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 podcast to make sure you don't miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to this special episode of the Alternative Allocations podcast series. In the first part of this episode, I’ll interview Will Dillard of Mercer as we were together at the CAIS Live conference. The second part, Will will turn the tables on me and interview me as part of a panel discussion evaluating various structures and strategies available in the marketplace, how the industry evolved, and ultimately where we think it will evolve to in the coming years. We hope that you’ll enjoy this special feature.
I'm thrilled to be joined today by Will Dillard from Mercer. Will, share with me a little bit about your background and your perspective, because I think you bring a different sort of lens to the discussion around alternative allocations.
Will:
Sure. Yeah. So I'm a Senior Investment Consultant at Mercer Investments. I work with institutions as well as private wealth investors around portfolio construction, manager selection, and asset allocation. So in my role, I work directly with our manager research group, which is very broad. We have over 200 asset class specialists across all asset classes, but also with our portfolio construction groups. But essentially in my client facing role, I'm ensuring that our clients have Mercer's best thinking in terms of portfolio construction and manager selection.
Tony:
And I want to delve into that a little bit because as much as we're talking about alternatives and the wealth channel, it's relatively new and it certainly hasn't been embraced the way that it's embraced historically by big institutions. What are some of the lessons learned from institutions that the private wealth community can take advantage of?
Will:
So I think there are a number of advantages that the private wealth community can definitely learn from institutions. And institutions, again, are much further along in terms of their allocations within private markets. Generally, private wealth firms allocate roughly five to 10 percent to alternatives. So it's much lower than the typical institution. I think it really comes back to manager selection. I think that's ultimately what's going to lead to success within private markets. You hear a lot of conversation around allocating to private markets, but there's a lot of differentiation within the asset classes.
And if you look at the dispersion between top and bottom quartile managers, it's much wider than if you were to look at public market asset classes. So I think aligning yourself with top GPs who have management teams that have ultimately delivered success for portfolio companies, but also for their LPs is very important to deliver success within the private wealth channel.
So I think it's an additional layer of due diligence. There's obviously the liquidity component within private markets. So I really do think that due diligence and manager selection is key for success within private wealth.
Tony:
And I think that's one of the challenges for advisors. They all know how to do due diligence on mutual funds and separately managed accounts because the information is readily available. It's transparent. It's easy to understand. What are maybe a few of the takeaways for an advisor when they start to think about allocating to the private markets? And in particular, now we don't have the visibility into what's happening inside the portfolios. What are a couple of the things that advisors should think about?
Will:
There are a number of platforms that are available to help advisors make the process more seamless. We partner with CAIS, and Mercer actually provides investment and operational due diligence on investments on their platform. So I think utilizing third parties that have significant experience within private markets could be one way to build out an alternative allocation to really feel that you have the support and understanding to make commitments that ultimately are going to be locked up longer than their public market equivalents.
Tony:
I think that's a really important point. So if you're one of the larger wire houses, you likely have some level of due diligence done at the headquarter levels. Certainly there are firms like CAIS and iCapital and others who do a lot of that work on their own, so it shouldn't be so daunting that they're doing it all on their own. They can leverage a lot of the expertise, but clearly what they want to do is they want to make sure that somebody is doing due diligence.
Let us delve in a little bit on that topic of dispersion of return. And again, I think you have a unique vantage point that you've been evaluating managers and looking at the differences between those top and bottom quartile managers for quite some time. We'll often cite the data that the difference between the top and the bottom of global equity returns, 200 basis points, depending on the time period that you look at, but the difference between the top and bottom private equity fund could be 2,000 to 2,500 basis points, big, big difference. Are there things that you've seen over the years that identify top performers versus bottom performers? Or are there things that advisors should be focused on?
Will:
We have a framework for evaluating investment managers across public and private market asset classes, and it's very similar. But essentially, from what we've seen within private markets, generally GPs that are very aligned with their limited partners, that's the first step in evaluating a manager, you want them to have skin in the game as well. A history of success. It may not be at the current firm, but if someone had branched out from a prior venture. So we also look at the track record. How are they sizing positions? Portfolio construction is another key aspect within manager evaluations.
But ultimately. Kind of all of those factors blend together. And ultimately we rate managers on a grading scale. And typically A to B+ we would consider to outperform over a full market cycle. And so that's generally how we view manager performance and who we would expect to outperform than alternatives.
