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 the latest episode of the Alternative Allocations podcast series. I'm thrilled to be joined today by Nick Veronis, one of the founding partners of iCapital Network. Welcome Nick.
Nick:
Thank you, Tony. It's a pleasure to be here.
Tony:
You've really sat in the center of this universe that has been changing so dramatically over the last couple decades. Now we're starting to talk about alternatives in the wealth channel. What have you seen over the last decade or so as we've started to integrate alternatives into the wealth channel from a product perspective, from an education perspective? And obviously, I think you folks do an awful lot to help in the technology and kind of making it a little bit more streamlined.
Nick:
Yeah, so Tony, there's a lot in there. So we started iCapital now almost a dozen years ago, and when we started, actually before we even incorporated, we talked to a few dozen general partners, private equity firms. And I would say at best it was sort of when we were talking about building this tech enabled bridge between the wealth management community and the private capital markets, when I say it was at best it was sort of a case of benign neglect. What I mean by that is that there was strong interest in reaching what then was a obviously still multi trillion dollar, it's gotten a lot bigger since, but a three and a half, four plus trillion dollar market on the independent side, independent wealth side.
The middle and back-office infrastructure of these GPs wasn't really set up properly to service that marketplace. So yes, there was interest. Why wouldn't they be interested? But if it meant taking in subscale commitments at really high volumes, they just couldn't handle that. It's hard to imagine this actually today because we've made so much progress, but we were living in a period when everything was done in a very labor intensive, paper intensive way.
Paper sub docs. By the way, people weren't sure If we would ever get to electronic signature. So we started out with feeder funds, I think you know that, building the feeder fund architecture. You were providing access. And that's what it started, started out with providing access to whatever percentage of the 2 million qualified purchaser households in the United States didn't have access and were willing to make commitments to funds that had 10-year lock ups, that had all the complexities of a J curve, capital calls, distributions, K-1’s arriving in August. And I think even today, there's by the way there's no survey or data on this, but I would venture to guess said well over 50% of those households, even if you rolled out the red carpet probably wouldn't step into a 10-year lockup with a K-1 arriving late in the year and requiring a tax extension.
So, in the early days, it was about getting well-established, proven GPs to give us a guaranteed protected allocation and then letting us go out and try and syndicate that. And at the beginning, the streamlined process was electronic subdocs. It was trying to create a document center so that post-commitment, they knew where to go to find their documents.
Managing capital calls and distributions, all of that was done in a very paper intensive way. So, we started building the technology to address that. But when you look back on, I consider that sort of 1.0 in the evolution of this marketplace, and you think about what we're entering now, which is almost 3.0, we’ve made tremendous strides with education, with all kinds of applications around that process to make it easier. And there's still a long way to go. I think we're just, you know, in the first couple innings of this.
Tony:
Yeah, I'll go back. I remember in my old Morgan days, how paper intensive it was, and we didn't have the plumbing and the wiring and for guys like you and I, who kind of lived through this, we've come a long way, but we still have advisors who are newer to the space and think it's more complicated than a mutual fund.
I think one of the real inflection points for our industry was the launch of these registered funds and primarily interval and tender offer funds, something you and I've talked about a lot over the years. That has really helped democratize the access to these great strategies. And again, I think you're in kind of a unique vantage point and you see so much of the product development going on. Can you just talk a little bit about registered funds and how they've helped democratize and ultimately some of the related challenges for advisors who are newer to the space?
Nick:
Yeah. Well, first of all, a lot of these structures, these evergreen structures, they're not new. So many of them have been around for 20 plus years, non-traded REITs, non-traded BDCs, private BDCs on the registered side, tender offer funds, which is where you typically find private equity. And then on the credit side interval, we're seeing, by the way, interval funds in the last several years switched to a daily NAV with a ticker.
So that really is starting to approach something that's more mutual fund-like. Okay. But the big change was really well-established GPs wanting to really in a meaningful way reach what channel that before was really out of reach for them. But taking greater ownership of these products, eliminating the intermediaries, bringing institutional style pricing to the marketplace. And by the way, they're doing that because they want to deliver strong results. They want to protect the integrity of their brands. And so they truly are playing the long game. So I think the structures have been around for a while. What you've seen is price compression. You've seen the very early part of this evergreen marketplace, which was sort of maybe the late 2000s, early 2010 period.
That was not a particularly good phase, particularly for, you know, the investors. There were very high load fees. The liquidity constraints weren't always properly communicated to the marketplace. You had a lot of managers that were, to me at least, sort of unknown managers. You didn't have these major players stepping in.
And so I think what's happened today, fast forward, it's not just that major players have adopted these structures. They've innovated around it, and they've made them more efficient. They've made them more fee and expense efficient. So, we've seen really just phenomenal change and it's accelerating, but going from feeder funds, which was really for iCapital early on, we built our business around feeder funds. And we've just seen this incredible shift in the marketplace in the last four or five years. And early on, it was driven by the just the search for yield, right? Advisors were desperate for yield. This is when the Fed funds rate was, whatever, less than 1%, you know, heading towards zero, and, and they were chasing yield and they were going into the credit funds, right? Non-traded BDCs, private BDCs, they were getting yield and they were getting better returns to the non-traded REITs. A lot of advisors won't necessarily change the way they do business unless there's something that's almost compelling and forcing them to. And I think when the fixed income side of their portfolios broke down, and that's what happened, it literally broke down, they had to find an alternative. We've been educating the marketplace for years and years and years, and I think that suddenly it's almost like it turned around – advisors came to us and home offices came to us and CIOs and heads of research and said, what do you have for us? How can you help solve this problem? And for us, obviously, that's what we've been waiting for, so.
