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 Kate Huntington, Head of Advisory Solutions Group at Fiduciary Trust. Welcome, Kate.
Kate:
Hi, Tony. It's so great to be here. Thanks for having me. I'm excited for the conversation.
Tony:
And I am too. I'm intrigued by your background and the way that you see the world.
I think you have a very unique role and a very unique set of experiences. Maybe for our audience, it would be worthwhile to start there.
Kate:
So as you said, my title is Head of Advisory Solutions Group, and that's a group within Fiduciary Trust International. As you know, Fiduciary is a private wealth arm of Franklin Templeton.
So we serve as an outsourced family office. And then for those families that have their own established family office, we really serve as a partner to them and an extension of that office. And then we serve for our endowment foundation clients as a OCIO or outsource CIO. And in doing this, we are partnering with each of our clients, providing a custom approach.
We are looking to really have a holistic view of their wealth, of their endowment, and help them manage it, help them simplify the complexity that comes with complex portfolios, with a lot of line items, with a lot of alternatives. and provide a very high touch, white glove type of experience. Our clients tend to have a lot of different entities and structures.
They're complicated, multifamily type of relationships. And making sure that things are running seamlessly. They don't have to worry. We're doing all the crossing the T's and dotting the I's. And then also there's the reporting. And when it comes to alternatives and private markets, it can seem very easy, but combining public and private investments together in one report is very complicated. And there's a lot of customization that our clients are looking for when they're trying to understand, you know, what's driving returns. How are they allocated? How are their kids allocated? And so we do that for them. We bring it all together in one platform.
I think you asked a bit about my background. I have a background more in research in private markets, due diligence and manager selection. Prior to this role, and I've been in this leadership role for four years, four and a half years, I was solely focused on private equity, private real estate, manager due diligence and selection at my predecessor firm, which Fiduciary bought four years ago called Athena Capital. I've been there 15 years. I learned the industry of private markets. I cut my teeth doing due diligence on a lot of funds going through the global financial crisis and was able to understand the right process you need to find and monitor the best managers.
I came to Athena from business school and I went to Yale school of management and I was very fortunate to take Swenson's class. I know you're a big fan of David Swenson, as am I. I was somewhat of a career switcher. I was looking to understand the investment space. I really was drawn to understanding the strategies of alternative investing. From him, I really learned a lot about not just hedge funds versus private equity and the purpose of each in a portfolio, but how do you evaluate them? How do you figure out which are the best ones? He always emphasized, you need to understand the people. You need to evaluate who you are basically getting married to for 10 to 15 years. Do you trust them? Are they people of high integrity? Do you find alignment with them? I always remember he would talk about taking managers out to restaurants and to baseball games to really see how they react in different environments. And that always stuck with me. Combining the qualitative and the quantitative type of research really led me to my role in manager due diligence.
Tony:
So there's a lot to unpack there. We certainly want to talk about some of the challenges. If we think about our audience, many of our advisors are relatively new to alternatives and private markets in particular. So you talked about some of the complexities of the reporting and account opening. Those are things we hear over and over again. There's a number of studies that kind of support that we'll talk about products in a little bit. I want to maybe use Swenson as the jumping off point to talk about the role and the use of alternatives though, because I think my listeners have probably heard me, whether they're listeners of the podcast, or me as conferences. I'm a big fan of David Swenson, and I think in many ways, he transformed the way that we think about alternative investments and I think a lot of the edge that he brought when he was the CIO of the Yale endowment was he used alternatives in a very big way because he understood the multifaceted nature of those.
So maybe if we can, let's delve into that just a little bit and from your lens of being involved in working with family offices and multifamily offices, how do they think about using these tools or how do you think about advising them to use these valuable and versatile tools.
Kate:
I'd say it's very simple. It's about the potential for enhanced returns as well as greater portfolio diversification. If you go back to Swenson in his book, which I still use as a reference, he was able to just really simplify and break down each asset class. What's the purpose? What's the role of each? What serves as a potential driver for portfolio appreciation and where can you get the potential for enhanced returns.
This is where you bring in more diversification. It can vary by family, but those are the driving factors as to why they would want to get exposure to alternative investments.
And they really want exposure to differentiated opportunities that you can't find in traditional public markets, stocks and bonds. And that's where you get the return on the diversification.
They are also fairly sophisticated, so they understand that with the potential for increased returns, that there are also tradeoffs, namely private equity, illiquidity risk.
