What are the interesting trends in 2019? What does the future of private equity investment hold? Where are returns to be found at the close of a bull market? And where does the search begin for strategies that can provide solid returns while delivering protection across asset classes? These were just some of the questions posed by panel moderator HSBC Global Asset Management’s Khaoula Begdouri in guiding a lively discussion during a CIO Roundtable panel at Markets Group’s 4th Annual Pacific Northwest Institutional Forum, in Seattle on April 30th.
The panelists, who rose to match Begdouri’s energy and were far from shy in offering competing views, included: Jason Malinowski, chief investment officer, Seattle City Employees’ Retirement System,Ian Toner, chief investment officer, Verus, Bob Maynard,chief investment officer, Public Employee Retirement System of Idaho, and Elmer Huh, chief investment officer, M.J. Murdock Charitable Trust.
Begdouri: What do you think is the most interesting investing trend of 2019?
Malinowski: The most interesting trend is the movement away from active to passive management. What will come of it? It has definitely been good for society, but not for all of the people in this room. The reason it’s so interesting is because the impact on the financial world is so unclear. It could make active management less attractive or more attractive, or the same—it’s unclear.
[The movement to passive management] also has enormous real-world applications. What happens when most shareholders are essentially trapped into owning a company because it’s in an index? What does that mean for the power of shareholders vis-a-vis company management going forward? What does it mean that the top three passive managers are going to own 10%, 15% or 20% a piece of each company? These are tremendous issues, and it will be interesting to see how it plays out over time.
Can the Future be Calculated?
Toner: I’ll give you a second theme that I think is interesting to mull over—the slow death of deterministic thinking about investments. It is comfortable but fallacious to think that the future is deterministically knowable.
Some of you know my favorite joke that the right order of magnitude of accuracy of all forward-looking investment calculations is “ish.” Uncertainty about plans, markets and the outcomes from portfolios is the reality that we must live with. If we just do what so much of the industry has done, which is to fall in love with the math, and fall in love with calculating the third decimal place, and with attempted certainty you fool yourself, and you can end up with an exactly accurate answer that bears no real representation of the future. You also end up with fiduciaries around the table trying to make a decision without a clear collective understanding of the bundle of risks and potential outcomes they may achieve. So, if anything over the last five or ten years has happened for the good, it’s the increasing understanding that the future is uncertain.
You have to understand the complexity and the multifarious possible outcomes you might have and the inherent existential uncertainty that is involved in investing. You must embrace it, because unless you can do that you can’t make coherent, effective and necessarily approximate plans for the future.
Maynard: Our fund is in a particular position. We can handle just getting market returns, even sub-par returns; we will still be fine. So, as a result, we are in a position that I want to wait through the next crisis to see which of all the ideas that we heard about today–from alternative beta to long duration to other sorts of things–survives the next crisis. Because it’s my observation that this millennium, since 2000, since the introduction of TIPS for example, all the new things that have come on board since then have really have not worked out.
You go back to the 2000s, with hedge funds, you go 130/30, you go portable alpha, risk parity, the alternative beta—the best article all year was by Clifford Scott Asness [hedge fund manager and the co-founder of AQR Capital Management]. It’s a tremendous article about the failure of alternate beta: “Liquid Alt Ragnorak” and was published on the AQR website. You have to wait a decade, sometimes. These things are still a matter of faith, not fact, and until you survive the next crisis, you won’t have any real indication that these ideas are long-term investments. Nothing really survived 2007, 2008. And, since we are not in a position that we have to make a move, we are perfectly willing to wait. I mean we are not like CalPERS, which says: “We have to do more private equity, doing nothing is not an option.” For us, we can do nothing; it’s always an option. And that is where we are right now, so I’m finding everything fascinating. I’m not convinced yet, it’s still a matter of faith. I can see all the arguments, but I will sure be interested when the next crisis comes to see what happens. I think it’s all interesting.
Begdouri: If it’s not broken, don’t fix it?
Maynard: It is harder to do nothing than something.
