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 my good friend, Scott Welch. Welcome Scott.
Scott:
Thank you. It's nice to be here.
Tony:
So Scott, you've recently changed roles. Talk to me a little bit about what you're doing now and what your set of responsibilities are.
Scott:
Sure. In some respects, it's a little bit of back to the future. I started my career in this space at an RIA, went onto a couple of B2B firms, went to an asset management firm, and now I'm back at an RIA as the chief investment officer. It's a multibillion-dollar multifamily office based down in Florida with offices around the country.
Tony:
And it's exciting because you and I have talked so much about allocating to capital. I've been waiting to have you as a guest for a long time, and I know you're passionate about allocating to alternatives. Something you and I both written about and spoken about quite a bit over the years. How specifically should advisors think about the role of alternatives and client portfolios?
Scott:
One of the things I think people should be aware of is that there's every flavor of alternative and private market investment that you can think of. Some of them are going to be more growth oriented. And some of them are going to be more income oriented. Just to put two broad strokes on it. And so, I think depending on what you're trying to do within the portfolio, if you're trying to add a little juice and more growth, then you might want to lean a certain way.
If you're trying to get diversification and with lower correlated assets, that's going to maybe steer you in a different direction. And thirdly, if you're looking for additional income that you're not finding in the public markets, then that's another area that you should be exploring.
Tony:
Yeah, we look at it the same way. And I think it's often you paint everything with the same brush and the reality is we think of four primary roles of all alternatives, which are growth, income, defense, or non-correlating assets, and inflation hedging, something we don't talk a lot about, but certainly you and I've talked a lot about it over the years.
Scott:
And I agree with that.
Tony:
: And I know earlier we're talking about the fact that one of the things that I think has been really interesting over the last couple of years is the growth of the evergreen products. And not just because those products are available to a broader group of investors, which we think is really appealing, but with the lower minimums, you can now start to get diversified exposure, which I actually think is really important because I'm not making a single bet, I’m making a diversified bet across alternatives. Talk to me a little bit about how you all think about the evergreen versus drawdown structure.
Scott:
Yeah, I'll say as a starting point that, and this is an opinion and other people might disagree with me, but I view private equity and again, we'll just keep it broad category. I view private equity as more suited for a drawdown facility. I think it requires a longer time horizon, People need to understand the J curve and all the things that go along, capital calls and all the things that go along with that. But I think it's the right vehicle for private equity.
On the other side, I think that the evergreen facility is a natural fit for private credit. The money gets right to work. There's no J curve. People start generating income right away. It's a 1099. Right, so there's a lot of positive aspects to the evergreen structure. I happen to think it's better suited for private credit than private equity.
Tony:
So one of the biggest challenges that I hear from advisors, and I think you do as well, is now we have more products at our disposal. That's great. But it's also daunting.
Scott:
Sure.
Tony:
So how should we help advisors think through making decisions across the various strategies as we think about due diligence, we think of IDD versus ODD.
What are some of the things that you think advisors should pay attention to?
Scott:
So, as a point of view, I think you start with the basic four P's, right, of due diligence, which is the people, the philosophy, the process, and the performance. If you don't like the people, stop there. Then what's their investment philosophy?
Does it make sense? Do you believe it can work consistently over time? How do they do it? What's the process for actually implementing that philosophy? And then, out of those three things comes to performance. With respect to alternatives or privates, and I'm going to make a distinction. First of all, that in my world, alternatives are what Tony, you might call hedge funds or hedge fund-like products, global macro, long, short event-driven, things like that, versus privates, which is its own thing.
Some people conflate those terms, but in terms of how I construct portfolios, I treat them differently. But anyway, back to the due diligence, the IDD or the investment due diligence is really not that much different than it is for a public investment.
Benchmarking can be a little difficult in this space, so what you're really trying to look at is peer comparison and consistency of performance over time and so forth, but that's not the hard part. Right. The harder part is the operational due diligence, right?
Because you're locking your money up for a long time, or even if it's an evergreen, you're still only semi liquid and you need to make sure that the shop that you're working with, or the sponsor of that strategy, is buttoned down tight from an operational perspective in terms of their audits and their taxes and how they run their business.
And so, that might be a little more straightforward in the public market than it is with alts and privates.
Tony:
And again, I think we agree with kind of the broad definition. I would say we spend most of our time thinking about and speaking to advisors about private markets. I think that's where the biggest interest is. One of the challenges with the private markets though, and I'll pick up on something you said earlier, is the data. Advisors don't always have access to the data. The other thing we're sometimes asking them to do is take a little bit of leap of faith to say, I want you to buy this fund because the last fund and the fund before that delivered similar sort of results. Where if you're evaluating mutual fund, you can see the data, it's daily price and all of that.
