Show V/O:
This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify or wherever you get your podcasts to make sure you don’t miss an episode. Here is your host, Tony Davidow.
Tony:
We recently hosted a group of global institutional clients for an educational event in our San Mateo headquarters. Our clients joined us from 23 different countries. The program highlighted the depth and breadth of resources offered by Franklin Templeton, as we examine the global economies, capital markets and opportunities across traditional and alternative investments. What follows is a panel discussion with Brooks Ritchey, chairman of K2 Advisors, and Peter Blue, head of Alternative Solutions at Franklin Templeton Investment Solutions.
Tony:
We wanted to share our discussion as a special feature of the Alternative Allocations Podcast series. We will begin with my first question for Brooks and Peter.
Tony:
When you think about it, what's different and unique about allocating to alternatives than maybe the way that they're allocating to their traditional investments?
Brooks:
Well, I'll tell you, my experience in using another product class, another asset class, alternatives. 60/40 works fantastically well over various market cycle horizons, but you get these events where they don't auto diversify themselves. And last year and that chart that Tony put up is a fantastic example of what happens when stocks and bonds correlate. So about 20 years ago, I shifted my career focus to hedge funds, hedge strategies in general, because I firmly believe and maybe some of you agree, that there are certain elements of life that are meant to be hedged – life insurance, car insurance, home insurance.
Brooks
But there wasn't enough tools for me to use in my managing of portfolios to protect against market stress events. And having been in this business for over 30 years, the key is to survive the stress events. And they will happen. On average, they happen about once every seven and a half years. So, what I feel is the biggest added value to a traditional long-only portfolio is, yes, some illiquid private credit, private equity type of allocations. But most portfolios that we've been asked to analyze and Peter is going to talk about the same thing. when we're asked to look at a client portfolio, our biggest area of assistance is in protecting against those eight months, 14 months to year drawdowns that can really eat into the compounding. So I'll keep it short for now. We're going to talk more about this in terms of the actual application. But long only is fine until you get a stress event and that's why there are certain protective, I call them conditionally diversifiers in the sense that they don't really take away from your upside performance, but boy, oh boy, when you get a 2022 or a 2020 or a 1987, they are very, very helpful not only to your portfolio but quite frankly, to your career.
Tony:
So, Peter, let's let's take a little bit of a step back. And I think we got a sense here we have some people who are 10% allocation and probably some people that are 0% allocated to alternatives. So let's just start with the basics. When we think about allocating to alternative investment, how do we start that process? How do we think about strategic and tactical and portfolio construction? Let's let's kind of start that discussion will delve down a little bit.
Peter:
Yeah. The first thing for us as a multi-asset provider is one just to define what we mean by alternatives, very heterogeneous asset class, subset of asset classes, and within it each different asset class does something a little bit different for your portfolio. Private equity, private credit, real assets, hedge strategies, understanding what we mean by those, and then going a layer deeper to pull a definition around what we think each one of these areas can do for our portfolio.
So once we've done that, the next question is what am I trying to do with my portfolio? What are my outcomes I'm trying to achieve? And that means a lot of different things based on the investor and based on the investor’s mandate. It could be as simple as improve the efficient frontier, improve risk adjusted returns, but it could be I want to increase my income flow, cash distribution. It could be to protect against downside risk and really robustify my portfolio, in a sense, with hedge strategies, it could be inflation protection. So there's a number of different things that we could try to achieve and we need to line up the building blocks with the target outcome and then find a thoughtful approach to combine them into a portfolio.
And where I’ll end is, you know, for us, we like to to use the total portfolio approach where it's really about understanding the marginal impact of the alternative exposure you're looking at on your existing portfolio and say if you're starting with the stock/bond/cash portfolio of some sort, how can I fund away from that into alternatives to improve the outcome?
And there is, you know, there's technical ways to do that. We can think about optimizations, how to think about correlations, expected returns. Sometimes it's efficient just to have a qualitative sense of what the portfolio does and to be thoughtful about how you fit it into your portfolio, to push it in the right direction.
Tony:
Peter, you're evaluating managers. You have a team about how do we determine what is the right inappropriate private equity manager to fulfill that mandate as we think about what are the ultimate goals we’re solving for.
Peter:
And this is one of the critical things you, you started, Tony, with what makes alternatives different. And one of the main issues is that the dispersion of manager performance, which makes manager selection a critical exercise. There is really no way to buy the index. And most of these private asset classes, there's no way to allocate passively and kind of confirm the asset class exposure that you're getting.