Huh: I’m 19 months into this new venture. We have a philosophy that I’ve been relearning and it’s about relationships. We place bets on people, not necessarily strategies. So, when I think about “new” strategies, there is an Old Testament saying about it. “There is nothing new under the sun.” I have heard, today, a bunch of things, here and at other conferences, but there is really nothing new under the sun. On my team, we just focus on people. And we attempt to keep it simple, as the qualitative part takes up most of the time. It’s our mantra; I think that we try to have a high conviction in our relationships. That produces other issues and challenges obviously, such as the one that was just talked about in the last panel—the painful exits that could arise.
But it’s been proven to us—if you want to take it in terms of the track record of my predecessor, and what I’ve experienced now in the short-term—that relationships do matter. If you believe in their acumen, their skill set, their thinking, and you have a high degree of respect for them, and they respect your values, and they want to partner up with you because they believe in the grant-making process that we are doing, then that it’s a step toward collaboration and partnership.
Public Vs. Private Markets
Begdouri: In the face of declining return assumptions, you expect an asset classes that gives you double digits returns to be an easy choice. As such, most of the activity of asset allocators and consultants has been focused on private equity, real estate and infrastructure. Do you think that investors are doing enough or too much? Should there be more assets migrating from public markets to private placements?
Maynard: We have 15% in private equity, and it’s been there for a number of years. Private real estate—everyone’s been sayings it’s late cycle, it may well not be for another three or four more years. I’m okay in private real estate, because I don’t see the signs of overbuilding. But with private equity, I am worried about it. The terms are outrageous, there is a huge amount of dry powder, people are being turned away, people are desperate to get into it. We are fine at 10%, we have gotten down to 6% invested. I’m in no rush to fill that area.
Malinowski: There is too much dry powder–that is one side of the equation–the supply of private capital that exists from folks like us. On the other side of the equation is: ‘What’s the demand for it?’ Many suggest that pubic companies are generally not that incentivized to invest in their business. The market does the opposite and gives them higher valuations to give money back to shareholders through share buybacks and dividends. And yet economic growth is happening, which suggests that it is occurring more in the private markets. So, while the supply of private capital is growing, I would also say that the demand for private capital is growing, and I continue to see it growing.
I don’t think the public company governance structure can be fixed in the short term, so I’m not that worried about dry powder when you think about it as a percentage of stock market capitalization or gross domestic product. To me, it doesn’t look outrageous, and I do think that private equity is a better governance structure.
The fees, I agree, are outrageous. What you are seeing is a lot of investors moving more to private markets, because the expected returns have declined in the public markets. If that is the reason, then that is potentially problematic. They should just adjust their return expectations and not reach for asset classes outside of their comfort zone or knowledge. But I find the level of dry power not really a concern.
Huh: One of the things that has not been mentioned, overtly, in conversations and in many panels including this one, where we talk about all the dry powder, is that there is a chance for higher risk. There is a lot of private equity capital that is being poured into pushing things to elevated levels. You can put venture capital in there, as well. I think illiquid alternatives is a big space, maybe too big. You can have 5% in your portfolio, but if it’s not moving the needle in some significant way in the portfolio, then don’t do it.
You’ve got to be committed to it. The key word, I would say, in conjunction with whatever perspective you would take, as a buy-sider, or asset allocator, is selectivity. My risk/reward and horizon period are much different than my colleagues’, right here. And so, I could have a different view about private equity and the demand we need from it.
I can’t say what’s right for someone else. All I can say is that, for us, the key is selectivity. We are not going to go into private equity just because we have a dire need for higher returns if it doesn’t fit. People are jumping in, as my colleagues say, because they are not getting it [the returns] in the public markets, and that is a conundrum. For us, it’s going to be proven in the selection of the right managers and the right private equity strategy. There are tons of buyout shops out there, tons of private equity niche strategies, LBO and growth equity, small cap, etc.
Toner: There is another important component: let’s remember what you are buying. In private equity, you are buying an incredibly active portfolio. If a really skilled public market manager came in and said: “I tell you what, in the public markets, over the course of the next 10 to 12 years, I’ll buy maybe seven, maybe maximum 15 companies. I’m going to use a significant amount of leverage when I do it. I’ll report to you, quarterly, maybe. And by the way, here are the economics of the deal.”
