Invest in People
Ask a CIO: Week 4
Early in the buildout of Ivy Invest, we ran a series of live interviews with potential users. Everyone interviewed had at least a passing interest in investing, but beyond that, it was a cross section of folks across ages and professional backgrounds. We asked a set of questions and kept an open mind.
We ended up with a bunch of unexpected insights. For me personally, one question really stuck out – we asked each person to rank order the importance of certain features when making investment decisions. The choices were slightly more detailed versions of returns, volatility, diversification, access, and team.
The professional investors, almost always, selected team as most important. Everyone else, without fail, selected team as least important.
In retrospect, I shouldn’t have been surprised. The disparity makes total sense. How often do individual investors interact with or hear from the decision makers behind the investments they make? Yet institutions would never invest without knowing who they’re partnering with, because investment funds are ultimately just a group of people and IP.
People and Process
What makes a great investment? Are there any consistent traits or themes among the best investments you’ve made?
Great investments are only great in hindsight, because they worked out. Ex-ante, there are no guarantees that anything will turn out to be a great investment.1
I think it’s important to state the above, because it can be easy to mistake a good outcome with a good process, and vice versa. But you’re right, the best investments do have some commonalities, and looking for these traits increases the odds of making great investments.
First and foremost, my best investments have been investments in the right people. Experience matters.2 Given this week’s intro, you probably could have guessed this is where I was going.
Investing in the right people is a fuzzy concept, so I’ll try to make it a little clearer. The best teams have a clear right to succeed in their market. They have the skillset and depth of experience to capitalize on the opportunities at hand, and that can present as having an advantage in sourcing, trading, structuring, operating, etc. They understand and appropriately manage risk (arguably the biggest differentiator). And they generally have some distinct, differentiated viewpoint into why they do what they do.
Investing in the right people also means investing in firms that operate ethically and with high integrity. They have tight risk controls across the firm. They’re well-regarded counterparties in their markets. They have a strong alignment with their investors and provide a reasonable degree of transparency.
I’ll frame this another way. I’ve been investing long enough that I’ve made my share of mistakes. Sometimes I underwrote the right people, but the opportunity set wasn’t what I thought it would be. I can live with that. But the mistakes that haunt me are the ones where I invested even though I had some doubts about the people (e.g., team dynamics, alignment with investors, maturity, risk appetite, etc).
A second trait, closely associated with the first: great teams have great processes. I could underwrite and understand how these teams navigated their markets and executed their strategies. I had a reasonable understanding of what these managers might do in different scenarios, and just as importantly, could understand when something wasn’t part of the typical process. Great teams with consistent, repeatable processes tend to create for themselves entrenched advantages that accrue over time.
Finally, my best investments have had structural longevity. They tended to be investments in markets with persistent inefficiencies, where the team’s expertise and processes could lead to continued attractive outcomes.
So basically – my best investments came down to a combination of great people, processes, and markets. Obvious in hindsight, right?
Secondary Markets
What are private equity secondaries, and are they good investments?
There are two parts to the private equity secondary market: LP (limited partner) secondaries and GP (general partner) secondaries.
Stepping back, when an investor (“LP”) makes an initial investment into a private equity fund, the LP is making a binding commitment to invest a certain dollar amount over a certain extended time. The private equity fund (“GP”) makes capital calls and draws down the commitments during the life of the fund (generally 10+ years). The LP then receives quarterly statements reflecting the status of the investment – total commitment, remaining uncalled capital, capital distributed, and remaining portfolio value.
In the early private equity days, if you were an LP and wanted to exit an investment, you couldn’t. You had to wait until the fund ended. Sometime in the ‘80s/’90s, a group of investment funds realized there was a market opportunity to purchase existing private equity investments, and any associated unfunded commitments, from LPs that no longer wanted them. But it was seen as this undesirable transaction that could reflect poorly on both the GP and the LP, so transactions were discreet, discounts were wide, and sourcing required directly reaching out to LPs.
Today, the LP secondary market is much more established, with investment bankers intermediating sale processes. LP secondary sales are viewed increasingly as portfolio management tools, and over $60 billion of LP secondaries transacted last year. Like any other established market, there are some periods where private equity LP secondaries are more attractive and some less so.
If you’ve read the WSJ lately, you’ve probably seen the articles around large institutional investors over-investing into private equity and looking to sell down diversified portfolios of private equity funds, partly to reduce exposure, partly to reduce to unfunded commitments. In conversations with secondary funds, I’m hearing that the pricing is good, but more importantly, high quality funds are being included in portfolio sales.3 This seems to be a good period for LP secondary buyers.
The GP-led secondary market is newer and has grown really quickly in the past five years or so.4 GP-led secondaries totaled over $50 billion last year, and are expected to account for half of all secondary market transactions going forward.
A GP-led secondary is a transaction where a private equity firm sells a portfolio company not to another fund or strategic buyer, but to a continuation vehicle (“CV”) that is established by the private equity firm specifically to purchase the company. The argument generally goes: the portfolio company is doing really well, the private equity firm wants to return capital to existing investors (because investors like capital back), but the private equity firm believes it can generate a lot more value by holding on to the company a while longer. In comes the CV as a solution. The fund sells the company to the CV, returns capital and gains to the LPs that want the distribution, and the fund continues to run the company through the CV.
