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 podcasts to make sure you don't miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to this special episode of the Alternative Allocations podcast. I'm thrilled to be joined today by Rich Byrne. of Benefit Street Partners, Taylor Robinson of Lexington Partners, and Rick Schaupp of Clarion Partners. Welcome, gentlemen. Taylor, let me start with you. Secondaries, certainly been getting a lot of attention recently, and you've heard me say probably all too often that I think that secondaries have become a vital cog in the overall PE ecosystem. What looks attractive to you as you look at the secondary market today?
Taylor:
Tony, there's a structural and persistent need for liquidity in the private markets generally. And so I try to keep it really simple for people. We do fairly complex deals with sellers who are holders of private assets, generally through funds.
But the concept is that we're providing liquidity to the holders of those assets. We become in most of these deals, replacement limited partners. Our job is to underwrite assets that we know that are managed by sponsors we know to prices and return levels that make sense to us. And so if you take a step back, what's happened in the private markets is that over the last couple of years, the liquidity from private asset portfolios has slowed significantly, and that's a market condition.
And our job is to show up and provide liquidity at a time when the limited partners, the original investors in those assets, need or want that liquidity because they're not getting it naturally today. And candidly, because of the size of the NAV that sits within private funds, today versus a few years ago, because of the strong performance in these portfolios and lack of liquidity, the problem is getting bigger in terms of need for cash flow from these portfolios, not smaller. And that's why I call it persistent and structural. We think the opportunity to provide that liquidity is going to last for a very long time.
Tony:
So let me pick up on that a little bit. You mentioned a tremendous amount of capital has been raised in the private markets, a lot of institutions that need for liquidity. If all of a sudden, We start to see an increase of exits, right? M&A activity pickups, the IPO pipeline picks up. Do you think that persistent advantage persists, or do you think that the complexion of the market changes?
Taylor:
It's not clear to us that the structural need for liquidity changes, and that is just because of the quantum of NAV that sits within funds.
I've said it to others before, but I personally think that private equity, and when I say private equity, I mean private equity and growth and venture capital and all of the private alternatives. The markets have grown so fast and the performance of the companies underlying has been pretty good and so that NAV has grown faster than the source of liquidity. And so it doesn't seem to us that if liquidity comes back, even to the levels we saw at the peak in 2021, where the average private equity portfolio probably spit off 25 plus percent of its starting NAV in cash over the following year. Even if we get back to that level, just the size of the NAV has grown so much that that level would not provide what were the historical levels of cash flow off a diversified portfolio.
So it will take a long time to work through this massive mountain of NAV that was created over a decade or up to 12, 13 years of low interest rates when capital was flowing in. And it could take that much time to work through it.
Tony:
That's great. Thanks so much. Rick, let me turn to you. We've been writing about real estate and some of the challenges in the real estate sector. And maybe I'll pick up on one of the themes that Taylor ended with, which is, ‘21 was a different environment, ‘21 peak valuations, a ton of money going into private equity, but a ton of money also going into real estate. And over the last couple of years, because of the concern about offices, it seemed like real estate valuations are down.
It seems to us as we're thinking about our 2025 outlook, which is the purpose of this call today, that it seemed like valuations are at much more attractive levels today than they were in ‘21. Where are you seeing opportunities in real estate and why do you think it's attractive today?
Rick:
Yeah. If you think big picture, private real estate over time has been a great diversifier for portfolios because of low correlation, low volatility, strong income inflation hedge.
So if you think of that as a foundation, but you want to look at entry point as well. So we think it should be a strategic part of a portfolio, but we're thinking about where is the entry point today? So you're comparing to 2021 where you're right, there was a plethora of capital, very low yields, pricing and values were above replacement costs.
And we've seen over the last 18 to 24 months, interest rates adjust and valuations in the real estate sector have adjusted. So it's partly driven by office. You mentioned office, right? Office is driven by lack of demand, income, rent challenges, and increasing yield for the risk of that asset class. But if you pull that apart and you look at sort of the macro demand drivers in the United States economy for real estate, you look at the pricing readjustment. We believe that there's a really a good potential entry point today for entering the private real estate space. And that's a focus when you look at the demand themes that we see. in the housing space, the logistics space, and even the necessity retail and healthcare space as well.
Tony:
So that's a perfect segue into, I know you've been talking about these big macro themes, and I've argued that real estate is not a monolithic investment decision. It's a diversified investment decision with offices being the area that gets the most attention. But what are those macro themes and where are you seeing opportunities?
Rick:
: Yeah, I mean, the macro themes start with almost every investment demographics, right? So you have millennials peak, I say, 33 year olds entering their housing formation years, peak earning and consumption years. We also have on the other end of the boomers, often their parents living longer and requiring different types of housing and other healthcare needs. We look at innovation. So e-commerce penetration has driven logistics and warehouse in the United States and globally. We continue to see that e-commerce penetration increase in retail sales, so we think there's tailwinds in that sector. There's also healthcare technology, which is changing significantly and providing opportunity to invest as well as again, as people live longer. The shifting globalization and investing in manufacturing theme is huge. That's provided new opportunities for where we find warehouse space, where the shifting trade patterns are providing new opportunities for new locations. That's also providing new housing demand as well. There's markets where new manufacturing has gone in, whether it's chip manufacturing or other types of manufacturing are providing other types of housing demand as well.
