WEBVTT - At the Money: Lessons in Allocating to Alternative Asset Classes

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<v Speaker 1>Bloomberg Audio Studios, podcasts, radio news Outside Hello, hedge funds,

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<v Speaker 1>Venture Kappa, private equity, private credit. Allocating capital to alternatives

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<v Speaker 1>has never been more popular or more challenging. How should

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<v Speaker 1>investors approach these asset classes? I'm Barry Ridholts, and on

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<v Speaker 1>today's edition of At the Money, we're going to discuss

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<v Speaker 1>how investors should think about alternative investments. To help us

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<v Speaker 1>unpack all of this and what it means for your portfolio,

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<v Speaker 1>Let's bring in Ted Sidies, who began his career at

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<v Speaker 1>the Yale University Investments Office under the legendary David Swinson.

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<v Speaker 1>He's founder and CIO of Capital Allocator, and since twenty

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<v Speaker 1>seventeen has hosted a podcast by that same name. His

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<v Speaker 1>latest book is Private Equity Deals Lessons in Investing, deal

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<v Speaker 1>Making and Operations from Private Equity Professionals, is out now.

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<v Speaker 1>So Ted, let's start with the basics. What is the

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<v Speaker 1>appeal of alternatives?

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<v Speaker 2>If you start with let's call it a traditional portfolio

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<v Speaker 2>of stocks and bonds, the idea of adding alternatives is

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<v Speaker 2>to improve the quality of your portfolio, meaning you're trying

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<v Speaker 2>to get the highest turns you can with the similar

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<v Speaker 2>level of risk or sometimes the same kind of returns

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<v Speaker 2>with a reduced level of risk, and bringing in these

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<v Speaker 2>other alternatives help you do that.

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<v Speaker 1>All right, So there I mentioned a run of different alternatives.

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<v Speaker 1>How do you distinguish between private equity, private credit, hedge funds,

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<v Speaker 1>venture capital? Lots of different types of alts. How do

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<v Speaker 1>you think about these?

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<v Speaker 2>Each of them have their own different risk and reward characteristics.

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<v Speaker 2>That's probably the easiest way to think about it. If

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<v Speaker 2>you go from a spectrum private credit, think about it.

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<v Speaker 2>It's the same as bonds, a little bit different. Hedge

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<v Speaker 2>funds can be like bonds or stocks a little bit different.

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<v Speaker 2>Then you get into private equity, which is kind of

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<v Speaker 2>a little bit of juiced stock portfolio, and venture capital

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<v Speaker 2>is the riskiest of them all.

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<v Speaker 1>So you're discussing risk there. Let's talk about reward. What

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<v Speaker 1>sort of return expectations should investors have for these different

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<v Speaker 1>asset classes?

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<v Speaker 2>Well, similarly, private credit, think about a bond portfolio with

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<v Speaker 2>credit risk and a little bit of illiquidity. So that's

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<v Speaker 2>bonds plus is it bonds plus two hundred basis points?

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<v Speaker 2>Maybe something like that. Hedge funds generally have either bond

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<v Speaker 2>like or stock like characteristics with less risk. Private equity

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<v Speaker 2>you should expect a premium over stocks and venture capital

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<v Speaker 2>a premium over that because of the early stage risk.

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<v Speaker 1>Huh, those are really kind of interesting. You mentioned illiquidity.

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<v Speaker 1>Let's talk a little bit about the illiquidity pre What

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<v Speaker 1>does that mean for investors? What's involved with that?

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<v Speaker 2>When you start with just traded stocks and bonds, you

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<v Speaker 2>can get out instantaneously. So if you're going to commit

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<v Speaker 2>your capital to any of these other categories, you have

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<v Speaker 2>to embrace some illiquidity. Meaning if you want to get

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<v Speaker 2>out in that moment, it's going to cost you. So

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<v Speaker 2>to take on that risk, you need some type of

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<v Speaker 2>extra return, otherwise it wouldn't make sense to do it.

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<v Speaker 2>So the concept of an illiquidity premium is that in

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<v Speaker 2>order to pursue these strategies that prevent you from accessing

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<v Speaker 2>your money instantaneously, you need to get paid for that.

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<v Speaker 1>So where does the illiquidity premium come from? My assumption

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<v Speaker 1>was because this is so much smaller than public markets,

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<v Speaker 1>with so many fewer investors, perhaps there are some inefficiencies

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<v Speaker 1>that these managers can identify. Any truth of that.