Who’s funding the CV and buying the portfolio company from the fund? Usually the same secondary funds that make LP secondary investments. GPs almost always fully roll over their ownership and economics into the CV, and existing fund LPs have the option to roll their capital and gains into the CV or take the distribution.
Are GP-led secondaries good investments? It depends on who you ask. The track record so far has been mostly good – there are high profile examples of CV investments generating big returns in short periods of time (e.g., SRS Distribution). But the LPs that are being asked to make the decision between a distribution and CV are not universally thrilled.5
To sum up, in a vacuum, private equity secondary funds have a lot of compelling attributes. Investors gain exposure to diversified private equity portfolios (diversified by vintage year and manager) with minimal or no J-curves. In the current environment, they’re also capitalizing on attractive tailwinds. More broadly, the growth of private equity secondaries is changing the private equity landscape and the options that are available both to LPs and GPs. Long-term, I think it’s a good thing, but change is hard.
Asset Class vs. Fee Structure
Are hedge funds just a big money-making scheme?
Oh man, I laughed when I saw this question. Fairly or not, it’s so easy to be cynical about hedge funds.
Hedge funds started out as primarily long/short equity investment strategies. A fund would invest in a portfolio of stocks that it expected to outperform the broader stock market and at the same time sell short a portfolio of stocks that it expected to underperform the stock market. In a good market, the long portfolio should outperform and more than offset losses from the short portfolio. In a bad market, the short portfolio should generate gains and hedge the losses from the long portfolio. Hence, hedge funds.
In return for the smoother, and over time, presumably better performance, hedge funds charge a management fee (a fee on total assets managed, typically 1% to 2%) and incentive fee (a share of all profits generated, typically 20%).
Over time, hedge funds expanded beyond long/short equities to include all sorts of other strategies – activist, event driven, credit-oriented, systematic, macro and CTA (managed futures), relative value and fixed income arbitrage, etc. These strategies take such different risks and approaches that you might say all they have in common at this point are the fees they charge.
And the fees are worth discussing. Hedge fund incentive fees typically have no hurdle rate attached, meaning that managers can generate mediocre returns for investors but still collect a lot for themselves.6 It’s not a stretch to say that hedge fund incentive fees are like call options on portfolios, which can lead to some really bad portfolio management decisions.7
On the other hand, of course there are great hedge funds. There are hedge funds that year after year successfully produce uncorrelated returns. They manage to consistently identify mispriced securities, hedge out market beta, and generate alpha. They combine exceptional risk management with some informational, sourcing, structural, or process advantage (i.e., the funds themselves have the ability to catalyze value).
All that said, how you think about hedge funds also has a lot to do with your expectations. The purpose of hedge funds is to provide diversification and non-equity correlated returns to a well-rounded portfolio. There’s a cost associated with that diversification, and as pointed out earlier, it’s not cheap. A lot of hedge funds are also short-term trading oriented and generate highly tax inefficient returns. For tax-exempt dollars, that’s not an issue, but it can really diminish the value to a taxable investor.
So are hedge funds just a money-making scheme? The short answer is, in many cases yes, but in plenty of cases, no. In other words, it depends – it depends on the manager, it depends on the strategy, it depends on your circumstances and goals. But if you’re a taxable investor with no background in hedge funds, and someone is selling you a hedge fund, you should probably think twice.
As always, if you have a question, I hope you’ll reach out: askacio@ivyinvest.co.
Until next week,
Wendy
Sure, there are market dislocations where the risk/reward is vastly in your favor, but these are generally trades versus investments, and you still need to get the timing and execution right. These are often great examples of investments that are most obvious in hindsight.
Experience is key, but a team’s “combined years of experience” is not. It is absurd. If this footnote prompts anyone to rethink the phrase in a marketing deck, I’ll consider it a moral victory.
There are multiple ways to make money in LP secondary investing. There are smaller funds that focus on tail end portfolios and capture wide discounts to NAV. There are funds that focus on mid-cycle portfolios and underwrite growth in the underlying portfolio companies. There are large funds that benefit from being liquidity providers to the largest transactions. The common factors for success are experience and detailed underwriting models. There’s nuance to structuring, financing, choosing reference dates, etc. It would be tough to do one-off transactions.
The GP-led secondary market isn’t exactly new, but it used to be bad assets or bad funds looking for some path to winding down. That’s no longer the prevalent use case for GP-led secondaries, and the current iteration looks so different, it may as well be new.
From an existing LP perspective, it can be hard to justify not taking risk off the table. At the same time, post transaction, the CV is often the GP’s single largest investment and biggest source of future carry. The GP is incentivized to focus on the success of the CV, arguably disproportionately so relative to all other fund investments. For better or worse, LPs will increasingly need to navigate these decisions because it’s clear that GP-led secondaries and CVs are becoming a permanent fixture in the private equity landscape.
It is remarkable that hedge funds have more or less retained the ability to charge incentive fees over 0% hurdles. Managers in other asset classes generally have to meet 6% or 8% performance minimums before collecting incentive.
LPs have seen all sorts of not great behavior. Funds that change strategies to match market fads. Funds that are underwater and take inordinate risk to try to recover. And my favorite, funds that are so underwater the manager insists the strategy no longer works and shuts down the fund, only to reappear two years later with a new fund (and more conveniently, a new highwater mark).