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Market-Based Solutions to Vital Economic Issues
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Apr 8, 2019

Generating Sustainable Returns: Positioning Portfolios for the Late-Stage Cycle Environment

On Thursday, March 28, about 250 private equity professionals gathered for the 12th annual Alternative Investments Conference, hosted by the Institute for Private Capital, to discuss portfolio positioning for the late-stage cycle environment.

Welcome

(Greg Brown, Executive Director, Kenan Institute of Private Enterprise; Research Director, Institute for Private Capital)

Kenan Institute Executive Director Greg Brown opened the conference with his thoughts on sustainability and the cyclicality of private and public markets. Brown said that the market is currently in late cycle, with a few signs of stress in the economy.

The question then, is what, if anything, should investors do? For most institutional investors, the discussion revolves around allocation decisions to alternative asset managers.  Or in short, can investors time their exposure to closed-end draw-down vehicles like private equity (PE) funds?  Some research evidence suggests this possibility, including the well-documented empirical regularity that funds raised in a hot fundraising environment experience a lower internal rate of return (IRR) over their lifetime.

To test whether this observation might lead to better performance, Brown considered three strategies: a fixed investment (i.e., committing the same amount each year), allocated across the funds in a given vintage year; best/worst case scenarios, where investors invest only in the best and worst PE half of each vintage year (as benchmarks for potential performance extremes); and cyclical investing using indicators that measure how hot the fundraising environment is to create a counter-cyclical allocation (i.e., investing more during cooler times) or pro-cyclical investment allocation (i.e., investing more during hot times).

So what do these strategies reveal? It turns out that the gains available to limited partners (LPs) are likely to be fairly limited, because general partners (GPs) are the ones who actually make the specific investment decisions.  Since GPs can typically invest over a five-year window, investors need to consider who makes the actual investment decision and what influence they have on investment timing.  Brown noted that, among the three approaches, exit strategies are positively correlated, meaning that it doesn’t really matter how much you contribute or when, because the ultimate decisions of GPs can undo commitment timing.

Keynote Address:  Principles of effective portfolio construction

(Mark Anson, CEO and CIO, Commonfund)

Mark Anson, CEO and CIO of Commonfund, agreed with Brown that investors should not try to time PE.  Anson said that in spite of late-cycle and other considerations, he advises clients to stick to their customary plans and let the GPs find the best opportunities and sources of alpha.

Anson turned to the important issue of determining how to measure the systematic risk of private investment vehicles. The beta of illiquid assets is easily underestimated, he said, since GPs often have discretion in reporting mark-to-market values. A good solution is to use lag betas—up to four quarters, depending on the asset class. Betas are linearly additive, so they can be summed up to arrive at a better estimate of the systematic risk for that asset class. Anson discussed other challenges to successful portfolio construction, including too much or too little liquidity risk, investment herding and the lack of a plan for market downturns.  He also said that many investors are too quick to sell bonds, explaining that bonds should be kept for protection against a downturn in the market because they are shock absorbing.

On the issue of strategic versus tactical asset allocation, Anson returned to the topic of market timing, cautioning against tactical asset allocation.  He noted that the equity risk premium (ERP) has averaged 3.8 percent historically, but with considerable fluctuation, making timing difficult. Likewise, the liquidity risk premium has averaged 3.2 percent, but also is volatile, with a major spike occurring in 2008-2009. Consequently, maintaining some liquidity to take advantage of opportunities, said Anson, should be coupled with good governance.

The bottom line is that a host of factors can be important for tactical asset allocation, including global growth, monetary policy positioning, the yield curve, ERP, employment and inflation.

In short, Anson offered these tips for portfolio construction:

  • Source alpha and force-rank managers along objective criteria.
  • Track daily alpha for long only mangers versus market — investors should try to get a few pennies each day rather than putting on large bets that could haunt performance for years if things go bad.
  • Beware of beta dressed in alpha clothing.
  • Diversify beyond beta. Diversify across assets, then within asset class, then find a differentiated (unique) alpha stream.
  • Align interests GP-LP…negotiate fees (for example, moving from 2&20 to 0&30)
  • Understand that crowded trades are another risk factor.