They are looking to be very selective and they want us to help them get into the best in class managers in each type of strategy and do our due diligence. It's about access and getting into hard to access managers and really having those networks. And then I mentioned diversification. That's a big driver of, especially in things like hedge funds and real estate and getting exposure to them and an overall portfolio.
You could say us as their advisor might be even more focused on the risk mitigation benefits of diversification. Our families, they are, a lot of times we're working with the generation that created the wealth. And so they are very focused on capital preservation. They're very sensitive to drawdowns. As much as they love that new speculative investment and the highs that it might bring to a portfolio, the sensitivity to losing capital can be even worse than the highs of a great venture capital fund.
We're focused on reducing overall volatility. We have very much a risk management mindset when it comes to managing portfolios, and really understanding that you can't evaluate a fund in a quarter or in a year. It really requires a long term mindset.
Tony:
We often talk to advisors about institutions and family offices have historically made pretty substantial allocations to alternatives. These are relatively new to the wealth channel, partly because they weren't available unless you're a qualified purchaser up until these new products have come to the marketplace.
But I've always argued there's great lessons that we can learn from looking at institutions and family offices. Maybe family offices are more similar to high-net-worth investors. So maybe if we start there as kind of a inflection point, family offices have historically made, I think, based on the last UBS family office report, there's something like a 43 percent allocation to alternatives. I think around 20 percent to private equity and private real estate being the largest percentages of that. What similarities can we draw between the way the family offices allocate and high net worth investors? And maybe equally as important, what are the distinctions between the two of them so we don't just blindly make those allocations just because the biggest and the best do it.
Kate:
The investment thesis is the same. It's about again the potential for enhanced returns, diversification, and really having that long term mindset. The differences, as you say, are more interesting and you touched on one of them. It's kind of just the magnitude of how it looks in practice, and in regard to that, the ability to really bucket and segment one's private illiquid assets and say, I'm not going to touch this. Family offices have even greater ability to do that, and I'll get into that more. By doing so that they can really leverage the diversification benefit.
Going back to the magnitude and the numbers you mentioned, I agree. You can see in terms of allocations to private markets upwards of 40, even 50%. And a lot of times you'll see a barbell approach when you look at an entire portfolio. And so a family office might be taking away from their public equity and doing more private so that their overall equity exposure might be similar, but they have the ability because of their scale, because of maybe there's a lot of cash flow coming off of an operating business to be more illiquid. And then also related to family businesses and having that operating business mindset. I think that allows for that natural capital allocation mindset that's really beneficial when you're investing in private strategies.
You need to know that's, my money over here that can't be touched. They have their operating business, they have their capital reserves, maybe that's money for the next strategic acquisition. And then over here is my investment portfolio, which has a different purpose, especially when it's a lot of locked up private equity investments. I know that I can't touch that for the liquidity I need to buy my next company.
Tony:
What's interesting in the podcast series, we've hit on illiquidity, I think in every one of the podcasts. And I remember my good friend, John Bowman said, “It's just a feature. It's not good nor bad. Inherently, it's just a feature,” but I think for advisors, that is one of the big impediments. And I think for investors. So I like the way you compartmentalize it. I've written a paper that seems to be getting a lot of use from advisors, and I talk about the cost of being too liquid, and I suggest you need to develop an illiquidity bucket similar to the way that Swenson at Yale and others have done over time.
And that somewhat separates the decision. Here's my long-term patient capital that I'm thinking about putting away for 10 years. And then for my traditional investments, I can be a little bit more tactical. I can respond to emotional stimuli when it comes in, or I can chase that hot idea that may make sense.
But that long-term capital, I know I'm going to be rewarded for. And I think that is one of the big challenges for the advisors as they think about this. So rather than thinking of illiquidity as a negative, we actually think you should view that as a positive. That's where you can be your disciplined capital allocation.
Think about that for the long run. I'd love to take that discussion we just had because I thought that was really instructive and I think advisors will get a lot out of it and maybe also do the same sort of comparisons of nonprofits dealing with endowments and foundations. What are the similarities there for high-net-worth investors and what are some of the unique things that we should think about there?
Kate:
With the family clients that we're working with, they are all pretty much institutional size. So the investment framework and the thesis behind investing in alts is very similar with nonprofits. What the differences are is in terms of execution and also in process. With nonprofits, I guess similar also to large family offices, they can typically invest more in terms of a higher allocation to illiquid private investments, especially the larger endowments. Endowments are set up for perpetuity, so they have that really long term investment horizon. As long as they have enough capital, back to the illiquidity part, to cover their spending and operations, they can move into those illiquid investments in a bit higher way.