Tony:
So there's clearly no replacing experience, experienced depth of resources, dedicated resources in the private market space. Unlike maybe looking at a small cap manager where there's an advantage of being maybe younger and smaller, here, you've really have to have deep resources dedicated and focused on private equity, private credit, private real estate.
Will:
I would totally agree having that depth of experience, having a track record and really going through multiple market cycles if possible is important, especially within private credit, having a team that’s gone through write downs, they've worked out credits that have underperformed and have needed additional care. So I think, yeah, the experience is something that you can't replace within private markets. And again, experience, alignment, and a good strategy overall. And typically you'll see the best of the best have some sort of competitive advantage in terms of sourcing relative to others.
Tony:
Fantastic. So let's go back to that allocation discussion in the beginning. And you made the comment that the wealth channel has historically been about five to 6 percent allocated to alternatives, by the way, that's been the percentage for the last decade. It really hasn't changed, even though there's more products coming to the marketplace. We often say that some of the newer products have helped democratize the access to alternative investments because now they're available to a broader group of investors.
But I think you guys had partnered with CAIS on a study asking advisors about some of the impediments. And I think some of the impediments were actually related to the understanding of some of these new product structures that are coming to the market, specifically interval and tender offer funds.
Maybe talk a little bit about the survey that you did and again, what some of those findings are and then ultimately how do we overcome some of those objections.
Will:
So the recent survey was a partnership between Mercer and CAIS. And I do believe that a lot of the pushback or misconceptions around private markets within the private wealth channels really around education and you need to have alignment between the end client and the liquidity structure of the vehicle that they're investing in. They need to understand what monthly and quarterly liquidity truly means. And that obviously isn't going to be available for the entire investment. I also think having alignment in terms of performance expectations is crucial and something that is harder to overcome because a lot of advisors and clients will compare maybe a private credit return to the S& P 500 and that's just not the comparable benchmark.
I think you need to have an understanding of the role that alternatives are playing overall within portfolio construction and benchmarking them appropriately. So having and setting appropriate expectations is very important. And I think just increased education is the only way to get there.
Tony:
Let me pick up on that illiquidity. Because I think that is one of the biggest impediments for advisors and investors. And I think part of it is they are preconditioned to think that for whatever reason, you want to be 100 percent liquid. And I'd argue the opposite. I would argue we need to lead into illiquidity. Because of course, the historical data will show us that you're handsomely rewarded in the form of an illiquidity premium allocating to private equity, private credit, private real estate.
And even though these structures allow more frequent liquidity features, I'd argue to capture the illiquidity premium, we need to think of them as long-term investments. So to me, I think we need to lean in and understand illiquidity is just a feature. As my friend John Bowman would say, it's neither good nor bad. It's just a feature. And that's the way that we need to think about it. But I think you're a hundred percent right. We need to educate advisors and investors on why it's important to lock up capital. Think of it as a long-term investment and then hold it to the end of the fund structure to capture that elusive illiquidity premium.
Will:
I totally agree.
Tony:
Yeah. Okay, good. So, let's switch a little bit now and I like what you just said in thinking about when we think about allocating capital, certainly we think about it in what are the goals of the underlying investment. So whether we fixate on what is the appropriate benchmark or maybe more specifically the way that we think about it. There are four primary goals for all investments: growth, income, defense, and inflation hedging. And to me that helps in the discussion of when we allocate capital. So, I think advisors at this point in time are starting to get more and more comfortable that they should have exposure to private equity and private credit and private real estate.
But often what I hear is “the how” is a little bit of a challenge. So if I think about sourcing private equity, the way that we think about it is, well, I would take that from my growth bucket. I would take it from my equity allocation. How do you think about it? And again, maybe going back to some other ways that institutions think about it, how do they think about allocating capital and does it align with that?
Will:
Typically, we have similar thoughts in terms of where to source alternatives. Again, we think of the overall asset allocation framework into two buckets, essentially kind of growth and defensive assets. So typically, the alternatives allocation is going to be sourced from that growth allocation. And we do have growth oriented public credits. So levered loans, high yield bonds. So it's not essentially sourced all from equity. We do have public credits that are aimed towards growth. We would definitely source the alternatives allocation from that particular bucket and the defensive allocation is generally public fixed income.
Tony:
So we sit here in 2024, we've had a tumultuous ride, ‘21 was a peak market, peak valuations, ‘22 we saw a little bit of a correction with rates rising, inflation rising, and we saw negative returns, double digit returns for both stocks and bonds, and then ‘23 a little bit of a snapback, although I'm not sure there's a rational reason for that. As we sit here in 2024, are there particular strategies that look appealing to you? You've mentioned private credit multiple times. Certainly we have a view that private credit looks attractive. Secondaries look attractive and then maybe select areas within real estate. Are there areas that look attractive that advisors should pay more attention to in today's market environment?