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<v Speaker 2>It depends on the strategy. That would be the story

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<v Speaker 2>with hedge funds. Sure, when you get into private equity

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<v Speaker 2>venture capital, it's always in price. So if you're getting

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<v Speaker 2>the same asset that's in the public markets or the

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<v Speaker 2>private markets, in theory, you should want to buy it

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<v Speaker 2>at a discount in the private markets because you can't

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<v Speaker 2>get your money out quickly, and that's where you would

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<v Speaker 2>see that premium.

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<v Speaker 1>And so, since we're talking about lockups and not being

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<v Speaker 1>able to get liquid except at very specific times, how

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<v Speaker 1>long should investors expect to lock up their capital in

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<v Speaker 1>each of these alternatives.

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<v Speaker 2>It depends on the strategy and whether you're investing directly

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<v Speaker 2>in these securities or let's just say you're in funds.

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<v Speaker 2>So private credit can vary, but oftentimes you may not

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<v Speaker 2>get the liquidity until the assets are liquidated.

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<v Speaker 1>So that could be anywhere from five to ten years.

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<v Speaker 2>It can be Hedge funds often are quarterly liquidity, depending

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<v Speaker 2>on the underlying you get into a private equity or

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<v Speaker 2>venture capital fund, now you're generally talking about ten to

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<v Speaker 2>fifteen years.

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<v Speaker 1>Because you have to wait for that private company to

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<v Speaker 1>have some liquidity of to free up the cash.

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<v Speaker 2>And on top of that, if you're investing in a fund,

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<v Speaker 2>you have to wait for the fund manager to find

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<v Speaker 2>the company. So you're committing your capital, they find the company,

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<v Speaker 2>they might own it for say three to eight years,

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<v Speaker 2>and then you're waiting to get the cash back.

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<v Speaker 1>Huh. That's really that's really kind of intriguing, all right.

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<v Speaker 1>So when investors interested in alts, how much capital do

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<v Speaker 1>they need before they can start seriously looking at the space?

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<v Speaker 1>Is this for five million dollar portfolios or fifty million

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<v Speaker 1>dollar portfolios?

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<v Speaker 2>It's changing a lot to move to smaller numbers. So

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<v Speaker 2>if I go back to when I started in this,

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<v Speaker 2>you didn't have kind of pooled alternatives. I think about

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<v Speaker 2>fund of funds or all this movement of the democratization

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<v Speaker 2>of alts, and a minimum might be a million dollars

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<v Speaker 2>for a single fund. If you want a diversification, and

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<v Speaker 2>you wanted to say ten different funds, Now you're talking

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<v Speaker 2>about ten million, and if that's only ten percent of

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<v Speaker 2>your portfolio, you're looking at one hundred million dollars just

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<v Speaker 2>to make it.

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<v Speaker 1>Those are big numbers.

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<v Speaker 2>Those are big numbers. That has changed a lot, and

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<v Speaker 2>now you're starting to see more and more products available

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<v Speaker 2>at you know, rather than a million dollar minimum, maybe

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<v Speaker 2>it's fifty thousand dollars or even less. So it's a

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<v Speaker 2>little bit less. What size I mean you do need

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<v Speaker 2>to have, you know, is it five million, is a

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<v Speaker 2>ten million? I don't really know.

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<v Speaker 1>The goal, but it's not five hundred thousand dollars.

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<v Speaker 2>It's not five hundred thousand dollars.

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<v Speaker 1>Right, So, and you were saying the goal is, well,

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<v Speaker 1>the goal is.

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<v Speaker 2>To get access to some of these areas, hopefully in

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<v Speaker 2>a very high quality way, and have some diversification within

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<v Speaker 2>the strategy that you're pursuing, and that does take some capital.

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<v Speaker 1>So you just set something really interesting before ten different

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<v Speaker 1>funds and a million dollars each out of one hundred

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<v Speaker 1>million dollars. You're implying that investors should allocate a certain percentage.

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<v Speaker 1>So let me rather than use that example, let me

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<v Speaker 1>just ask that directly, how much in the alt and

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<v Speaker 1>private space should investors think about allocating in order to

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<v Speaker 1>generate potentially better returns and increase their diversification.

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<v Speaker 2>It's entirely a function of let's say, a liquidity budget. So,

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<v Speaker 2>as you mentioned it, you need to lock up your capital,

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<v Speaker 2>particularly when you're getting into private equity and venture capital,

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<v Speaker 2>and that means you can't access it. So if someone

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<v Speaker 2>has enough money that they don't really need to access.