So how do we think about bridging that gap a little bit?
Scott:
That's a good question. What history suggests, of course, past is not a guarantee of future performance, but I think what history suggests is that within the private markets, particularly with private equity, there's consistency of top performers, right?
And one of the things I would caution people about is the dispersion between the top quartile managers and the bottom quartile managers across the private equity spectrum and the private credit spectrum is, can be severe. The dispersion in the public market is pretty de minimis, which is why way back when David Swenson said, why would I want to pay an analyst to study the public markets?
Because if I find the best manager, it's not going to make all that much difference. Whereas if I get the best private equity manager, it's going to make a huge difference. And so the one thing that I caution people on is if you're going to go into this space, if you're going to allocate, there is history that shows that the top quartile managers are consistently in the top quartile and those are the folks you need to get access to. Right?
You don't want even a medium level performer, and you certainly don't want anybody below medium because you're not going to get the results that you want, given the illiquidity and the fee structures, especially.
Tony:
Yeah, and it's funny. We often make the same sort of points. We emphasize the dispersion of return.
And again, I'll agree with you when I think Swenson and anyone who's really looked at this space, there's not a lot of value in picking traditional managers. There's not that big of a difference between the top and the bottom. There's a huge difference between the top and the bottom, private equity, private credit, real estate.
So where those specialized areas, you really need to pay attention. And I think that we have seen the data tends to support that the top remains the top and the bottom remains the bottom. And one of the things that we were talking about earlier with a lot of interest in private credit and a lot of money going in there.
I've often made the point that I think an experienced manager will thrive in an environment like today where somebody who's just chasing the returns and maybe doesn't have the experience, maybe we'll struggle a little bit as we're going through a different regime change.
Scott:
Different for sure. Absolutely.
Tony:
So I did want to get into the topic of where you've seen the most attractive opportunities. Again, we talked about private credit and secondaries, real estate, both equity and debt. Where are you seeing the best opportunities and why do you think those areas are of importance?
Scott:
So, I can share with you what we're looking at. Now, we already have a fairly nice platform of both private credit and private equity. We're a little light on real estate. And so that's an area of search for us right now. I think, again, there's so many different sectors of real estate, it's difficult to paint everything with a single stroke, but the real estate market in general got so beaten up during the COVID years.
And people really ran away from it. If you are a long-term investor, that should trigger the thought that maybe there's some opportunity there that can be scooped up. So, we're looking there in a couple of different ways. I like infrastructure. We're looking for infrastructure. And, and as I mentioned to you before we went on the air here, I have a thesis, which is that when you look at the energy demand for AI data centers, Microsoft was firing up one of the Three Mile Island nuke plants. I think there's an opportunity in energy production and transmission.
I think the demand is just going to skyrocket, and I don't know that we can support it on the current grid. So that creates investment opportunities. And then on sort of more traditional stuff, we're big fans of secondaries. The traditional sources of liquidity for the private equity sponsors have not been there as much as they have been in the past. You know, M&A, Strategic sales, IPOs, those markets haven't been as robust and these managers need to get out of some of their investments to put capital to work on new vintage or whatever it might be. And that's creating, I think, significant discounts and opportunities within the secondaries market. We just added one that I'm very excited about, and we're hoping to get that closed and capitalized by the end of the year.
Tony:
I agree with you. We love secondaries. We think the slowing exits are going to be with us for a while. We think secondaries look really, really attractive here. It's interesting you said real estate. I would agree with you. I think real estate is so beaten down. It does represent an opportunity. And I think on the podcast, we've talked to a number of people who have talked about the office sector and the office sector is clearly a challenging area, but it's a smaller and decreasing sector of the overall real estate pie and people kind of get caught up in the noise rather than looking under the hood.
Scott:
I completely agree. And it's not an insignificant part of what we might call real estate, but in comparison to the attention it gets, it's very small. There's lots of other areas in real estate that look much more interesting. You don't have to go into office.
Tony:
And you also mentioned real estate debt, which is something we've been following as well. That's great. That's great. So when advisors think about private markets, and you and I have been speaking to advisors for decades and decades, and–
Scott:
You're dating me, Tony.
Tony:
But I think early on it was, why would I spend all this time and effort to learn something that's very complicated, opaque, and maybe not as liquid as I'd like. It seems like we're at a different inflection point. It seems like we're getting to the point where it's not, why would I allocate to private markets? It's more, how do I allocate? And I think that's a real positive reflection of how we've come as an industry. But I still think there's some advisor adoption sort of issues out there.