Peter:
There's a lot of idiosyncratic risk across the managers you allocate to. And that means different things across the asset classes. But a single private equity fund say a buyout fund, they may only have 5 to 15 companies within that portfolio. So think of how concentrated a single mutual fund or UCITS fund would be with just 5 to 15 and there's a ton of idiosyncratic risk. So what we try to do is balance having to go really deep to make sure you get really comfortable with the managers we work with, which takes a lot of work and perhaps is a bit of a higher hurdle than maybe a long only mandate with a prudent level manager diversification. Because even if you feel highly comfortable what the manager is selecting, you typically want more than one to balance out and have a little bit of diversification, help you better capture that asset class exposure.
You know, So for us, our manager research team – they’re very thoughtful about investment, due diligence, operational due diligence. It's fairly custom based on the asset class. Each asset class is different. And so for us it's a matter of going really deep, getting comfortable with the exposure, the strategy of the manager, alpha potential, and thoughtfully aggregating those those managers into a portfolio.
Tony:
But you want to weigh in on due diligence. I mean you guys have been doing it for a long time as well.
Brooks:
Yeah, everything Peter said I'd like to just echo. The the goal of individual manager due diligence is to figure out their personality, the personality, the risk profile of the investments they're making. Clearly fraud risk and the Bernie Madoff events of the past. That is very, very important. But there's the industry has come a long way to monitoring and performing due diligence, looking for operational fraud and whatnot. The next level down and Peter mentioned it is these managers are oftentimes very different. Some of them have a bullish bias. Some of them have a bearish bias. Even in the private space, you've got to get regional diversification in real estate. You've got to really perform hands on due diligence or have a team do it for you so that you understand the personality of the investment offering. It's it's not like buying an ETF on an index.
Tony:
There's a big premium in selecting the right manager and avoiding the wrong manager. So there's absolutely a critical process of evaluating it. I think that part of what you're trying to do when you evaluate managers, you're trying to determine, is the future going to be like the past right? So you understand their personality. They want to understand how did they get to this point in time, and do I think the future is going to be like the past?
So it's really critical. It's the investment, due diligence, it's the operational due diligence. But part of it is to understand does the team have the depth and the experience to deliver those like or similar results in the future? And it's hard to do. And I don't think that, you know, it's something that you should take lightly. But there is such a premium – if I'm going to dedicate the resources, that's where I'm going to be dedicating them to.
Brooks:
Because of the variance and returns.
Tony:
Dispersion, yeah.
Brooks:
If you do above average due diligence or you you you partner up with a team that can help with that. Yes, it can more than compensate for any extra fees you're paying for the product class. That's a key point.
Peter:
We like to say, Tony, that asset allocation and manager selection, they're iterative. There's a feedback loop between the two. Because if you can find the top quartile managers and get comfortable with them, you should have a higher allocation to that asset class to access that alpha potential. But if, say for whatever reason, you don't feel comfortable manager selection, then then maybe there should be a lower allocation to the asset class as a whole, despite maybe the average return being attractive. And so that's a feedback loop to build up capabilities, go deep, get comfortable with the managers.
Tony:
So I want to pick up on something that I think is interesting. So we think about allocating to traditional investments. We have active versus passive decisions. There really isn't a passive decision when you're allocating to private equity, right? I'm going to select a private equity manager with deep resources. They have a lot of experience doing it. There isn't a benchmark per say that I can say I'm going to buy an ETF to do that. So there really is a skill and a premium in spending the time and really understanding that space.
Peter:
The key point is the net expected return of the strategies you're allocating to. So, gross return minus the fees if that's that's attractive more often than not it's hard to find the high alpha private managers because historically, you know, the larger larger investors have filled up their capacity. So when you find them and you feel comfortable with them, it's you go for it, because it's hard to find the good ones.
Brooks:
Yeah. A fair price. Yeah. For the value added, the alpha, the communication. Does the investment team tell the investors how they're positioned, where they made recent changes? Are they, are they being genuine in the communications? And then one other element which may come up later, but Peter reminded me of it. You want the managers in your private investment area to end your hedged strategy area to play well together, at least mathematically.
