Risk v Return: Growth

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Hi, I'm Stacie Jacobsen. Thanks so much for joining us today on the Pulse, where we bring you insights on the economy, global markets, and all the complexities of wealth management.

Today we're concluding our two-part series on alternative investments. We covered alternatives focused on income generation in our last episode and this time, we'll be looking at growth alternatives.

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It is a broad-based category that can include hedge funds, some real estate strategies, and private equity.

Now any or, all of these could have a place in an investor's portfolios, but today we'll be focusing on private. And to understand a little bit more about private equity, we'll be talking to our special guest, Martin Atkin. But before we talk to the expert, let's just have a quick look at this asset class, see what the benefits might be, and touch on some of the trade-offs as well.

So first, private equity essentially involves taking a direct stake in a company, and over time, private equity managers aim to create value through hands-on improvements. This could include growth initiatives like expanding locations or strategic acquisitions. Managers also aim to improve how the company is run by streamlining operations or improving the underlying financials.

Eventually, managers can sell the company into public markets via an IPO. They might find a strategic buyer through an M&A transaction, or the company could remain private after a restructuring.

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It is most often at this juncture that investors realize a return. And the opportunity can be very attractive with returns potentially in excess of public stocks, which explains why commitments to private equity have quadrupled in the last decade.

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It is also worth noting that a large slice of corporate Americas in private hands and is not publicly listed. Private equity is one of the only means to gain exposure to this large, unchartered expanse of the US economy, but a major trade off is a lack of liquidity. It takes time to realize improvements in companies, so private equity investors need to be comfortable with a longer-term investment horizon.

Another consideration is that the returns are, of course, uncertain. The success of an investment depends on a number of different factors, but the skills and experience of the manager are essential. When we come back, I'll talk to my colleague, Martin Atkin, senior Investment Director at Alliances Bernstein.

Stay with us.

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I'm Beata KIrr co-head of Investment Strategies and host of Women and Wealth at Bernstein Private Wealth. Women and Wealth is a show that aim to educate and inspire women to make the right choices for their wealth. Catch our latest episode with Jody Gunderson of AB CarVal. She'll share insights from nearly three decades of investing in the credit sector.

Stacie Jacobsen: Welcome back to The Pulse by Bernstein. We have with us Martin Atkin, senior Investment Director at Alliances Bernstein, who's going to help us better understand what is going on in the world of alternative investments. Martin, thanks so much for being with us today.

Martin Atkin: It's a pleasure. I'm looking forward to it.

Stacie Jacobsen: Good, good. So, you know, to get started here, let's just, you know, start with the basics. What should an investor whose interest in private equity really be [00:03:15] looking for?

Martin Atkin: Well, first, the reason to buy private equity is the return, expectations. It should exceed public market equity returns. And if you look back over the last 10, 20 years, it surely has, you know, there's been a true evidence of something we call the illiquidity premium.

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So in exchange for giving up access to your money for a long period of time, you earn a better return. And the reason for that is, These are long duration assets. Um, these are private companies, so the managers of the private companies can behave in a manner that's different to public market companies.

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They can behave in a manner that is about fundamentals and adding value without being overly focused on short run quarterly earnings reports that can frankly distract managers from the long. run.

So it seems they can almost just detach themselves from the quarterly earnings and focus on the improvements from a long-term perspective on what they think will add value to the company itself.

Correct. And that's what the company managers are doing. In meantime, the owners of the company, and this is where it gets complicated, cuz we call them managers too, private equity managers, the owners of those companies. Are able to provide capital to ensure that there's investment and even engage directly with the company managers to improve their strategies, maybe help them acquire different businesses.

So really foster growth in the asset because there is an alignment between the company manager and the manager of the private equity fund to maximize the value cuz they are owners of the company, all of.

You know, there's really been widespread adoption of private equity. If we're calling it an asset class, what's really the attraction for the more sophisticated investor?

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Well, for the more sophisticated investor, there's first attraction is always going to be the return, but the second attraction is that, The pattern of returns is also different to traditional stocks and bonds. Private equity does not resemble a bond. It has much higher risk than a bond, but it does resemble public equity, but it's return profile is different to that of public equity.

So there's evidence. You can even go back to the. Tech bubble in the early two thousands, the great financial [00:05:45] crisis in the mid two thousands when private equity returns remained quite robust, even as public markets were under stress. And in fact last year in the funds that we have access to, we saw positive and quite encouraging returns even as.

The other markets were selling off significantly.

We've been talking about private equity as kind of one investment or one asset class, but underneath all of that is a wide range of different strategies. Can you talk about what some of those strategies may be?

I can, and this is of course where it gets complicated because like any big asset class, there's a lexicon, right?

There's a whole new vocabulary associated with this class, and so it can immediately get very difficult for an outsider to understand. So there's early stage venture. There's middle um [00:06:45] market. There's middle market buyout, there's late stage growth. These things are all talking about the stage of the growth of the company in which you are invested.