We fundamentally have a housing shortage in the U. S., so we hear a little bit about housing oversupply in certain markets in the short term, but fundamentally we believe we're over three million units short of housing. Really post the global financial crisis, we have not been building enough for sale homes or rental product. That's one reason why housing costs have gone up, and then we have the demographic theme behind it as well. So you blend all those together.
We also think of resiliency. We obviously see the need to be in resilient economies and places and understanding the different impacts of the changing environment that we're in. So we blend all those together and that really focuses us on housing, different types of housing. Warehouses, logistics, different types of that as well. Even indoor outdoor storage and some other themes behind that. And then on the healthcare side, it's more senior type housing and other opportunities there.
So really that drives us to a broad set of demand in the space, but certainly excluding certain sectors such as office that you spoke about.
Tony:
Maybe Rick, I'll stay with you on this because I think you kind of tease some of this out already, and that is, when we think about allocating capital in 2025 and beyond, we've been making the point for the last couple of years that there's two macro themes we've been focused on. One is we believe there'll be a larger dispersion of return between the winners and the losers just because of the macro environment has shifted so dramatically over the last several years. And the other is putting capital to work in ‘21 versus today where you've had a lot of that excess taken out of the market. So maybe if you can, talk to us about how do you view those macro themes and what impact do you think it has when you think about allocating capital today?
Rick:
I think the two themes are really important. One of the timing, right? And so we don't think again, real estate is a timing investment. We think it's a durable investment class that should be a strategic part of a portfolio. But certainly entry point does matter. And if you can come in when values have adjusted and the private real estate markets have adjusted down over 15 percent over the last year and a half. And so, if you can enter at a low replacement cost valuation, we think you can argue we're entering a new cycle and it makes a lot of sense.
With regards to sort of who you invest with, I think to focus on managers that have been doing something for a long period of time, fiduciaries to their investors, and really can focus on certain type of investing, right? And not get distracted by the latest fad of different ideas and really just continue to do the same thing brings expertise and knowledge to a place. And you've talked about in the private markets, we've seen manager selection does matter because there is a wider dispersion of returns.
Tony:
It's so true. And thank you for all of that. Let me turn to Taylor, the same sort of question, you know, these macro themes that again, we're not trying to time the market, but if you have the opportunity to sit on dry powder today or you have the ability to put capital to work, are you seeing different opportunities today than you have in the past? And then this whole issue of dispersion of return, I think really does speak to the fact that you need to have the experience of navigating in good times and bad.
Taylor:
Sure, so first, I mean, the guiding principle in secondary is to have as low a dispersion of returns as you possibly can because it's an asset class where investors expect to sleep easily at night. So if we're doing our job correctly as a market, the bandwidth of potential returns is quite narrow. Ours is a funny market because you're pricing deals off of today's valuations, but you're looking out into the future deciding what you think that set of cash flows is worth and deciding what price in return you want based on the values today.
So it may be the only market I can think of where you have the ability to buy the same asset or set of assets at different points in its valuation cycle. And so, in 2021, we might have bought a fund at a higher valuation or earlier in its life with limited discount with the assumption that those assets would return, obviously, a higher amount in the future.
Today, we're three years later. That asset could be marked in the same place. It could be marked lower. It could be marked higher based on performance. And we just adjust our pricing to earn that same return today. So it's a little bit of a different asset class. You have the ability to price assets at different points in time, if that makes sense.
And then in terms of dispersion, the entire secondary market will hit a record volume level this year. It could be 150 billion, maybe 140 billion, I think is what I last saw on some of the projections. That's a lot bigger than the last peak year, but that's still relatively small. And it's a growing market.
When I started doing this, the market was about 9 billion dollars globally that year. Less than half of our current global fund that we're investing today. And so as markets grow and mature and different firms specialize, I think when we look back five, 10 years from now, you're going to see a wider dispersion of outcomes just because the practitioners in the market have specialized in the types of deals they do and the way they do it.
So the market is changing in ways where there are different deal types. The buyers are specializing and there will be a wider dispersion of outcomes for a number of reasons. But again, I go back to, for most people, this is a strategy where they expect broad diversification. They expect predictable cash flows and a bandwidth of returns and so, we ought to be doing that. Otherwise, it will be harder for us.
Tony:
Rich, thanks so much for joining us. We're excited about the opportunities as we start to peer forward and think about 2025. Where are you seeing the most attractive opportunities and why?