Tony:
I love that journey because I think we are at a different point in time. And Nick, you've heard me say, you know, multiple times in the past. It's no longer a nice to have. It's a need to have. We'd argue there are three primary pillars that are driving this growth.
One is the market environment, which you talked about at the other inflection point, which is 2022, when the 60 and the 40 were both down double digits and advisors and investors were saying, I need a more robust and reliable toolbox. You're exactly right on the products. We think the products, even though they've been here, they've certainly evolved to meet the needs of high net worth investors and those below the accredited investor standard. But as you point out, none of this would work unless you had access to those institutional quality managers. And again, that's to me, the most exciting thing about the time and place that we are now is you're having all these great managers bring great products, which is a win for the advisor and the client and the overall industry.
I did want to touch on education, something that you and I have both passionate about, and that is that I think advisors recognize they need to be on that journey. And advisors are either in the journey that they're just recognizing they're getting started, or they're allocating a little, and they're trying to figure out how to do it in a more meaningful way for their practice.
And then, of course, you've got power users who are using alts in a very big way. But because there are different stages of their journey, how are you helping to educate them, and what role does education play in ultimately making this a more lasting experience?
Nick:
Education plays a critical role, and Tony, you know that because you worked very closely with iCapital in building out our online program, Alts Edge. So we created a program that has 10 modules, each module earns an advisor CE credit, but that's just one element of it, right? It's almost like when you go through those 10, you get a driver's license, sort of like a, hey, now you can go freely talk to all your clients about this, and obviously I'm joking when I say driver's license, but what it does is it equips the advisor with basic fundamental knowledge so that they understand the products that, first of all, they have to not only understand it, they have to appreciate the benefits of it, how it can enhance returns, how it can diversify portfolios. And then there's product specific education, where you're actually providing the information around a specific fund, a specific manager.
That includes, by the way, what are the liquidity constraints, understanding the fee table, how does this fit in my portfolio? So the sort of asset allocation risk analytics part of that, that's also critical. And there, we've built a portfolio construction tool to help the home offices, but right down to the frontline advisor, help them understand that if they add a fund, by the way, you can drag and drop the return stream of a specific fund into a client's portfolio and see what would have happened to that fund had they had, you know, you can play around with the weightings.
Or you can just say generically what would happen if they introduced private equity or private credit or real estate and portfolio or hedge funds. And one thing we always tell advisors is that if you've had a 60/40 portfolio, keep that. Don't change from that. Just on the 60s side, diversify so that it's not all public equities.
Incorporate some private equities in there and stair step your way up. Don't just go from zero to 10 or 15 percent overnight. Sort of stair step from two, three, four, five, six, work your way up. And the fixed income side, same thing. Diversify into private credit. Just add some private, senior secured, first lien, second lien.
And obviously go with managers and that's another key thing is alongside the education is the research. And Tony, you know that. I mean, that's when we started iCapital, the intent was to really try and provide institutional quality research. What you'd find at a big gatekeeper, big consultant to pension funds, endowments, foundations.
Develop that in-house and then make that available, really for free, to the entire wealth advisory community. Even for players that come register, they come into our password protected encrypted environment and they can kick tires or window shop and not allocate. They still have access to all the due diligence reports that we write on these funds.
So I think the education covers a lot of things, including that, the research, the portfolio analytics. But there's a lot of it, and it's never ending. It's constantly ongoing, and a lot of it is in person. The old adage that private equity is sold, not bought, that's just true in our online, tech enabled world, as it is in the offline world.
You really have to go meet in person. You have to talk to advisors, answer their questions, and you have to do it repeatedly, right? You don't just have one meeting and suddenly they start to allocate. It takes a long time to get them comfortable so that they fully understand it.
Tony:
And we obviously have the exact same experience here after building the online education, we recognize that we're in it for the long game.
And the long game is engaging people where they are, wherever they are on that journey. It's part of the reason we have this podcast series. So we get to speak to experts like you and help people who are trying to figure out what role it plays in the portfolio and ultimately how we think about allocating over the long run.
And so much of our focus is, as you say, really on the portfolio you. construction and allocation and thinking about the funding strategy over time. And I think that's for the more sophisticated advisors, you know, their biggest issue. How do I scale it? How do I allocate? How do I think about structure and strategy?
I wanted to maybe ask the question that I think we always think about here, which is you and I have been doing this for a long time, and we're roughly a five to 6 percent allocation across the wealth channel. We know family offices are 45 percent. We know institutions are 50, 60 some more. Yale's 70 to 80 percent. How do we take the wealth advisor community from 5 percent to 10 percent to 15 percent?
