At the Money: Lessons in Allocating to Alternative Asset Classes

Hedge funds, venture capital, private equity, and private credit have never been more popular. Investors have lots of questions when allocating to these asset classes:  How much capital do you need? What percentage of your portfolio should be allocated? Ted Seides is founder and CIO of Capital Allocators, and learned about alts working under the legendary David Swensen at the Yale University Investments Office. He wrote the book, “Private Equity Deals: Lessons in investing, dealmaking and operations.” Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

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• 1:19Barry Ritholtz?

  Hedge funds, venture capital, private equity, private credit. Allocating capital to alternatives has never been more popular or more challenging. How should investors approach these asset classes? I'm Barry Ritholtz, and on today's edition of At the Money, we're going to discuss how investors should think about alternative investments. To help us unpack all of this and what it means for your portfolio, let's bring in Ted Seides, who began his career at the Yale University Investments Office under the legendary David Swensen. He's founder and CIO of Capital Allocators, and since 2017, has hosted a podcast by that same name.

• 2:00Barry Ritholtz?

  His latest book is Private Equity Deals: Lessons in Investing, Deal Making, and Operations from Private Equity Professionals is out now. So Ted, let's start with the basics. What is the appeal of alternatives?

• 2:14Speaker 03

  If you start with, let's call it a traditional portfolio of stocks and bonds, the idea of adding alternatives is to improve the quality of your portfolio. Meaning, you're trying to get the highest returns you can with a similar level of risk, or sometimes the same kind of returns with a reduced level of risk. And bringing in these other alternatives help you do that?

• 2:37Barry Ritholtz?

  All right, so there, I mentioned a run of different alternatives. How do you distinguish between private equity, private credit, hedge funds, venture capital, lots of different types of alts? How do you think about these?

• 2:51Speaker 03

  Each of them have their own different risk and reward characteristics. And that's probably the easiest way to think about it. If you go from a spectrum, private credit, think about it as the same as bonds, a little bit different. Hedge funds can be like bonds or stocks, a little bit different. Then you get into private equity, which is kind of a little bit of juiced stock portfolio. And venture capital is the riskiest of them all.

• 3:15Barry Ritholtz?

  So you're discussing risk there. Let's talk about reward. What sort of return expectation should investors have for these different asset classes?

• 3:24Speaker 03

  Well, similarly, private credit, think about a bond portfolio with credit risk and a little bit of illiquidity. So that's bonds plus, is it bonds plus 200 basis points? Maybe something like that. Hedge funds generally have either bond-like or stock-like characteristics with less risk. Private equity, you should expect a premium over stocks. And venture capital, a premium over that because of the early-stage risk.

• 3:49Barry Ritholtz?

  Those are really kind of interesting. You mentioned illiquidity. Let's talk a little bit about the illiquidity premium. What does that mean for investors? What's involved with that?

• 4:00Speaker 03

  When you start with just traded stocks and bonds, you can get out instantaneously. So if you're going to commit your capital to any of these other categories, you have to embrace some illiquidity. Meaning, if you want to get out in that moment, it's going to cost you. So to take on that risk, you need some type of extra return. Otherwise, it wouldn't make sense to do it. So the concept of an illiquidity premium is that in order to pursue these strategies that Prevent you from accessing your money instantaneously, you need to get paid for that.

• 4:35Barry Ritholtz?

  So where does the illiquidity premium come from? My assumption was because this is so much smaller than public markets with so many fewer investors, perhaps there are some inefficiencies that these managers can identify? Any truth to that?

• 4:52Speaker 03

  It depends on the strategy. That would be the story with hedge funds, for sure. When you get into private equity or venture capital, it's always in price. So if you're getting the same asset that's in the public markets or the private markets, in theory, you should want to buy it at a discount in the private markets because you can't get your money out quickly. And that's where you would see that premium.

• 5:15Barry Ritholtz?

  And so, since we're talking about lockups and not being able to get liquid except at very specific times, how long should investors expect to lock up their capital on each of these alternatives?

• 5:27Speaker 03

  It depends on the strategy and whether you're investing directly in these securities or let's just say you're in funds. So private credit can vary, but oftentimes you may not get the liquidity until the assets are liquidated.

• 5:39Barry Ritholtz?

  So that could be anywhere from five to 10 years.