Also, I'd say just in terms of process, there's more formality. There's more governance with an endowment and an institution. We work with a lot of investment committees, and that is one thing that I really love to do, is working with investment committees. These people typically have very busy lives, they have a real job, and they're on these committees because they're passionate about the institutions and putting themselves in a position to be a fiduciary and really make some tough decisions for a place they love about a critical capital asset of that institution. So I really just love working with them, helping them come together. And make the right decision.
One of the big decisions that we're seeing more endowments and foundations making these days with increased inflation, higher cost structures is how do we cover all that? How do we create enhanced returns for the portfolio? Meaning we need to start stepping into alternatives, and in particular private equity, to get that potential for enhanced returns. And that decision to make that first step into alternatives, it can be a really big one for investment committees. You’re taking on that illiquidity risk again, making sure you're covering all your liabilities. And there's a lot of stakeholders and a lot of differences within an investment committee.
It's great to be able to walk them through that, create a strategic plan and stick to it in terms of getting to their target allocation. And one other thing that I haven't mentioned before is also a big part of our work with endowments, foundations, and also with families, is integrating mission, personal values into our portfolio. So that's another way we work with our clients. A lot of times you're seeing with endowments, the desire to align their mission. They operate day to day towards a mission with their grant making and their programmatic activities. And how do we make sure at least we're not conflicting within our endowment? And many times how do we create real intentional impact through private investments?
Tony:
So we've touched on it a little bit in our discussion here already, but I think it's important maybe to kind of put this in a framework. Across the industry, I think the alternative allocation across the wealth channel has roughly been between five and six percent for the last decade or so. Probably three percent allocated to private markets. For those who are in the industry and people like Jenny Johnson, our CEO, has used the numbers 15 to 20 percent would be a good number. Partly because with a 15 to 20 percent allocation, it starts to change the complexion of the portfolio, and you really do change the likelihood of achieving goals over the long run.
But we're not going to get there in one fell swoop. It's going to take time, and I think the way that we are certainly conditioning advisors as we're providing a lot of great insights with the podcast and writing and illustrating the impact of adding alternatives. But I did want to get into a little bit about the alternative allocation. We know that institutions and family offices have substantially higher allocations and we know there's differences. They have different time horizons and family offices are thinking multi-generation, but ultimately we need to start to put a roadmap out there for advisors. How do we get them to the right level of allocation?
So I always just like to ask guests if they can talk a little bit about where's your allocation. And I understand every family's different, but put some markers out there. What's a reasonable allocation to alternatives? And then specifically, how might you break that down?
Kate:
As you said, every portfolio is different and customized, but we do start from one reference point framework. So for quote unquote, institutional size clients, whether it's families or actual institutions, we think about alts in three main buckets: private equity, private real estate, and hedge funds. And in aggregate, that typically sums to around 30 percent of a portfolio. So you have 12.5 to maybe 15 percent in private equity, 12.5 percent in hedge funds, and then the balance around 5 percent in private real estate. It varies widely with risk tolerance and preferences. And then you'll see some, as we already discussed, larger clients, family offices with upwards towards 50 percent and a more barbelled approach.
Ramping up to that target seems easy. It can get very complicated and it's a big part of what we do. Not just with clients who are ramping up, but how to also stay at that consistent target with private equity, which is just a constant churn of capital calls and distributions. It's something that constantly, each year, you have to commit to to maintain that allocation.
And we believe that it's really hard to predict right now what's going to be the best venture or buyout fund in 10 years. And the best you can do to get exposure to all the different alpha drivers of a vintage year is have a consistent overall commitment to private equity and private real estate each year and have a diversity of within that, different strategies.
That'll vary based on which managers are raising, but making sure that you're not getting over your skis in one vintage year or strategy, so you're getting the exposure of the full cycle. And there's a lot of behavioral tendencies, obviously, when volatility and market uncertainty could cause people to pull back. And typically, that is one of the best vintage years to start to invest or to have exposure when there's uncertainty. Making that discipline is a big part of what we do with our clients. We've developed a lot of tools just to help our portfolio managers think about, okay, I want to get to that 12.5 percent of private equity.