Will:
I do think secondaries are an attractive area of the market today, and with the institutions that we work with, a number of corporate pensions are looking to de-risk their plans, they're looking to ultimately terminate their liability and offload those to insurers, and you're seeing those institutions that have private market allocations, that they're looking to reduce those.
Similarly, I would think that other public pensions are also probably at or overweight their target allocation to alternatives, just given what we saw in 2022 with assets not being marked down to the same degree as the public markets. So again, I think across the institutional landscape, you have an over allocation to alternatives. You're not seeing distributions being able to fund new commitments. So I do think there's going to be interesting secondary opportunities, both LP- and GP-led over the coming years.
Tony:
Yeah, similarly, we are very excited about the opportunities in the secondary space. From a product perspective, we're starting to see a lot more products coming to the market, in particular, products that come from institutional quality managers. And those are really the only ones that we should be paying attention to.
Which sort of products are you seeing coming to the market, and are you hearing specific demand from advisors, I need exposure to X, or I need exposure to Y?
Will:
That's a great point. We are seeing a ton of institutionally-focused GPs actually developing products for the private wealth channel. And these are firms that historically have built their AUM on an institutional LP base.
But I think they do see that there's a channel for growth within private wealth with that education and understanding that we mentioned earlier. And it's interesting because you actually see them putting more resources internally behind some of these semi-liquid offerings that are coming to market.
So there's been a shift, I would say the trend of large investment managers, global investment managers, offering semi-liquid alternatives is probably going to continue. And again, I think differentiation is going to be key. You know, having management teams that have proven track records and success. It's going to be something to focus on because I do think there's going to be increased demand.
And I do think that from our partnership with CAIS, we do see advisors requesting more of the semi-liquid structures that have been really launched to the market over the last several years. I know our manager research group, they ultimately get directed quite a bit of those types of products. So I would expect that to continue.
Tony:
So I'm going to ask you to put your magic hat on looking into the future five years. We're currently looking at a 5-6% allocation to alternatives, but I think most people in the know would argue that the numbers should be closer to 20-30% across the wealth channel. How do we get there? And it was not one magic step, but how do we get there over the next five to 10 years where it's a more meaningful allocation, advisors feel more comfortable with it, investors feel more comfortable with it.
Will:
That's a great question. And I think it's a combination of factors. I think as we spoke about earlier, education is important, aligning expectations from a performance perspective and a liquidity perspective.
Also with institutional quality, GPs really coming to market and developing products for the private wealth channel. I think the confluence of those events would ultimately lead to larger allocations. And again, I think it'll take time, but ultimately if GPs are providing value and you ultimately see returns above public markets, I would expect advisors to become more comfortable with allocating to private markets over time.
Tony:
I'm going to hit you with one more question that I often hear, and that is, well, If individual investors start to get exposure to this and all of a sudden the wealth channel explodes and it goes from 5% to 20%, do we believe that that actually takes away the alpha or that illiquidity premium over time or should we be concerned about so much money going into the private market space?
Will:
It's a point that we're definitely thinking about, and I would say there would be increased competition for deals within the private market space, if there are a number of investment managers and additional capital coming in. You know, I do think you may see a pullback a bit from institutions, especially on the corporate DB side that again, as I mentioned, we're likely to try and terminate and ultimately transfer those liabilities to insurers. But I do think private wealth could fill that gap, but with a number of new entrants in terms of investment managers, there could be increased competition and maybe lower quality underwriting for portfolio companies.
So I think due diligence will become ever more important if that is the case. Truly understanding and aligning yourselves with the best GPs will be important if that does occur.
Tony:
So the best of the best will continue to deliver the alpha, but there likely will be some who provide average returns.
Will:
Right, I would say that the inefficiencies within the private market, they're likely to still be there. But I think that dispersion gap that we spoke about earlier could shrink a bit if that does occur in the future.
Tony:
Fantastic. Will, thank you so much. I think we've covered a lot of ground that would be certainly helpful for advisors as they think about allocating capital.
We talked about the importance of manager selection and due diligence. We talked about these new structures and how they're tradeoffs, not necessarily one better than the other. And then we talked aspirationally about how, as an industry, we can hopefully move along that train to 20 percent allocations to alternatives and the importance of education and getting there appropriately, rather than just chasing where the returns are. So thank you so much for your time today. I think this would be very helpful for our audience.