Scott:
I think that's probably true, but I also think it's a function of your client base and who you're trying to attract, right? As you move up the wealth scale, not having at least thoughts or allocation ideas into these spaces is probably going to be a negative differentiator for you because that's what they expect from their advisor.
A lot of these folks may already have private market exposure from wherever they came from or just on their own. So especially with the advent of the evergreen structure and the RIC structure and the various kinds of semi liquid structures that are out there, there's really no excuse to be thinking about this.
And there's lots of organizations that can help you get educated. There's lots of organizations that are making entries and forays into this space and all they want to do is teach you. And most importantly, they want an educated buyer. And so, yeah, you may have to get out of your comfort zone, but if you want to target high net worth investors or ultra high net worth families, you have to have solutions in this space.
Tony:
Yeah. And it's, in fact, our sole focus with the podcast is, again, we never talk about products. We want to help advisors make better informed decisions. Everything we do is to help them think through these complex allocation decisions. I think the reality is something you hit on, which is if you're not having a conversation with your clients about private markets, somebody else will.
Scott:
Absolutely.
Tony:
And the reality is high net worth and ultra high net worth families actually expect and demand access to these unique investments. And if you're not going to have those discussions, they'll find somebody else who will.
Scott:
Completely agree.
Tony:
So Scott, your clientele is a little bit different than the average advisor, but maybe as a starting point, as we kind of drill down a little bit, what's an average allocation for your client size? [00:12:07] And then specifically, how might you think about allocating across the alternative spectrum?
Scott:
Good question. I am relatively new in this role at my firm. So I've been reviewing our model portfolios and the good news is the people who were there before me, their investment philosophy is not that dissimilar from mine. And I think it would be hard to find somebody whose was if you're targeting that particular kind of client.
And so, let me talk about portfolio construction. I'll answer your question, but let me give it a broader context. So, first of all, on the traditional side, as you know, Tony, I've written about it, we've talked about it. I'm an advocate of the 75/25 is the new 60/40. Right? So, I think that if you build a public market portfolio that is…let's put it this way. If you start with a portfolio that's 75 percent factor tilted equities, specifically dividends and quality, and then you fill it in with whatever public debt you want, right?
I think that gives you a better outcome over time than what people used to consider the moderate portfolio of a 60/40. So that's the starting point for my portfolios. Then, depending on the client, we're allocating currently about 10 percent to what I would call alternatives, multi-strats, global macro, that kind of stuff.
And then another 10 to 15 percent to the private market. And again, depending on what the objective of a particular portfolio is, that would tilt toward either private credit or private equity or various other flavors that are available. So the bottom line is, and then you would fund the growth oriented privates out of your equity portfolio, and you would fund the income oriented privates out of your fixed income portfolio.
So the numbers would just sort of pro rata go up and down based on what you're doing. But the bottom line is, if somebody were to just take my model off the shelf right now, it would have about a 25 percent combination of alternatives and privates.
Tony:
I think that makes 100 percent complete sense and I think directionally that's where we think advisors should go, right? So if the numbers today are 5 percent across the wealth channel, family office – the UBS family office report, I think is 42%. You and I are both disciples of Swenson who’s 70 to 80 percent.
Scott:
Yeah, but he's an institution. You always have to filter–
Tony:
I know.
Scott:
That you're dealing with human beings who pay taxes and are going to react differently to market disruptions and therefore may not be willing to have that much illiquidity in their portfolio.
Tony:
I know we've had this discussion. I would never suggest an individual investor have 70 to 80 percent. But clearly what Swenson saw and what Swenson wrote about and what Swenson really, I think, kind of got all of us thinking about is the value of having exposure to privates and in particular, he talks about this illiquidity premium, which is where I wanted to take the discussion a little bit.
So if we think about the Wealth channel is 5 percent and you're 25 and maybe others are a little higher. How do we get them from 5 to 25? And maybe I'll just throw out one thing that I'd love for you to kind of weigh in on. And that is the thing I hear from advisors over and over again is this concern about illiquidity.
And I've argued illiquidity is a good thing.
Scott:
Can be.
Tony:
Right. If you embrace it and you understand that in advance and you understand that that money is money I'm putting aside for the long run. But I think that's one of the impediments How do we help advisors get from that 5 percent to the 20 to 25 percent.
Scott:
Well, I think that's where the evergreen structure can be a good place to start. Because you're not making the leap from publicly traded securities to seven- or ten-year lockup and a J curve and capital calls and all the things and a K-1, right? All the things that go along with a drawdown facility. So I think that's the place to start and again, it's an educational process. You need to teach your client that there is an illiquidity premium. Or put more fundamentally, either they’re semi liquid or relatively illiquid; you're giving the manager time to execute their best ideas.