What you don't want to do is have two or three private equity managers, two or three real estate managers that all of a sudden behave the same way, primarily during a stress event. Don't worry about the bull market cycles. Do all of your analysis, answer the question on how do these managers, individually and or together, how do they behave in a stress market environment? The bull market is going to take care of itself. Everybody's going to make money. But it's that conditional stress test that that you can really get a sense for. Does
Manager A play very well and diversify Manager B or C?
Tony:
Peter, I know you guys do some work around, you know, how do we adjust for and you know de smoothing or however you want to describe it to this audience. But I think it is important is you guys think that through you take that into consideration.
Peter:
Yeah it's a good question for sure. I think I think the answer depends on your process and how you allocate capital, how you build portfolios. So if you're using quantitative techniques like optimization, mean variance optimization, where the process is very sensitive to the inputs – expected returns, covariance matrix – then I think you do want be very thoughtful about the risk estimates you're putting into that model because if you're using volatility estimates that that may have some sort of, you know, lag bias in them, the Sharpe ratios for those private assets are going to be very high and the exercise almost becomes frivolous because it'll recommend 100% to alternatives.
And so so it's about being thoughtful. But in terms of quantitative techniques, there are things we can do like de-smoothing our algorithms to effectively remove the serial correlation from the historical return series, and that can make an historical estimate a little bit better fitted for use in the mean variance optimization.
Now, that being said, I don't know that you need to do the quantitative exercise if you have more of a qualitative approach. It may be sufficient just to know that private equity is a form of equity and to fit it into the portfolio with a general understanding that it'll have a risk profile similar to public equities, all else equal. And the same for private credit being reasonably similar on a factor basis to, you know, high yield credit or real estate. You know, I think you can take a very sensible approach. Say real estate is probably 50/50 stock and bonds some sort of risk profile in between and fit it into your portfolio that way. And so all that's to say is there are quantitative techniques that you can do and apply that can support a quantitative process. But there's also qualitative overlays that that can guide the thinking, you know, kind of look through the historical data issue and arrive at reasonable allocations.
Tony:
And I like what Peter said there, which I think is important. Let's just all understand the nature of it, take it into consideration however you adjust for it over time or you don't adjust for it – at least be mindful of it. Right. Which I think is kind of a segue to another area that I just wanted to get into, Peter, since you've got the floor here. The other thing to think about with private markets is they are illiquid investments. And for a lot of you who are allocating capital, you know, the beauty of hedge funds are generally pretty liquid, right? They may have some some gates on how easy it is to get out of them. But private markets, I certainly view them as long term investments. If I want to capture the illiquidity premium that we were talking about, I view them as a 10 to 12 year investment. So when you think about allocating, how do you take that into consideration? Maybe talk a little bit too about I make the decision, I'm going to allocate it to private equity and how do I deal with capital calls, that money that's drawn down over time?
Peter:
Yeah, so, so with alternatives, private markets, liquidity becomes the key differentiating element. So that's really what we're talking about here. How do how do I handle illiquid exposures in my allocation and manage that risk over time? I think it's important to do the work upfront to assign a liquidity budget. What's the level of illiquidity that you're comfortable with? Stress test that and down market scenarios, make sure that you have the amount of liquidity you need to maintain your operations through all different market environments. And that becomes the liquidity budget that you're willing to operate within. And fit private equity, private credit, hedge funds, the less liquid exposures within. But you're effectively assigning a constraint because you're not letting yourself breech a limit that would put your put your program at risk.
So so that's the first thing. And then the second thing is in the portfolio construction process, just to recognize that there will be demands for liquidity over time and capital cost structures in particular. So when you commit the capital and the capital gets called over 3 to 5 years, you know, that's an off balance sheet liability that we need to be aware of.
And that's where it's all effectively planning in advance, knowing how you will fund those capital calls, whether it's in liquid asset, safer reserves or, you know, we often think it makes sense just to do a rebalancing approach where you can rebalance your liquid assets to source the funding for the private asset capital call. But effectively, Tony, it's all about planning in advance and be very thoughtful about how much liquidity you can take./p>
Tony:
I want to pick up on your point, though, on this illiquidity bucket. I've written a paper on this and we actually describe it the exact same way as I think the way that I would think about allocating to private markets is determine in advance what is your illiquidity bucket. And you can do that based on your your cash flow needs and your funding requirements. Figure out what that is and then allocate that over an extended period of time. By the way, that's the way that Yale does it. And they have a 50% illiquidity bucket and a 70 to 80% allocation to alternatives. This is a great environment for secondary managers that people have over-allocated or they had a static allocation, but because of the performance of the public market falling, they wake up and they have an over-allocation of private equity and they've made commitments that they're still making over time. So they're looking to exit that now. I don't know, Peter, if you want to add to that.