And I know we're not going to get there in one fell swoop, but there's got to be a path to getting there. And I'm just curious based on where you're sitting, where you think we get and how we get there over time.
Nick:
Yeah, Tony, it's a great question. I think there's a lot of key drivers to move that needle.
They're still restricted to the QP universe, but they figured out ways to deliver Or K-1, perhaps synthetic K-1 before the end of March. It's a very complex ecosystem when you start doing evergreen open-ended funds. And the connectivity into the transfer agents, the custodians. Today, it's evolving. It needs to evolve faster, but post trade, for example, when you, someone wants to place a redemption order or a transfer or even just change one data point on a shareholder profile, it's not easy.
So extending the plumbing, and this is one of the things that iCapital is working on, it's one of our top priorities, is extending all the workflows. into that ecosystem so that we can meet the advisor where the advisor is doing business. So the advisor can do whatever he or she needs to do from one place, one desktop.
And by the way, that means you need to have a robust, secure document center. You need to be able to look in one place and find everything you need. How do I process a K-1? These are things that, right now, have slowed the adoption down a little bit, I think, because people are still trying to figure that out.
And then in terms of how to think about the right allocation, think about pension funds, right? Pension funds have an annual spend rate of about 8 percent and they can comfortably hold 20 plus percent. in private capital. Many of them hold significantly more than that. So if you think about the rule of thumb for an individual investor, it might be 4%, maybe a 5 percent annual spend rate.
So for those investors to hold, start out maybe getting into the mid-single digits, by the way, you're four to 5%. I think that might be a little optimistic. I actually think it might be well below that if you really canvass the entire marketplace. But for somebody to go from the mid, single digits up to eight, 10, 12%.
By the way, I think people should do that, particularly now, given what's happening in the marketplace. The need to diversify today, I think is greater than ever. And in 2016, capital raising through the private markets overtook public markets, equity issuance, and it's continued to do so. So if you think about this incredible shift and you think about There's 23,000 companies in the United States that are generating annual revenues of a hundred million dollars or greater. 87 percent of those are private. So do you want your entire equity book to be just in that relatively small mass? Do you want it all in that public market mix? And then by the way, when you go down to 25 million in annual revenue to a hundred million, which is where you really experience most of the hyper growth today.
I don't think there's a lot of hyper growth left in public markets. But if you really want to experience that hyper growth, you need to dip down there. And when you do that, 97 percent of those companies are private. And what's fueling a lot of that growth, particularly like, you know, think about how private equity bear hug the SAS movement in the mid-2000s.
Private equity more and more is fueling the growth of companies, not just smaller, high growth companies that might still. be losing money and haven't turned a profit yet, but big cash flowing, profitable businesses, people talk about they're staying private longer, which is true. But I look at it and say, they may never go public.
So just saying they're staying private longer. I think that underplays what's really happening. What's happening is they never need to go public. And I think a lot of them don't want to go public. They don't want to, you know, get into that cycle of having to worry about next quarter's earnings and not being able to truly pursue, day in and day out, pursue a three to five year strategic plan.
And I think that's very hard to do when you're public. And the difference today from 20, 25 years ago, is there's an abundance of private capital so that those companies don't have to go public. And I think that's what we're seeing. You know, even when the market, the IPO market opened up and was on fire in 2021, we saw a record number of IPOs over a thousand IPOs.
Many of those companies were losing money. And many of those, you know, sort of the unicorns were all queued up to go out during that period. And they went out at tremendous valuations. Sometimes I think we were living through the biggest asset bubble in the history of mankind in 21, but I don't think that was a great period for companies that went public.
I think a lot of them, I don't know the percentage, but I think 40 plus percent are trading well below their IPO price, a significant percent, probably 50 percent below that. Valuations have obviously reset, but if you want to find growth and you want to find opportunity and you want to diversify your portfolio, I think increasingly you really need to start looking at the private capital markets.
Tony:
We agree a hundred percent with everything you said. And one of the things that was interesting is I had a podcast with Jenny Johnson, our CEO, when we talked about the difference between a public company and a private company, of course, the CEO of a public company, she wishes she was private sometimes and didn't have to answer to shareholders because you can execute that long term strategy.
And I do agree that I think many of those companies will never go. public. They don't need to anymore. In the old days, they had to. So, Nick, thank you. We've just covered so much ground. It was great to kind of revisit where we've come from, because I think it's always important to appreciate the journey we've been on.
Obviously, there's a lot more work to be done, love the insights on product evolution, which again, registered funds have helped democratize, but there's a lot more that's going on, and I suspect that will continue to change over time. Clearly, alternative education is paramount to doing this well and making sure.
And I think at the end of the day, how we get to 10, 15 percent, I'm not sure it's a single lever. I suspect it's multiple levers that we're going to be pulling. But at the end of the day, that's a good thing for investors, advisors, and certainly overall for the industry. So Nick Veronis, thank you so much for joining us on the Alternative Allocations podcast series. You've been a great guest.
Nick:
Tony, thank you. It's been my pleasure. And I'm a fan of your podcast and keep up the good work. Thank you.
Tony:
Thank you.
Show V/O:
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