How much do I need to do right now and next year, next year to get there and revisiting that every year. And, you know, typically it does take four to five years if you’re starting from scratch.
Tony:
I just wanted to clarify for our listeners, I suspect I know the answer to this. Private credit is part of your private equity allocation.
Kate:
That’s right. Private equity and debt.
Tony:
I just want to make sure that for our listeners, because we've had guests on talking about private credit and they're like, well, where does that fit? Private equity is kind of your umbrella for everything.
Kate:
Exactly. And we do have private credit type exposure in our hedge fund allocation. There's a lot of credit-oriented strategies that will also do lending where the liquidity is a bit better than some of the more private equity type of lending strategies.
Tony:
We don't want to be so super specific because we know the markets change and certainly we think about allocating to alternatives as a long term opportunity. But as we are sitting here and we start to see that rates are changing, I'm curious where you see the most attractive opportunities today. Again, not that we're going to dramatically change our allocation, but are there things that you're seeing as rates are starting to come down? We've gone through a period of regime changes, whether it's the ‘21 run up where everything was Goldilocks and perfect, when then all of a sudden we had high inflation and interest rates going up. Now we're starting to see interest rates reversing course. Is there a type of investment that you think will do particularly well in this market environment?
Kate:
It's hard to be tactical. There are opportunities that we would say are both market opportunities and manager opportunities right now in private markets.
Everyone talks a lot about secondaries. I continue to believe that is an interesting strategy, but within that, venture secondaries are particularly interesting. There's been a huge run up over the past four or five years in the size of the venture market. There's just a huge supply of startup companies held by founders and employees and funds, and many of them want some liquidity.
There's a longer window now for private companies to be private. There's just more of a premium I'd say placed on being a liquidity provider, especially in that market. You need to sift through a lot of deals, but you can find some quality companies at a discount. So that's one thing. And then also just related to rates, there is a lot going on in real estate.
In private real estate, we've been through a real secular change, especially in property types like office. But yet there's still a lot of momentum and growth behind other property types, whether it's multifamily or industrial. We've looked a lot at the space, and I think right now, even in a rate changing, slightly lower environment, being a lender is particularly interesting compared to where rates were post GFC. And looking at the risk adjusted returns of where you can get from being, whether it's a mezzanine or more secure lender in real estate, is banks are pulling back. And so there's just a huge wall of debt maturities coming due for deals that were bought at higher valuations with a good deal of leverage. So being a liquidity provider is interesting in that space. I know you did a recent podcast on this and I love what he said. We've recently done some work as well and came, I guess, to some similar conclusions.
Tony:
We have not coordinated on this, but your views align very much with the way that we're seeing the world and opportunities. Real estate again, office being a bad spot, but certainly other opportunities, real estate, debt, lending makes sense. Secondaries we like. It's interesting. I mean, the world is definitely evolving. We're not trying to be tactical, but I think there seems to be a consensus around where the puck is going, so to speak.
Kate:
My perpetual favorite is lower middle market buyout. They don't use much leverage. It's that real old school, roll up your sleeves, operationally focused type of strategy. And especially in the lower middle market space where there's a lot of companies, mom and pop type of businesses that need to be more institutional. Of course, it's hard to find them, but if you do and you get them at an interesting valuation, you don't need much leverage. You do your operational value add, do maybe a buy and build approach and sell it to a strategic at a higher multiple. To me, that's just a continual plug and play type of strategy you need in your portfolio to get alpha.
Tony:
I did want to hit on something that you and I were talking about beforehand, and I think it's instructive for our audience. We have these new products coming to the market, interval and tender offer funds. We talk about this term “democratizing alternatives”, and clearly we're not going to have the same level of access as institutions and family offices.
But I think sometimes when I'm traveling with advisors, they say, well, gee, are these lesser vehicles? And it was interesting as you and I were talking about it, you actually think there's a role for interval and tender offer funds and the world that you traffic in. Maybe we can talk about that a little bit, then I'll offer one last closing question for you.
Kate:
So there are a lot more vehicles right now that is really opening up the private investment space to a lot more investors, which is good. But you need to also really understand, just like you would in any new investment, the vehicle and the mechanics of that vehicle before you invest. It gets back to our due diligence team. We've actually done a lot of work this year on evergreen vehicles and do believe that they solve for some of the challenges of investing in private markets, such as the minimums are typically lower. A lot of times there's no K-1’s, which is great. You're not dealing with that J curve of the time that you commit to four or five years when you're actually getting invested. And so you're able to kind of ramp up to that target quicker.