Peter:
I think more generally we advocate for a “through the cycle” approach to thinking about the denominator effect because the prices will move at different speeds for public versus private assets. So you have to look through those movements almost like a full cycle approach and not overreact any given quarter to the relative weights and think I need to put it back in I need to fix it, get back in tolerance.
Peter:
And maybe more than anything else, a governance issue of managing the ranges that you allow the private markets to drift based on their prevailing marks and having that through the cycle approach. I mean, I think just the current market prices have moved closer to the gap between public and private has closed. Not fully. And there's still fundraising issues where allocators are pausing or slowing down some of their their new allocation decisions. But it's working itself out. And I think the prudent decision for an allocator is just be very thoughtful and take that long-term perspective.
Tony:
So a couple of questions around data. And Peter, maybe you and I can just kind of start this discussion. Where do we source data? Because I think it's so important to source real data when we look at what's going on in the marketplace.
Peter:
That is half the battle because private markets, by definition they’re private. So all the data isn’t available, particularly manager-specific data. There are some vendors in the market. We work with one called Burgess that have aggregated data over time. They have different approaches, but there are data sets available for a number of the private markets that are high quality, reliable, good granularity too – a cash flow, capital call, distribution histories.
There's a lot you can do with that information through those vendors. Over time, you may build up your own internal database. As you move managers, you kind of ask for the information you aggregate it, you store it, you build up your own record. But it's one of those things where it's either working with a specialist partner that's been aggregating data for a while and contracting with them, or endeavoring to build up yourself which will take a little bit longer.
Tony:
I would just say, you know, I don't have a horse in the race here, but I think two of the bigger data aggregators that are available in the US are Pitchbook and Preqin. They have a lot of alternative data. They're very reliable. I would just be careful, when you look at data, you’re probably like me, read the footnotes, understand where it comes from, understand if it's reliable data as opposed to something that's kind of made up over time. You really can't take a public market surrogate and convert it into a private equivalent. So the way that Burgess and Cliff Water and all of these data universes are provided, they're actually universes of data. The real private equity and private credit managers are providing returns. They're collected. It's a universe as opposed to an underlying index. So it is important to do that.
And then I think your other point, which is an important one, is leverage all the managers, right? They have data. They you know, they definitely know what's going on in their space. Ask them, ask them for comparables.
Peter:
Manager information is one of the best sources you can get. The markets are pretty opaque at a transaction level. There is more data available recently, but working with the managers closely is one of the best ways to do it.
Tony:
Peter Can you address the challenge in committing capital to private investments and then dealing with capital calls as the funds are drawn down over time?
Peter:
One of the techniques that I think is important to apply in advance is a commitment pacing analysis, which within that you're effectively modeling out potential ranges of capital calls and distributions and distributions are likely to slow down like we've seen in difficult market environments when exits, when exit volume is lower. So that part of the messaging goes back to in advance, planning ahead for scenarios where distributions might slow down, capital calls might even increase. How does my allocation change in that area? And there a number of pacing models available that are worth exploring in that area.
These managers, they're very prudent allocators, but they're trying to maximize value for their shareholders and find the best exit routes possible. And that may mean delaying an exit for a year or two based on their expectation for a market environment or that may mean doing a GP continuation vehicle to allow their current investors to be liquidated out if they want to, but allow an opportunity for that asset to continue to grow.
So, you know, I don't think it's as black and white as saying you're always expecting distributions at certain point in time. There's a range. It may come faster, may come slower. As part of working with managers you believe in and trust that you know, you know, they'll do the right thing on your behalf in those difficult market environments.
Tony:
So we talked quite a bit about this charge and volatility and Brooks, I think you're very specific about stress testing portfolios. We have a couple of questions about how do people go about stress testing the portfolio. So maybe for both of you, how do you think about stress testing portfolios, realizing we're going to have these bumps in the road? And Peter, it gets to that point that you and I always talk about, which is you don't have all the data for the length that you'd want to really stress test it.
Peter:
It's really, really difficult and a lot of judgment required because there's no one straightforward quantitative approach to conducting risk analysis. Public markets are a little bit easier. They can be more easily decomposed into factors. You can use risk systems and get very rich data, but it's harder in the private market space. And so a lot of judgment is required.