So very simply, a venture company might be a company that has very little in the way of current earnings. The future is the promise. There's a lot more risk in a company like that, or a growth company might be a company that today is able to accelerate its growth through some of those mechanisms we talked about earlier, through acquiring strategically other companies, um, through frankly just making large investments of capital in their own business.

These are the latest stage C. I would say it matters less about, um, all those categories and more about getting a broad exposure to all of that, right? That's what an investor that I would, if I were counseling investor, I'd say, make sure you have breadth [00:07:45] across these strategies rather than being overly focused in one.

So with that, you know, if we think about a, an investor can easily access the public markets, but how would an investor that's interested in expanding their portfolio, their [00:08:00] diversification and adding private equity, what's the entry look like? How do you actually get access to it?

Well, that's the big question.

So, you know, sophisticated public institutional investors, they have large amounts of money to deploy and they can go to private equity managers directly and make an investment.

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For most individuals, they don't have the wherewithal to get the attention of that, uh, private equity manager. So essentially you have to work [00:08:30] through a company like ours, an investment management company to get access.

And I would say that access to premier managers with robust track records that go back a long period of time, that show they have credibility and capability in this. Um, that is the key. Access is the key, but it's unlike, um, say public market equity where you can do it yourself. You know, you can buy an index fund or, uh, do research on a public market company.

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It is very difficult to do research on a private market company that's not the same level of information available and. There's no index available to you [00:09:15] either. So entering through funds like our own that are directly designed to help private investors get diversity across wide range of different strategies and excellent managers with

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proven capability, right?

So when I think about the public markets again, right? An investor can just go in and. basically buy an index fund, and whether you do it through a number of different companies, your returns will be relatively similar.

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When you think about using a private equity manager, the dependence on them is pretty high when you think about what the investment returns may look like

Martin Atkin: it is, and so therefore, you know, we, we typically would have our client exposed to many managers, not a single manager, because there is always the risk that.

Even if they've got a good record in the past, suddenly that hot hand goes cold, right? And they no longer can deliver the types of

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returns they did historically. So we need to continually diversify across managers, most of whom have very good records in order to ensure that we stabilize the overall.

That in itself is very complicated, but part of what we do, we try to remove a lot of the complexity because the complexity could overwhelm many individuals, but we make it convenient. You know, we make it possible to get exposed to multiple managers.

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And do that in a considered way so that the investment is itself extremely diversified.

Okay, so we know that the manager skill and experience is essential when you're talking about private equity, and we know that it can really give you

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potentially a better return and diversification, which really helps out with the risk side of it as well. So if we have an an individual investor that's ready to start to build out their private equity allocation, how do they start to think about what's the right amount and where should it come from within their portfolio?

So those are critical things to consider, and this is really where the, I think the advice and the knowledge of our clients really can help us make the right decision.

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The first, um, aspect of a private equity investment is you need to be able to tolerate this long horizon, right? You're going to essentially make a commitment to this strategy, and over time the managers will identify opportunities for investment and they will call that capital that you've committed that can.

In the case of private equity, it can take three to five years for them to call that capital, and then they [00:12:00] have to nurture those assets and get them ready for sale to realize the value of the assets. And it's the realization through sale. It can be an I P O or public market sale. It could be a strategic sale like m and a, or it could be just a restructuring that that ultimately brings liquidity to the equity.

All of these are what adds value, and once the value is added, there is a distribution from the manager back to the investor.

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The whole experience, therefore, is something we, we describe in the industry. As a J curve, you make a commitment to the investment, slowly, your cash is drawn down, and then we get distributions.

The whole experience resembles a J curve. You're going in at the beginning, money's going out. And then over time, money comes in to the point where it rises up at the end of the J Curve,

you know? And then when you say call the capital, just to make sure it's clear, that's, you know, when the money is actually invested.

This is again, you know, new to many people. Let's just give it an example. You make a commitment, and I'm just doing this for rounding a million dollars to private. It may take the manager three to five years to call your capital. Each time they call, they will ask for, say, 20,000 or 30,000 of your money to make an investment.

Of course you are with a pool of different investors, so they're not making an investment of 20,000. Your share is [00:13:30] 20,000. And so then they will, um, call capital over time. So you have to have funds available to meet those calls as they're made. And then you need to, you have to be patient to wait for the distributions to] arrive.

The reason I am explaining all of this is another aspect of private equity is you measure return differently. You measure return through what's called an I R R calculation. That requires that you look at when you put your cash in and when you get your cash out. It's a very fair and appropriate way to measure the return, and it's that return that has been attractive over.

Stacie Jacobsen: you know, so I think one thing with individual investors too, um, I wanna go back to your comment on illiquidity premium. So somebody who's spending from their portfolio, so they're no longer in that growth phase, um, might think that they need the money, right? And they don't want to lock it up for that eight to 10 year period.

So how would you discuss that fact with an investor who says that they're spending from the portfolio? How do you think about what the right allocation would be?

At our firm, we make very careful distinctions between the money that. Needs to support their lifestyle over the next five to 10 years. That's what we call their core capital.

