosyncratic nature of individual investments.
Unearthing uncorrelated return streams is challenging. Those investors who can accept the illiquid nature of the asset class could benefit from the illiquidity risk premium and the risk premium within this inefficient market. Like all inefficient markets the opportunity is there for investors to plug the funding gap that exists in this market and as more participants enter the market the risk premium narrows. We believe that this may be the case for this asset class over time.
As such, if constructed properly and for those who can afford the illiquidity, adding Divorce Financing investments could be a good source of risk adjusted returns to traditional portfolios.
2 New chapter Capital
This document is for information purposes only. Nothing herein constitutes, or should be construed as constituting, investment, tax, legal or any other advice or an offer to subscribe in any particular financial instrument or asset class or to participate in any investment strategy. The views or opinions expressed herein do not necessarily reflect the views of MASECO LLP. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
Investing in this asset class is for Sophisticated and Certified High Net-worth Investors. Always consult a Financial Adviser before making a decision to invest. Past performance is not a reliable indicator of future performance. Currency fluctuations may increase or decrease the returns of any investment. The value of investments can fall as well as rise. You may not get back what you invest.
Issued by MASECO LLP, a limited liability partnership registered under the laws of England and Wales (Companies House No. OC337650), which is authorized and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered in the US with the Securities & Exchange Commission as a Registered Investment Adviser. Its registered office is at Burleigh House, 357 Strand, London, WC2R 0HS, United Kingdom.