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<v Speaker 2>You know, if you have one hundred million dollars, you're

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<v Speaker 2>probably not accessing most of that year to year. And

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<v Speaker 2>you've seen in some of the most sophisticated institutions all

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<v Speaker 2>these alts get up to fifty percent of their portfolio.

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<v Speaker 2>If you're talking about maybe you have five million to invest,

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<v Speaker 2>it's not clear you want to take half of that

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<v Speaker 2>and put it away so that you can't access it

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<v Speaker 2>in case you need the capital in between now and

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<v Speaker 2>fifteen years from now.

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<v Speaker 1>So a phrase I heard that kind of made me

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<v Speaker 1>a giggle, but I want to share it with you.

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<v Speaker 1>Sixty forty is now fifty thirty, twenty or some variation

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<v Speaker 1>to that effect. What are your thoughts on that.

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<v Speaker 2>I think about it a little bit differently, which is

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<v Speaker 2>most of the time you want to think about the

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<v Speaker 2>risk and return of the overall and you can break

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<v Speaker 2>that down into stockbond risk. So whether that's sixty forty

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<v Speaker 2>or seventy thirty, that's fine. The question with alts is

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<v Speaker 2>how do you want to take that risk? So rather

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<v Speaker 2>than in a seventy thirty having seventy percent in US stocks, yeah,

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<v Speaker 2>you may want to say, hey, maybe twenty percent of

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<v Speaker 2>that should be in private equity. You have similar risk,

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<v Speaker 2>but you have a different type of return stream and

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<v Speaker 2>hopefully a little more octane.

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<v Speaker 1>That's kind of interesting. Let's talk about fees. It used

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<v Speaker 1>to be that two and twenty two percent of the

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<v Speaker 1>underlying investment plus twenty percent of the that gains was

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<v Speaker 1>the standard. What are standard fees in the old space today?

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<v Speaker 2>It is a function a little bit of that return characteristic.

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<v Speaker 2>So if you get to the higher octane private equity,

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<v Speaker 2>venture capital, you generally do still see two and twenty

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<v Speaker 2>hedge funds and private credit it tends to be a

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<v Speaker 2>little bit less than that. But make no mistake about it,

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<v Speaker 2>the fees are higher in the alternatives than they are

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<v Speaker 2>in the traditional world.

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<v Speaker 1>How should investors go about finding alternative managers and evaluating

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<v Speaker 1>their funds?

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<v Speaker 2>So this is incredibly important because unlike in the stock

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<v Speaker 2>and bond markets, the dispersion of returns and alts is

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<v Speaker 2>much much wider, Meaning if you find a good manager

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<v Speaker 2>it matters a lot more than if you find a

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<v Speaker 2>good stock manager a good bond manager Cumbersely, if you

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<v Speaker 2>find a bad one it hurts you much more. Than

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<v Speaker 2>if you're hurt by stock and bond. So how do

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<v Speaker 2>you do it? It does take a fair amount of

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<v Speaker 2>research and either a trusted advisor or someone who knows

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<v Speaker 2>the space. There's a lot of different ways to get

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<v Speaker 2>involved in that. One of the ways you're seeing more

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<v Speaker 2>and more as all to get democratized is the bigger

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<v Speaker 2>brands are creating products. You can go to Blackstone and

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<v Speaker 2>you'll be fine. I don't know if you'll get the

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<v Speaker 2>best returns, but you're not going to get the worst returns.

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<v Speaker 2>And so one way that people think about participating is

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<v Speaker 2>you look at who these larger public alternative managers are.

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<v Speaker 2>It's a Blackstone, Ares, Apollo, KKR, TPG. These are super

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<v Speaker 2>high quality investment organizations.

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<v Speaker 1>How do you gain entry to the best funds? A

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<v Speaker 1>lot of you know, it's a little bit like the

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<v Speaker 1>old Groucho Marx joke. I wouldn't want to be a

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<v Speaker 1>member of any club that would have me. The funds

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<v Speaker 1>you want to get into the most very often require

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<v Speaker 1>giant minimums because they're working with foundations and endowments, and

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<v Speaker 1>very often they're either closed or there's a giant queue

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<v Speaker 1>to get into them. How does one go about establishing

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<v Speaker 1>a relationship ps. All these questions come right from your book.

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<v Speaker 1>But how do you go about establishing a relationship with

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<v Speaker 1>the potential alternative funds that you might want to have

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<v Speaker 1>exposure to?

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<v Speaker 2>Yeah, it's really hard, particularly as an individual. If you think

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<v Speaker 2>about it, you're competing with all of those very well

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<v Speaker 2>resourced institutions and down its foundations, pension funds that have people,

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<v Speaker 2>well compensated people that are out looking for these funds.