• 5:40Speaker 03

  It can be. Hedge funds often are quarterly liquidity, depending on the underlying. You get into a private equity or venture capital fund, now you're generally talking about 10 to 15 years.

• 5:52Barry Ritholtz?

  Because you have to wait for that private company to have some liquidity event to free up the cash.

• 5:58Speaker 03

  And on top of that, if you're investing in a fund, you have to wait for the fund manager to find the company. So you're committing your capital, they find the company, they might own it for, say, three to eight years, and then you're waiting to get the cash back.

• 6:10Barry Ritholtz?

  Huh, that's really kind of intriguing. All right, so when investors are interested in alts, how much capital do they need before they can start seriously looking at the space? Is this for $5 million portfolios or $50 million portfolios?

• 6:26Speaker 03

  It's changing a lot to move to smaller numbers. So if I go back to when I started in this, you didn't have pooled alternatives. Think about fund of funds or all this movement of the democratization of alts. And a minimum might be $1 million for a single fund. If you wanted diversification and you wanted, say, 10 different funds, now you're talking about 10 million. And if that's only 10% of your portfolio, you're looking at $100 million just to make it.

• 6:51Barry Ritholtz?

  Those are big numbers.

• 6:52Speaker 03

  Those are big numbers. That has changed a lot and now you're starting to see more and more products available at, you know, rather than a million dollar minimum, maybe it's $50,000 or even less. So it's a little bit less what size. I mean, you do need to have, you know, is it 5 million? Is it 10 million? I don't really know. The goal is-

• 7:14Barry Ritholtz?

  But it's not $500,000.

• 7:16Speaker 03

  It's not $500,000.

• 7:18Barry Ritholtz?

  Right. So, so, and you were saying the goal is-

• 7:21Speaker 03

  Well, the goal is to get access to some of these areas, hopefully in a very high-quality way, and have some diversification within the strategy that you're pursuing, and that does take some capital.

• 7:31Barry Ritholtz?

  So, so you just said something really interesting before, 10 different funds and a million dollars each out of 100 million dollars. You're implying that investors should allocate a certain percentage. So let me, rather than use that example, let me just ask that directly. How much in the alt and private space should investors think about allocating in order to generate potentially better returns and increase their diversification?

• 8:01Speaker 03

  It's entirely a function of, let's say, a liquidity budget. So, as you mentioned, you need to lock up your capital, particularly when you're getting into private equity and venture capital. And that means you can't access it. So if someone has enough money that they don't really need to access, you know, if you have 100 million dollars, you're probably not accessing most of that year to year. And you've seen in some of the most sophisticated institutions, all these alts get up to 50% of their portfolio. If you're talking about maybe you have 5 million to invest, it's not clear you want to take half of that and put it away so that you can't access it in case you need the capital in between now and 15 years from now.

• 8:45Barry Ritholtz?

  So a phrase I heard that kind of made me giggle, but I want to share it with you. 60-40 is now 50-30-20. What, or some variation to that effect. What are your thoughts on that?

• 8:58Speaker 03

  I think about it a little bit differently, which is most of the time you want to think about the risk and return of the overall, and you can break that down into stock bond risk. So whether that's 60/40 or 70/30, that's fine. The question with alts is how do you want to take that risk? So rather than in a 70/30, having 70% in US stocks, you may want to say, hey, maybe 20% of that should be in private equity. You have similar risk, but you have a different type of return stream and hopefully a little more octane.

• 9:30Barry Ritholtz?

  That's kind of interesting. Let's talk about fees. It used to be that 2 and 20, 2% of the underlying investment plus 20% of the net gains was the standard. What are standard fees in the alt space today?

• 9:47Speaker 03

  It is a function, a little bit of that return characteristic. So if you get to the higher octane, private equity and venture capital, you generally do still see 2 and 20. On hedge funds and private credit, it tends to be a little bit less than that. But make no mistake about it, the fees are higher in the alternatives than they are in the traditional world.

• 10:04Barry Ritholtz?

  How should investors go about finding alternative managers and evaluating their funds?

• 10:10Speaker 03

  So this is incredibly important because unlike in the stock and bond markets, the dispersion of returns in alts is much, much wider. Meaning if you find a good manager, it matters a lot more than if you find a good stock manager, a good bond manager. Conversely, if you find a bad one, it hurts you much more than if you're hurt by stock and bond. So how do you do it? It does take a fair amount of research and either a trusted advisor or someone who knows the space. There's a lot of different ways to get involved in that. One of the ways you're seeing more and more as alts get democratized is the bigger brands are creating products. You can go to Blackstone and you'll be fine.