Rich:
Great to be with you, Tony. As you know, at BSP, we do everything credit, liquid credit, illiquid credit, private credit, real estate credit, distressed credit, and we're always looking over the landscape to see where the best relative value is. And today to answer your question, it's real estate credit.
Tony:
Yeah, it's exciting. And I know you've been writing and speaking about it quite a bit. Why is now such a good time for real estate debt when everyone seems to be concerned about the real estate market.
Rich:
Yeah, well, Tony, you're right. It's a bit counterintuitive. Often when things are at their worst, often creates the best buying opportunities. And I think that's the case here. And think about what's happened in the real estate markets. The rise in interest rate for all asset classes, of course, has had a meaningful impact on valuations for real estate borrowers. It's affected their ability to service their debt and to refinance that maturity. And there is a wall of maturity in real estate credit that's upon us now. Something like 1.7 trillion over the next few years. So that's reason number one. But the bigger reason is the office sector. Office has been, and I'm sure I'm not telling anybody anything they don't already know, but office has been a major problem across the board, of course, ever since COVID. There's just more office space than there are people that want to work in offices.
And that's going to create some really bad outcomes for a lot of lending portfolios. And those bad outcomes are leading those lenders to hoard their cash and not make loans right now. So for the lenders with capital, like us, for example, we're really getting the pick of the litter of deals right now. And that's why it's so attractive.
Tony:
So Rich, let's be a little bit more specific. I know you're concerned about the office sector and that's probably an area that's going to be under distress for quite some time, but you are seeing attractive opportunities when you're looking at lending within real estate. Maybe share with us just where those opportunities are.
Rich:
Yeah. So at the moment, I think office is somewhat off the table. Of course, we'll always look and there might be a situation that might be worth investing some capital. But for us, as we have focused in the past, our portfolio is constructed with the leading part being multifamily. We're under supplied of single family homes. The cost of a mortgage just went up dramatically when rates started going up. So the affordability of a home has become something even further away from most people. That leads people to multifamily.
Separately, there's tons of liquidity in multifamily. We've either through deed in lieu or through some other portfolios, we've run, have sold some properties recently, and there's just been a line around the block, literally, of bidders looking for multifamily. I think people think it's a good time to buy. So as a lender, you always want a liquid underlying asset class, which I don't think you have in most of the other varieties.
And then lastly, nobody is starting to build or has built since rates started going up in 2022. What does that mean? It means that there's no new capacity being delivered. And for the most part, in most of the ‘25, certainly ‘26 and maybe ‘27. So we think that's going to lead to some real attractive rent growth. The big knock against multifamily now is there was so much capacity built in 2021, let's say, when money was virtually free coming out of Covid, that rent growth really slowed. ut I think it's a question of skating to where the puck is going, not where it is. And looking out that rent growth story just seems to be stacked in our favor, so that's why about 75% of the portfolios we've been constructing are multifamily.
Tony:
Lots of great insights as always. And Rich, we've been talking about this theme for the last couple of years, where we think there's a difference in putting capital to work today. And we also believe that there's going to be a larger dispersion of return and differences between the winners and the losers in the marketplace. And I think that's so true when we think about the commercial real estate debt sector. What are your thoughts?
Rich:
Absolutely, Tony. So we'd be foolish to think that an opportunity like the one I'm describing, where there's a whole lot of supply and not a lot of demand is not going to lead to capital markets being efficient and more lenders coming out of the woodwork to take advantage of the opportunity. But you're right. Those lenders are not always the folks that have been doing credit all their lives, sort of like the way we have. There's so much nuance to credit documents and adverse selection around different properties, different portfolios and different sponsors that I think that experience will always shine through.
Tony:
Thank you so much. There's so much there to unpack. The one thing I'm just going to maybe leave our audience with is something you said at the end, which I think is such an important thing, which is you are now the term maker, as opposed to the term taker, you're dictating the terms that you're lending capital, which I think the pendulum has shifted and private credit managers really sit at a great position right now.
Rich:
Absolutely agree with that, Tony, the supply demand imbalance that exists in commercial real estate lending does not exist right now in many other asset classes. For example, private credit, you know, or corporate private credit, we love, I mean, it's a big sector of ours. We think there's great relative value relative to the liquid markets. But the fact of the matter is with a slow M&A calendar and lots of capital being raised, searching for opportunities. That supply demand balance is the other way, where there's more capital than opportunity. That's what we like so much about the real estate market, is when there's more supply than demand, you tend to be able to make your own terms, as you said.
Tony:
Thank you, Rich, Rick and Taylor. We've covered a lot here today. Thank you for your insights on the opportunity. Thank you for sharing your views on some of these macro themes, which we think will be something we should all be paying attention to in the near future.
I want to remind everyone that we have a really comprehensive 2025 private market outlook that gets into all of these topics in much greater detail. But we wanted to hit the tips of the wave today, talking about secondaries, talking about real estate, and talking about real estate debt. Thank you all for the participants who have been listening to us and giving us great feedback on the Alternative Allocation podcast series, and good luck investing, everyone.
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