But there are tradeoffs that need to be understood. One thing that we point to is that you're giving up a lot of the control in terms of vintage year and strategy diversification. Because if you think about it, the flows for a lot of these funds, they're dictated by investor demand. And when there's more exuberance, investors will flow into them and that fund will need to buy more in that particular vintage year, which sometimes can be the opposite of when you want to invest. Going back to the times of uncertainty can be the best times to invest and you want that vintage year exposure. So that vintage year strategy diversification is dictated a lot of times by the fund flows.
The other thing is liquidity. And there are more options within these vehicles to have liquidity, which is great. But also, you can't always depend on that. There could be times when everyone wants liquidity, and you might not be able to get it. So you really need to go back to that “put it aside” approach. There are some liquidity options. These evergreen vehicles still need to think about it as a traditional type of alternative and not try and get liquidity from it.
Tony:
And that's something we emphasize over and over again. We still think of them as long-term investments, but it's nice to have that safety valve if you needed it.
So let us think about the future, where we're going. We've certainly come a really long way in a relatively short amount of time. Again, John Bowman of CAIA was commenting that the industry today is roughly a 17 trillion dollar alternative investment industry. He thinks in the next decade, it goes to 30 trillion.
A lot of that will come from the private markets because that's where a lot of the demand and the interest is. And one of the things I was sharing with you earlier, when I'm traveling, sometimes advisors are concerned, is this going to be a concern that the alpha goes away because so much money is coming into the space? And of course, my response is, I think there's ample room for growth here, but I'd be curious if you want to weigh in on that with the growth and where we see that growth coming from.
Kate:
It still comes down to finding the best managers in each strategy. There's going to be winners and losers from a smaller alternatives market size now to a bigger one.
The time that companies are private is longer now. We're seeing private companies become much bigger as a private company before they IPO. And so that means there's more opportunity in private markets versus public. There's a lot more volatility these days. You know, you go from periods of market exuberance to real disdain for particular sectors or part of the market.
All of a sudden, there can be a change in terms of risk on and risk off. And to me, that brings more opportunity. There's more opportunity for being an active manager, whether that's hedge fund or in the private illiquid markets. So that is another way that there can still be alpha generation in a much larger space.
Tony:
We think it's a growing opportunity in the private market space. I think the market will definitely continue to grow, but I don't believe that the alpha goes away just because there's more money. To your point, you need to be more selective in identifying those great managers who have a long history of doing it. As opposed to those who are just chasing where the money is going.
Kate, thank you so much. I think we covered so much ground. I think there's so many great lessons that can be learned from institutions and family offices. I hope our audience can take some of these, bring them back to their practice and think about how to apply some of the lessons learned at how we think about allocating capital. It has been my pleasure to have you here today, Kate.
Kate:
Well, thank you, Tony. It's been a great conversation.
Show V/O:
Thanks for listening to Alternative Allocations by Franklin Templeton. For more information, please go to alternativeallocationspodcast.com. That's alternativeallocationspodcast.com. And don't forget to subscribe wherever you get your podcasts.
Disclaimers V/O:
This material reflects the analysis and opinions of the speakers as of the date of this podcast and may differ from the opinion of portfolio managers, investment teams, or platforms at Franklin Templeton. It is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell, or hold any security or to adopt any investment strategy. It does not constitute legal. or tax advice.
The views expressed are those of the speakers, and the comments, opinions, and analyses are rendered as of the date of this podcast and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, security, or strategy. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
Please see episode specific disclosures for important risk information regarding content covered in the specific episode.
Data from third party sources may have been used in the preparation of this material, and Franklin Templeton, FT, has not independently verified, validated, or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions, and analyses in the material is at the sole discretion of the user. Products, services, and information may not be available in all jurisdictions and are offered outside the U. S. by other FT affiliates and or their distributors as local laws and regulation permits. Please consult your own financial professional for further information on availability of products and services in your jurisdiction.
Issued in the U. S. by Franklin Distributors, LLC. Member FINRA/SIPC, the principal distributor of Franklin Templeton's U.S. registered products, which are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation. Issued by Franklin Templeton outside of the U. S. Please visit www.franklinresources.com to be directed to your local Franklin Templeton website.
Copyright Franklin Templeton. All rights reserved.