• 10:53Speaker 03

  I don't know if you'll get the best returns, but you're not going to get the worst returns. And so one way that people think about participating is you look at who these larger public alternative managers are. It's a Blackstone, Ares, Apollo, KKR, TPG. These are super high-quality investment organizations.

• 11:12Barry Ritholtz?

  How do you gain entry to the best funds? A lot of, you know, it's a little bit like the old Groucho Marx joke. I wouldn't want to be a member of any club that would have me. The funds you want to get into the most very often require giant minimums because they're working with foundations and endowments. And very often, they're either closed or there's a giant queue to get into them. How does one go about establishing a relationship? P.S. All these questions come right from your book. But how do you go about establishing a relationship with the potential alternative funds that you might want to have exposure to?

• 11:51Speaker 03

  Yeah. It's really hard, particularly as an individual. If you think about it, you're competing with all of those very well-resourced institutions, endowments, foundations, pension funds, that have people, well-compensated people, that are out looking for these funds. So the question you have to ask is, what are you trying to accomplish? And that can be different for, you know, different people and different organizations. But generally speaking, it does require working into networks where you start to learn who the players are and trying to figure out from that who are the better ones. It takes a lot of time to do that well.

• 12:32Barry Ritholtz?

  So if someone wants some assistance in building out the alternative portion of their portfolios, where do they begin looking? How do they go find that sort of, those sort of resources?

• 12:46Speaker 03

  Usually, the first step comes from the fund of funds world. And you could look at, as a great example, Vanguard now, as part of their retirement package, did a deal with Harbor Vest. Harbor Vest is one of the leading fund of funds to allow entry to get good quality exposure. So a Harbor Vest, a Hamilton Lane, StepStone, some of these are some of the bigger established, say, private equity fund of funds. They do a very good job of getting people access to high-quality exposure.

• 13:18Barry Ritholtz?

  Huh. So if you're, if you're a 401(k) at Vanguard, do you have access to that? Or is that just broad portfolios?

• 13:27Speaker 03

  I know it exists within their suite. I'm not sure if it's part of their target funds or you can directly access.

• 13:34Barry Ritholtz?

  So what are some of the bigger challenges and misconceptions about investing in alternatives?

• 13:41Speaker 03

  Well, the biggest misconceptions come from the public perception of it because most of the time in the news, you only read about sensationalization. You read about huge returns and big failures. In almost all the cases, and let's set aside venture capital because venture capital is designed to have huge successes and failures. All the action happens in the middle. Hedge funds, generally speaking, are very boring. They're not newsworthy. They shouldn't make the news. Private credit's the same way. There will be a time in private credit where there are defaults and you'll read about defaults. But you probably won't read that the returns are just fine, even with the defaults.

• 14:20Barry Ritholtz?

  So how do investors go about doing some due diligence on the funds they're interested in? How do they make sure they're getting what they expect to get?

• 14:30Speaker 03

  A lot of it starts with meeting the people and trying to understand what is their philosophy? What is their strategy? And how do they go about deal making? You then can get into the data. So any of these firms that's been around, they've done deals in the past. And you could try to figure out, how do they add value? Do they buy well? Do they run the companies well? Do they sell well? Is it financial leverage? And then trying to figure out what you think works? And is that a fit with how that firm pursues investing?

• 15:01Barry Ritholtz?

  Really interesting. So to wrap up, investors who have a long time horizon, a substantial portfolio, the time, effort, and interest in exploring the alternative space may want to pull some modest percentage of their holdings aside and locking these up for an extended period with the hope of getting a better than average return on a diversified basis, or an average return on a lower risk basis. Start out by looking at some of the bigger names in the space that Ted had mentioned. Do your homework and your due diligence. Go into this with open eyes and make sure that you are not allocating too

• 15:46Barry Ritholtz?

  much capital to a space that might be locked up for five or 10 years or more. Successful alternative investors have been rewarded with outstanding returns. Unsuccessful ones have underperformed the public markets. I'm Barry Ritholtz, and this is Bloomberg's At the Money.

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