Will:
Yeah, thank you for having me. This is great.
Tony:
As noted in the beginning of this episode, I was with Will Dillard at the CAIS Live event in Atlanta. And Will was the moderator of a session and this is an excerpt from the discussion we had about allocating to alternatives.
Will:
Tony, given your role as a Senior Alternative Investment Specialist at Franklin Templeton Institute, how do you all go about incorporating alternatives into a strategic asset allocation framework?
Tony:
It's a great question. So everyone's here because they're interested in alternatives. And the biggest question I think I get is how to allocate and where to allocate from. And we start with a basic framework. We look at all investments from a goals-based investing format. So I think if we think about all investments, whether the traditional or alternatives, there are four primary roles that all investments play: growth, income, defense and inflation hedging. And we actually started by really focusing in on where do alternatives fit in that. So obviously, we would think about adding private equity because we think we get more growth in our portfolio. We think about adding private credit and real estate because we want more income in our portfolio. If we want to play defense rather than just cash and gold, maybe we think about macro strategies, which are more defensive in nature. And if we want to think about how do we solve for the impact of inflation? That's obviously a role of real estate and other real assets.
So I think if we define what it is that the role that each one of these investments play, one, it makes it easier when we develop that framework, but two, it makes it more effective when we start to think about where do we source the capital from? I'm going to source my private equity from my growth bucket. Because that's the role ultimately it plays in the portfolio. I'm going to source my income, my private credit, and my private real estate from my income bucket. So I think that helps frame it. And if anyone's interested, I've actually written a series of white papers on that topic called Building Better Portfolios with Alternatives. There's a whole series of those where I use case studies to illustrate the impact of adding diversified baskets of alternatives.
Will:
That's great. So with the emergence of semi-liquid structures, how do you incorporate the new vehicles that are more frequently used within private wealth when building out that strategic asset allocation framework, just given the more immediate exposure relative to drawdown vehicles?
Tony:
Yeah, and I think one of the great things about these strategies and these structures is they're now available at lower minimums, which means I could actually, for a high net worth family, I could actually get diversified exposure to private equity, private credit, private real estate. I think that's a really good thing.
But Will, as you and I were talking about earlier, and I think it's more to remind everyone in this room, even though they are called semi-liquid, the reality is, if you want to capture that illiquidity premium, I think you should think of them as being long term investments. It's nice to have that safety valve, that quarterly liquidity feature, but the reality is, if you want to capture that illiquidity premium, you're not going to get it if you're in today and out tomorrow. You've got to hold it for the duration. But I do think the lower minimums make it easier to get the diversified exposure across these various tools, because again, they're not necessarily solving for the same things over time.
Will:
Now, how do you deal with benchmarking challenges and aligning performance expectations with clients?
Tony:
So I think there's two elements to the benchmarking question. One is what is the goal that it should play in a portfolio when again, the reality is, as much as we try to condition our clients, a lot of them focus on did this investment outperform the market over the long run? So again, the way that we frame it in growth, income, defense, and inflation, one of the things you clearly point out to clients in the beginning is most of these investments are really not designed to outperform the S& P 500 in a raging bull market. Clearly, I think we need to establish that and reinforce that over time.
But I think the more difficult question, I think, for a lot of the folks in this audience is the benchmarking of the data. So we use independent, reliable sources to get all of our private market data. I think you all need to accept the fact private market data is typically going to be late – one to two quarters late. You need to understand that in advance. But we use all independent universe data. So we use Burgess for private equity, Cliffwater for private credit, and then we use Odyssey for real estate data. We actually get that data. We analyze it on an ongoing basis. We also use data from pitch books, and we're constantly looking at the marketplace and looking at what are the appropriate benchmark, what's going on, what are the risk return characteristics over time.
I think for all of you, it's a little bit more challenging because you're not going to spend $100,000 to get the data sets that we do. So I would definitely rely upon your managers. I think what's important is to establish in the beginning that we shouldn't look at the S&P 500 and we shouldn't look at the Barclays AG or any of these traditional sort of benchmarks.
But I think then it becomes a little bit challenging for you is how do you get the appropriate underlying data. We're generally using universes too, that's the other thing to be mindful of. There isn't an index that replicates the S&P 500 for private equity. It's typically looking at like universes and the like universes, VC universes are going to be different than growth equity, which are going to be different than buyout universes.