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<v Speaker 2>So the question you have to ask is what are

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<v Speaker 2>you trying to accomplish? And that can be different for

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<v Speaker 2>different people, different organizations, but generally speaking, it does require

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<v Speaker 2>working into networks where you start to learn who the

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<v Speaker 2>players are and trying to figure out from that who

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<v Speaker 2>are the better ones. It takes a lot of time

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<v Speaker 2>to do that well.

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<v Speaker 1>So if someone wants some assistance in building out the

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<v Speaker 1>alternative portion of their portfolios, where do they begin looking?

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<v Speaker 1>How do they go find that sort of those sort

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<v Speaker 1>of resources.

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<v Speaker 2>Usually the first step comes from the fund to funds world,

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<v Speaker 2>and you could look at as a great example, Vanguard

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<v Speaker 2>Now as part of their retirement package, did a deal

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<v Speaker 2>with harbor Vest. Harbor Vest is one of the leading

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<v Speaker 2>fund of funds to allow entry to get good quality exposure.

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<v Speaker 2>So a harbor Vest, a Hamilton Lane, Stepstone, some of

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<v Speaker 2>these are some of the bigger established, say private equity

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<v Speaker 2>fund of funds. They do a very good job of

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<v Speaker 2>getting people access to high quality exposure.

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<v Speaker 1>Huh So if you're a four to one k at Vanguard,

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<v Speaker 1>do you have access to that or is that just

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<v Speaker 1>broad portfolios?

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<v Speaker 2>I know it exists within their suite. I'm not sure

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<v Speaker 2>if it's part of their target funds or you can

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<v Speaker 2>directly access.

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<v Speaker 1>So what are some of the bigger challenges and misconceptions

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<v Speaker 1>about investing in alternatives?

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<v Speaker 2>Well, the biggest misconceptions come from the public perception of

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<v Speaker 2>it because most of the time in the news you

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<v Speaker 2>only read about sensationalization. You read about huge returns and

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<v Speaker 2>big failures in almost all the cases. Set a side

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<v Speaker 2>venture capital, because venture capital is designed to have huge

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<v Speaker 2>successes and failures. All the action happens in the middle.

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<v Speaker 2>Like hedge funds generally speaking, are very boring, they're not newsworthy.

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<v Speaker 2>They shouldn't make the news. Private credits the same way.

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<v Speaker 2>There will be a time in private credit where there

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<v Speaker 2>are defaults, and you'll read about defaults but you probably

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<v Speaker 2>won't read that the returns are just fine even with

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<v Speaker 2>the defaults.

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<v Speaker 1>So how do investors go about doing some due diligence

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<v Speaker 1>on the funds they're interested in? How do they make

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<v Speaker 1>sure they're getting what they expect to get.

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<v Speaker 2>A lot of it starts with meeting the people and

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<v Speaker 2>trying to understand what is their philosophy, what is their strategy,

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<v Speaker 2>and how do they go about deal making. You then

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<v Speaker 2>can get into the data. So any of these firms

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<v Speaker 2>that's been around, they've done deals in the past, and

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<v Speaker 2>you could try to figure out how do they add value?

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<v Speaker 2>Do they buy well, do they run the companies well,

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<v Speaker 2>do they sell well? Is it financial leverage? And then

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<v Speaker 2>trying to figure out what do you think works and

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<v Speaker 2>is that a fit with how that firm pursues investing

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<v Speaker 2>really interesting.

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<v Speaker 1>So to wrap up, investors who have a long time horizon,

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<v Speaker 1>a substantial portfolio, the time effort and interest in exploring

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<v Speaker 1>the alternative space may want to pull some modest percentage

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<v Speaker 1>of their holdings aside and locking these up for an

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<v Speaker 1>extended period with the hope of getting a better than

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<v Speaker 1>average return on a diversified basis or an average return

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<v Speaker 1>on a lower risk basis. Start out by looking at

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<v Speaker 1>some of the bigger names in the space that Ted

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<v Speaker 1>had mentioned. Do your homework and your due diligence. Go

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<v Speaker 1>into this with open eyes and make sure that you

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<v Speaker 1>are not allocating too much capital to a space that

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<v Speaker 1>might be locked up for five or ten years or more.

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<v Speaker 1>Successful alternative investors have been rewarded with outstanding returns. Unsuccessful

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<v Speaker 1>ones have underperformed the public markets. I'm Barry Ritholtz and

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<v Speaker 1>this is Bloomberg's at the Money.

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<v Speaker 2>Arm outside of Girl Grown Russ