We do try to take a thoughtful approach to to break private assets down into their factor building blocks as best we can. And that requires almost as much economic intuition as any sort of statistical analysis to do so. And then you can kind of create synthetic return streams historically based on that factor composition, where you have more data available for those factors and that that gives you more of the economic look at how you might expect private equity to perform in a downturn.
Peter:
It doesn't necessarily provide the appraisal value look where it might take private equity a little bit longer to kind of get to the bottom and work itself back up when you look at the marks. And so you have to sort through those issues of appraisal, values, how those might perform, and then looking as we do at the the factor profile under the hood.
Tony:
And Brooks, we're fortunate there's a lot more hedge fund data. I mean, hedge fund data goes back a long time. It's also more granular, right? So, you know, we tend to look at hedge fund in an aggregate, but, you know, macro is very different than long short, which is different than activist. So how do how do you guys do it? Because you guys do a lot of modeling here as well.
Brooks:
Oh, yeah. That's a minimum requirement that we have holdings-based risk transparency. So yeah, I've got a bit of an easier job than Peter here, but Peter and I, his team and our team, we do have some common clients where we've had to look at a multi-asset stress test type of analysis and yes, the hedge funds are easier to decompose and to calculate a potential stress performance profile.
Brooks:
But I do want to highlight two words that Peter mentioned, that we both make use of whether we're working together or separately, and that is judgment. He used that word and intuition for the private side of my client portfolios that have privates in it and and where I utilized the solutions team and Peter's help, was let's just talk this through.
Peter mentioned it, but I want to just stress that no pun intended, the if interest rates go from 0 to 500 basis points, try to find a small period in the past, maybe it's 2013. What did the valuation vendors do with private credit, private equity, etc.? It's part art and it's part science. So don't be afraid to use judgment and intuition on top of the principal component analysis.
Tony:
So we got a great question. I think we made the comment earlier that, you know, making an allocation of private equity is the first stop, but it's not the end result. Right. So there's a question in here, Peter, maybe just weigh in on this. You know, how do we make a decision on how we want to allocate to secondaries, which has come up quite a bit to buyout? And then, of course, thinking about regional sort of exposure, because all of you, you know, would like to have representation in your local markets. So how do we think about that from an allocation perspective? And then ultimately, you know, where do we source those opportunities?
Peter:
Yeah, I mean, I think it always comes back to trying to assess the expected return and risk profile of the asset class you're interested in. And so secondaries, you know, part of the equation there is the discounts on offer in the market as we're working with managers to understand what the deal flow they're seeing, where transactions are pricing can be really interesting. And working towards an expected return profile for that asset class, so you can then feed that into your your allocation process. And likewise on risk. Secondaries like any other asset class, there's a lot of nuance in the different types of under underlying exposure. So some secondaries could be later stage buyout exposures that are closer to exit and from that perspective, you know, there's less, to some extent, less risk if you have more transparency of the exit potential in near term.
And so you can kind of think through how that impacts the risk profile, that exposure, think through the discounts on offer again for expected returns and feed that in your process. You know, there is a real tangible benefit to something like secondaries or any other kind of shorter duration or higher liquidity exposure where they can help your liquidity profile within your portfolio. And so the J Curve was mentioned. Secondaries do a great job of how you work past that. Their closer to distributions so you have distributions kicking back to you sooner which you can reallocate and rebalance your portfolio. So there are real tangible benefits just in terms of portfolio management that can come with these exposures. It's a matter of thinking through all these dimensions. No one right way to do it.
Brooks:
It's a mosaic.
Peter:
It’s a mosaic approach. And once you've done it, you kind of get comfortable with how this fits into your portfolio and what role it plays.
Tony:
But what I like about the question is recognizing that not all private equity is created equally, not all private debt. And it's really important to really understand where is the opportunity. And I like the way Peter described. I mean, we should really think about what's the risk return characteristics with each one of those. A buyout is a different states and VC. Similarly, when we look at private credit or private debt, distressed is very different than direct lending and mezzanine is somewhere in between. So if we think about how we allocate, we should start by thinking about what, what types of exposure am I getting, what's the risk return tradeoff? And then ultimately, how do I get there over time?
Tony:
We hope that you enjoyed this special episode of the Alternative Allocations podcast series, where we covered due diligence, fund selection, asset allocation and portfolio construction, and how to put all the pieces of the puzzle together.
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