So I think it's really important to understand what it is you're looking at to make sure we get as close to an apples to apples comparison as possible. And I suspect that's one of the more daunting things for the folks in the audience.
Will:
One point that we wanted to talk about today was dispersion within private markets around due diligence. Typically, within public markets, the spread between top and bottom quartile managers is fairly small and you see very wide gaps within the private markets.
Tony, if you could just give your views on how advisors should be looking at GPs within the space and what you think differentiates top and bottom quartile performers.
Tony:
So it is funny. We were talking about it earlier today and not to be disparaging, but the difference between the top and bottom traditional equity managers, 200 basis points, don't spend a lot of time on it. It doesn't make a lot of difference. The dispersion of return between the top and bottom private equity managers, somewhere between 2,000 and 2,500 basis points, big difference over time. And I was actually asking Will because he spent a lot of time, Mercer's focused on the institutional marketplace. Are there common traits of really successful GP’s. And I think we probably intuitively all know this, but I think clearly it needs to be a manager with deep resources. This is not somebody who's just getting started in the space. You need somebody who's been through multiple market cycles, need deep and dedicated resources that understands the space that they're trafficking in private markets, in particular. You need a team that is constantly looking at how to source capital and put capital to work. But I think ultimately the managers who were consistently at the top of the pack tend to be your big institutional managers. And the beauty of the industry over the last 10 years is a lot of those institutional managers are now starting to bring product to the market, many of whom are in the room here today.
That's a really good thing for us, because for those of you who have been around for a long time and you may remember the experience of liquid alternatives. Right after the 2008 GFC, everyone's saying, well, I want some hedge fund exposure to dampen the volatility in the portfolio. A lot of those managers didn't work well.
And the reason they didn't work well is the structure really wasn't conducive for it. You're trying to force a strategy, a very specialized strategy into a structure that didn't really work. The beauty today is I think we're getting institutional quality managers. But the interval and the tender offer structure actually allow the managers to do what they do best, but it makes it more available to you and to your clients. So we've kind of got this confluence of events that I think it makes it a really interesting time to think about allocating to private markets.
Will:
Let's pivot a bit and talk about market opportunities that we're seeing today. Tony, I recently read a piece that you all produced, your 2024 outlook. One of the points that you made was an unprecedented opportunity within the private equity secondary space. Could you spend a few minutes on what you're seeing there and the evolution within the secondary space?
Tony:
If we think about what's happened in the private equity space over the last couple of years, and think of ‘21 as the peak valuations, all the money is flooding into private equity. Why? Because you're getting these oversized returns, but you're also paying higher valuations for some of the private equity over time, and all of a sudden, 2022 comes and equity returns are down, and all of a sudden, exits stop.
There's no private equity exits. There's no distribution of capital back and institutions kind of wake up and they realize they're over allocated. So CalPERS, don't hold me to the numbers, but CalPERS is over allocated by 3 percent in private equity. So what do they have to do? They need to seek liquidity in the marketplace, and they seek the advantage of the secondary market, which provides that liquidity.
So private equity, and secondaries in particular, I think has really fulfilled a vital role of providing more liquidity across the institutional spectrum. We focus a lot on private equity secondaries, but actually the same exists in infrastructure, real estate and private credit. We think that continues. We think institutions are over allocated now.
Not only are they over allocated and there are no exits, they've committed to the future deals that they know they need to get into. So secondary managers provide the liquidity for the space. They buy positions that are already seasoned, so they shorten up the J curve. You get diversification by vintage, diversification by industry. So, we really like the secondary market. We think it's going to continue to grow. A lot of opportunities there we think over the next couple of years. I'd also say in the outlook that we do like private credit a lot from direct lending to distressed, which are different ends of the spectrum for different reasons, but we also like real estate debt.
And we actually think there are opportunities selectively across the real estate spectrum. Office is clearly a problem area. We think that will continue for the foreseeable future, but we think industrials, multifamily housing and life sciences look attractive. So again, I think you've heard throughout our discussion here today – diversification, not all areas of the market are created equally. As much as real estate is getting the bad reputation because of the concerns about the office sector, we do think there are opportunities if you can be a little bit more selective in allocating capital.
Tony:
We hope you that enjoyed this special episode of the Alternative Allocations podcast series featuring Will Dillard of Mercer. We hope that you enjoy future podcasts and if you haven’t already done so, please subscribe so you never miss a future episode. Thank you.
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