To sum up, Anson provided the following calculation for total portfolio value:

Risk Premium Capture + Thematic Investing + Active Management + Strategic Tilts = Total Portfolio Value

Keynote:  A CIO perspective on governance

(Andrew Palmer, CIO, Maryland State Retirement and Pension System)

Andrew Palmer, CIO of the Maryland State Retirement and Pension System, opened his keynote with a definition of governance, saying that it incorporates the investment policy statement (IPS), written rules, unwritten rules and all relationships between agents for effective solutions. Palmer said governance is an important driver of investment outcomes, since investment is complex, as are relationships between parties. Governance defines the opportunity set and decision-making process, and can be a critical determinant of investment possibilities. Governance can take the form of sole fiduciary, a single board with combined investment or a separate investment organization. Does the form of governance matter? Palmer said it does, citing academic studies that show that pension fund boards with politicians bring down PE performance.

Palmer touched on evaluating the effectiveness of governance by using the example of teacher plans versus employee plans.  In 11 states, there is no discernable difference or persistent trend around the number of board members, whether positions are appointed or elected or how members are selected for these two types of plans; the primary difference is governance. When you look at results, the difference is clear: In the long run, teacher plans do better than employee plans.

State by state, both types of plans look similar when you look at their funded status (i.e., their assets versus their liabilities).  When looking at stability of the investment function (i.e., the form of  governance, though, teacher plans tend to have more stability.

Palmer summed up with the following suggestions for governance development:

  • Work closely with legislators to determine investment objectives.
  • Clearly delineate the responsibilities of the board, committees, staff and CIO in the IPC and charters.
  • Develop a forward-looking vision for the board by asking where you want to be in 10 years, and how you plan to fill the gap of what’s missing today.
  • Verify and address the political and social issues important to stakeholders (e.g., ESG, peer risk, fees, etc.) to promote trust between stakeholders and the governance team.
  • Be aware of other issues that impact investors’ decisions, such as laws that prevent investing, trustee churn and innovation.

Keynote:  The growing importance of private capital and innovation in financial

(Brad Coleman, Global Asset Managers Group, Citigroup)

Brad Coleman of Citigroup’s Global Asset Managers Group began his presentation with a look at the state of financial markets.   Coleman said that companies are staying private longer, creating more value. At the same time the number of PE-backed companies is increasing, the number of public companies is declining, but private markets are still a very small piece of the overall picture. To illustrate the point, Coleman pointed out that five of the largest U.S. stocks have a larger combined market cap than all U.S. private equity assets under management.

Although alpha may be declining, investors should consider PE for the benefits of diversification, said Coleman. Recent trends and innovation taking place in private equity continue to provide diversifying opportunities.  These include:

  • The rise of secondary funds as an asset class
  • A demand for co-investments. Investors want access to direct-deal co-investments, mainly for scale-related reasons.
  • A rise in private credit. More and more, private debt is filling funding gaps.
  • An increase in products that provide creativity in duration
  • The growing influence of technology and digitalization on business. Digitalization is expected to drive investments, the due diligence process, etc.
  • An expanding focus on ESG and diversity. Mounting evidence suggests that ESG factors may offer investors potential long-term performance advantages.
  • Innovation in direct investing and GP stakes
  • The transformation of PE through portfolio and data analytics

Keynote:  The evolution of alternative asset managers

(Lauren Dillard, Head of Investment Solutions, The Carlyle Group)

Lauren Dillard, head of investment solutions for The Carlyle Group, wrapped up the luncheon keynote presentations with a discussion of how PE has evolved, who the players are, and what is happening in consolidation and convergence.

In looking at the question of why PE firms diversify from pure private equity to private credit, venture capital, real estate and hedge funds, Dillard said that LPs want to do more with fewer managers, while GPs want to grow and stabilize revenues, given the growing pressure on fees.  Dillard summed up her presentation with a discussion of how alternative investing has evolved.  Her major themes included:

  • The strategic use of balance sheets (such as the approach taken by KKR)
  • A drive for more permanent capital, such as a rise in entries into insurance to fuel credit AUM (asset under management) growth
  • A large secondary market for greater liquidity
  • The more frequent use of direct investments or co-investments
  • The rise of family offices
  • The changes in U.S. tax law fueling M&A activity
  • An Asian focus on global diversification, through strategies such as regional or sector focus, SPAC funds, or a concentration on infrastructure, credit or real estate.
  • Other strategic activity, such as joint ventures

To learn more about the Institute for Private Capital, visit their website.

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