Maynard: Like a hedge fund.
Toner: Yes, but even there, in most cases, the number of holdings is very different. So the point is, a good private equity manager, who is able to generate the returns can do so not primarily because of an inherent property of private markets, but because of their active management skills, invested in a highly concentrated way, and applied over time with leverage and focus, and to some extent because of the style bias and the size bias of the companies they buy relative to the public markets. And, also in some cases, because of the other characteristics of some of the companies they are buying, not just because they happen to be working in private, not public, markets. Done correctly, you are buying active investment skill when you buy private equity, and for sure, with some managers, there really is strong active skill available.
Maynard: So then, why is the medium private equity manager underperforming the Russell 3000 over the last ten years?
Toner: Because, on average, they are not awesome, so you need good manager selection.
Maynard: So, you have to be able to pick the better ones?
Toner: That’s exactly right. You need to think about it not so much just as an asset class, but importantly, as a way to access skilled managers.
Huh: I think Bain [a management consulting firm] put out a report a couple of months ago on the private equity industry. It basically said, as I recall, that the 1st quartile funds, from 10 or 12 years ago, had reverted to the mean. That is a big theme in the private equity markets to work through. Many of the funds in the top quartile of funds, back in, say, 2004, are in 3rd quartile right now, and that should not be surprising.
Another article came out in Fortune magazine about how a certain venture cap firm in San Francisco lost its way; it used to be the pioneer. According to the article, one of the first things compromised was leadership succession; it appeared that they had no plan for it. It’s the inability to find talented people. And then on top of that they hired people who are the stars or the politicians, who may not have any acumen [in PE]—that goes back to the skill set. Again, according to the article, you are betting on people, and you bet on a skill set.
Toner: That’s exactly right. We have a decent-sized private market team, doing unbelievably high-quality, in-depth due diligence on the managers they pick. You have to be aware that in private market portfolios what you are doing is making a very small number of decisions, on a very specific team of people, to run a very concentrated active portfolio over a very long period. You are tying your money up, and you pay high fees to get access to products run by those people, and if you pick the correct team then, based on history, there is every reason to believe that they have a very good chance to produce exceptional returns. You also have to remember, though, that if you pick the wrong team, then it’s less attractive–but the fees and illiquidity stay the same.
Malinowski: There was an interesting report that Arizona State University published, six months ago, that showed that the median public company from IPO to today, or whenever it went out of business, earned a return of less than the return on cash. Yet, we all know that the public equity market has generated strong long-term performance, which this research pointed out is driven by relatively few companies. So, I think there are a lot of ways to think about historical performance and some are better than others.
Maynard: The top decile of anything, the top decile of public-funded companies, has driven the public-fund companies. They have driven the excess stock returns. If you buy the top decile, it’s great no matter what it is—if we can, in advance, pick the top quartile people. For every John Paulson [founder and head of hedge fund Paulson & Co.], there is a John Paulson. For every Bill Ackman [founder and CEO of hedge fun Pershing Square Capital Management], there is a Bill Ackman. Trying to find the people who are really successful going forward is a losing game as far as I can see in my industry in the last 25 or 30 years; so, it’s tough.
Huh: From a foundation that started out with $91 million in 1975, my predecessor, who was there for over 31 years, identified some good managers, remained with many of them. [The fund] is now close to $1.3 billion, as of last month. This does not include the cumulative grants to the five states in the Pacific Northwest that we gave over the same time period. So, I would say that, probably, I would disagree with that.
I would say that the hardest part of our job, in our view, is when I think about the decision to bet on people and high-conviction managers that we are already familiar with. Just because they did well, on funds one, two, and/or three, we still go back and do the due diligence on program four. So, when they say “Hey, by the way, we want to talk to you about fund four, we are doing a capital raise,” we still need to do our work.
We had a manager last year whose fund programs were in the multiples of 1.5 to 2.0 times in their first six funds and an IRR (internal rate of return) of 21%, probably more like a range of 18% to 22 % net. They said: “We are raising a $9 billion fund. For funds one through six, committed capital grew exponentially over the progression of these funds. And I would say we had to pass, because I just didn’t believe that in this day in age, with the market sentiment where it is and could head, and with the culture of their firm, that the performance would remain there. I didn’t believe that, over the next four to five years, an $18 billion portfolio would result from a $9 billion commitment.