Right? You're not being impatient. They don't have to be impatient. They can survey the market, find their best ideas, and deploy. And that's what you want from them. And the other aspect of that is leverage. So, the two primary drivers of the excess performance that we historically have seen out of the private market is a function of illiquidity and leverage. Right? And those are things you just don't have access to in the public markets. Now leverage is a good thing. Could be a good thing or a bad thing, but that's why you need to focus your due diligence on the managers that historically have shown that they can manage it well, and that's where the returns come from.
So it's a combination of the structure, itself, which is beneficial for investors because the things that the managers can do that they cannot do in the public markets. And, teaching them that sometimes illiquidity is a good thing. And because people have a very natural reaction when something goes wrong, the market disrupts. And as an opinion, I think the public markets are priced for perfection right now. And so, who knows? But there's a lot of complacency out there. But if some geopolitical event makes a turn for the worse, let's just put a horrific example out there, right? And the market disrupts. Natural human behavior is going to say, give me my money.
I want to get out of the market. I want to put it in gold, however they want to react. And sometimes that's not the right answer, right? Sometimes the right answer is slow down. We're not making investment decisions for a month. We're making investment decisions for, even on the short end, at least five years. Let this play out. If something goes wrong, if it gets worse and worse and worse, we will take care of it. We will get you out. But sometimes you got to just be patient and let the markets do their thing.
Tony:
It's interesting as you know, I write a lot and sometimes I write things and it goes over people's head. The one paper that I've written that has been far and away the most popular is a paper I wrote called “The Cost of Being Too Liquid”. And in that I talked about developing an illiquidity bucket exactly for those reasons that it protects the clients from their worst impulses, which is when there is market volatility, they want to head for the exits.
If we could, in a disciplined way, develop an illiquidity bucket for a client, maybe it's 10 to 20 percent, 10, 15 percent, whatever, And that money was truly put away for the long run. That would be a good thing, not only for the portfolio, but also for that emotional impulse, which is to head for the exits at the worst time.
So again, I think that that's an important thing. The other thing I wanted to pick up on, and it's something I speak a lot about, and I think sometimes we need to focus on the why a little bit more. And that is, why is it that there's the illiquidity premium and you kind of hit on it.
To me, there's really two factors. One is the shrinking size of the public market and growing size of the private market, which means there's a richer opportunity set. But the other is that notion that you're giving the manager the ability to unlock the value. So it's not just the fact that you're tying up the capital for seven to 10 years. It's in that period of time, you're giving them the ability to execute that long term strategy.
That's a huge premium and that's a great value. And sometimes we just focus on the number without focusing on the why.
Scott:
Well, absolutely. I mean, if you think of a traditional growth manager in the private space, that's exactly what they do. They, I try to identify companies that are either undervalued or need help on the management side or need capital to make investments or whatever it is they need. And, and most of the good ones, at least the ones that I try to follow, they're not passive investors.
They're not just handing over capital and hoping for the best. They get in there and they work with management, and they restructure the capital structure, and they come in and do their best to fix whatever they identified as being wrong. Well, in the anticipation that that will help that company that they saw intrinsic value in can realize its potential.
And that's part of what you're paying for if people push back on you on the fees. They're not just running a fund. They are managing a fund, but they're also, they're in the weeds. They're rolling up their sleeves and helping these companies do what they're supposed to do. That's part of what you're paying for as well.
Tony:
Yeah. To your point, it's not just the monetary capital, it's the human capital. A lot of times those private equity firms are providing adult supervision. They're helping making acquisitions, looking at verticals. So there's an awful lot of value that comes out of that. Scott, this has been fantastic. I've been waiting to have you on for a long time because I knew that we'd really kind of delve into these issues.
I think this is tremendously helpful for advisors as again, they're somewhere on that journey from five to 25. And I think that's kind of the direction that we're seeing the industry go. I did want to take this opportunity just as we are starting our second season of the Alternative Allocations podcast.
First to thank my producer, Julia Giordano, who has just been unbelievable. We started, we thought we would develop an audience. We have really just had a great audience and great receptivity over time. We're fortunate to recently win a Star Award by the IMEA organization and a “Wealthie” from wealthmanagement.com.
And I think those are reflective of the fact that we have met an audience who is in need of more of a dialogue around allocating to alternative investments. We've had tremendous guests, which I think have really helped us get where we need to be. For those who are avid listeners, and I know there's a lot of you out there, we would encourage you to rate and then reach out to us. Tell us what topics are of interest to you. As we think of expanding our series, we've been very pleased with the feedback, but we're excited as we enter our second year and see where we can take this podcast series. So Scott, thank you so much for being a guest on our program and we'll have to have you back soon.
Scott:
It was great. Thank you for having me here. I'd love to come back.
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