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And then, uh, to the extent that there is capital, that they have wealth in excess of what that need might be, then that can be deployed for other objectives, legacy objectives, philanthropic objectives, or fun objectives, and that. Often has a longer horizon associated with it, and so it's usually that portion of a client's allocation that is very suitable to private equity.

I don't want to mention that not all private equity has this eight to 10 year horizon. Uh, we do operate a secondary private equity fund, which probably needs its own explanation, but has a shorter horizon on it. So we can think about horizon, we can think about return expectations and requirements, and we can think about the client's ability to withstand that illiquid.

Over a period of time

When you say core capital, right, so if I were to define core capital, it's the amount of wealth that you need to really support your inflation adjusted spending for a period of time, and to the extent that an investor doesn't need to spend from that pool of money immediately, right?

Your whole investment portfolio isn't a checking account that needs to be very liquid. There is room for a private equity investment in that portfolio.

I think you said it better than I did.

Ah, okay. I don't know about that. You're the expert here on this one. All right. So look at Bernstein. We think about this really in three different kind of suites or, or buckets of private equity.

It's really that traditional private equity, purpose driven, and then secondary, which secondary is one that you had just mentioned. So can you, um, give us a, you know, even a 30,000 foot view definition of what secondary is and purpose driven?

Yes. So traditional private equity, as we've discussed, is investing.

Both growth companies and venture companies for the idea that over a long period of time you can enhance the value and then realize that value for an attractive return. Purpose-driven private equity is absolutely the same concept.

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However, in that circumstance, The business of the companies in which you are investing is directly aligned with making an impact.

That impact could be environmental impact, uh, [00:17:00] sustainability. It could be economic equality, could be health equality. It could be any form of making an impact that has a social good or an environmental. This is very desirable to certain of our clients, to, to invest money in a purpose-driven manner. I think there's a, a caution that comes with that is that having companies with impact and investing in that manner is a relatively short experience.

[00:17:30] When we compare it with traditional private equity, which has a 25 to 30 year life, so there is an additional risk, and the evaluation for the managers has to be much more intense than even in traditional private equity.

Now, how about secondary? Can you walk us through that one?

Yes. So secondary exists in private equity because unlike public markets, there's no liquid.

For the investor, right? So in a private equity partnership, the manager is called the general partner. The investors are called the limited partners. There may be times when a limited partner who made an agreement to be in a private equity fund.

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Five years ago, six years ago, has a change of mind. It may not be connected to the performance.

It may be connected to the need to simply access their money. And so as a consequence, there exists an active secondary market, a market that will acquire interests from the limited partners in existing private equity partnerships. And provide them with an exit. So this is an interesting business because you have the ability as a secondary private equity manager to look at the portfolio and look at the companies and see, see a longer life of those companies and determine whether you think this is a goodbye or not.

Um, because you've got the seasoning of the underlying assets. It's also interesting because, Time to realization is likely faster because in a way, you know, the company we work with say that they're going into the baseball game at the sixth inning. You know, there's people coming out entering their seats and they go in and the people coming out think they know the outcomes.

You know, they think they know the way the game's going to end, our manager thinks that they can go in and assess what the [00:19:30] game might be and there might be something more in it than, uh, the exiting person believes. And so it's, uh, it's interesting. It's got a shorter horizon. It has slightly less, uh, return expectation, which is not surprising cuz in the world of investing there's usually trade offs to everything.

Right? Um, so one of the trade offs there is a little less juicy returns.

It seems though that the risk would be a little bit less as well, right? With more information that you can assess before making that investment. It's not as early stage,

yes. The risk is a little less, which is why actually in our case, when we engage in.

Traditional private equity or purpose driven private equity, we use a fund to fund approach. We actually go have a manager who allocates money across many different managers. In our secondary business, we've chosen to use just one manager. So I think that just does express our belief that the risk is less great in secondary and, and so I agree completely.

Well, Martin, we're coming up on our time here. Is there anything that I didn't ask you that you wanna make sure that our listeners know about private equity?

Well, firstly, I'd say it's very exciting. Private equity is exciting to own. One of the things though that can be frustrating is you don't know much about your investment.

There's a lack of transparency, right? And so in a way, the this investment is for people who. Tolerate time, tolerate some uncertainties, tolerate, um, unevenness of cash flows tolerate lack of transparency, all in return for earning that illiquidity premium that we began with. So I think that there's a list of trade-offs.

I'd say from the complexity point of view, I think we strive to make it quite convenient to our clients and I believe we succeed.

I second that one as well. So, Martin, thank you so much for joining us today.

Uh, it was great to be with you. Thank you.

And thanks to everyone for tuning in. You'll hear from us again on March 14th when the inflection points.

Brian Halloosim as our guest host, he'll talk with Jaime Schmidt, founder of Schmidt's Naturals and Color Capital, and how she went from creating her first business in her kitchen to a nine figure sale to Unilever. You won't wanna miss it. Don't forget to subscribe to The Pulse by Bernstein wherever you get your podcast.

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To ensure you never miss a beat, I'm your host, Stacie Jacobson, wishing you a great rest of the week.