Maynard: You mentioned 1975 as your start date. Just being a reasonably diversified investor, institutional, we were at $150 million in 1975. We paid out $2 billion more in benefits than we took in contributions, and we are $18 billion right now, just from being a straightforward institutional investor. You don’thave to go out there and pick the best performing managers. If you are setting yourself up as a measure of success that, ‘I’m going to pick the top quartile managers, I am going to pick the top,’ that is setting up a very difficult precedent.
Huh: I’m talking about people I believe in. I would love for them to be top quartile. I would love for Jane Smith and John Doe to be top quartile managers from fund one through fund ten. But it’s not happening, and never has for many of them. All I’m saying is that I want to see consistency—in culture, leadership and trust, and doing the right thing with the LP’s [limited partner] money.
Strategies for a Volatile Market
Begdouri: This year marks the ten-year anniversary of the bull market. We talked about declining return expectations, but there is also increased volatility across the board. I think everyone is looking for strategies that have both offense and defense properties: they can provide solid returns, and at the same time give protection across asset classes. Do you think such strategies exist or are they unicorns?
Toner: Yes, but there is a problem inherent in the way we think about it. Once you have stared into the void and the void looks back…it’s very difficult to look into a dark room without assuming you are going to get eaten. So, when you look at what happened ten years ago, that was a once-in-a-generation economic crisis. That is not the typical model for a normal market downturn. You certainly need to understand what happens in the really huge tail-risk events, like what happened 10 years ago, and what happened 70-odd years ago. But you also need to understand what happens more regularly, every five to ten to 15 years. Those are bad stories as well, but they are more manageable. You can’t easily get out of the way of those huge events that are equivalent of a meteor hitting the earth and taking out the dinosaurs. The really big crisis will cause all kinds of problems that are much less predictable, but the smaller, more regular, bear market or recession can be modelled and managed a little more easily with diversification. Make sure you are not taking overly concentrated bets. Do your homework, pick effective managers, and try to build a diversified portfolio that is as simple as it can be, but that gives you the best chance of producing the outcomes you need.
Huh: Bob said you can go into it and do nothing. And some on the other panels have said that they aren’t in a rush to hire [new] managers. Those are some principles we stand by–we are not in a rush, and we don’t have to do anything. So, diversification is a smart thing to do. Just remember, there are cycles that you can’t do, you can’t avoid or control.
So, it goes back to a comment Ian made earlier, about having certainty about the uncertain. You can’t. My colleague has said, when I came on board: ‘We have been through these storms before. We will get through them when they come around again.’ And part of what I think about people is that when you at look at managers, I question how many of them have experienced a market cycle? The term “newbie” was pointed out, meaning if you started out in the industry in the last ten years and all you’ve experienced is the bull market, except one small crash in December, then you are a “newbie.” I’m not going to buy into the efficacy of your strategy if it is x,y,z, and you say ‘we are going to kill it in the next five to six years,’ because you are not, especially since you have been around only since post-March 2009.
What I do believe is that we will take a hit. We will get set back, but we will bounce back, because of the way our portfolio is constructed-diversified between alternatives, highly-liquid and semi-liquid strategies, which will help weather the storms. There is too much to worry about that is uncontrollable, because if I worry about when the recession comes or when the next market correction comes, we could start doing reactionary, stupid things, like trying to reallocate asset classes, and that just may cause noise in the portfolio and create tension, excessive fees, and missed opportunities particularly in the public strategies.
Malinowski: I thought the discussion on the earlier panel on defensive strategies and diversified strategies was somewhat thoughtful, and I enjoyed those. There are possibly strategies out there that are diversifying, but it’s not that they are without risk, or that they can’t work against you for many years, consecutively. We met with many, many firms in the last three years, and are looking to add managers to a category we call ‘diversified strategies.’ We have made one very small investment. So, I think I am somewhat or very skeptical, but it’s possible.