Alternative assets are less correlated, if not entirely uncorrelated, with public markets than traditional assets, and the best executed strategies can offer outsized returns. The deals are long-term and illiquid in nature and have been increasingly sought after by institutions to both diversify and de-risk their portfolios, especially amid current turmoil in the public markets.
We have interviewed over 40 institutional investors. In this week's edition of Trusted Answers, we look at some of their insights on the challenges and opportunities of including alternative assets within an investment portfolio:
Private equity is such a long-term strategy. The issues that we’re currently facing when investing in a fund now are probably going to be different when we exit the investment five to eight years from now. You need a long-term perspective, especially when you're looking at the emerging markets. We do recognize the risk, and I don't think you should overweight this year, but you also have to be consistent and make sure you diversify your investments across the vintage years.
As for the year 2016 and how we are positioned, we have fortunately performed very well in 2015, but on an annual basis, we actually don’t move the needle that much. Because of the nature of the capital and how we invest, we tend to be focused on finding the right companies and the right managers to invest in these regions. These managers and companies have always exhibited amazingly a fairly high degree of resilience versus the local markets, especially when the local markets are seeing volatile times.
For us, it’s about finding the right managers and the right companies and sticking with them for the long run.
…Because we are more focused on long-term results than on the annual results, what we have found is that in the years when there is a lot of venture funds getting raised and there are a lot of high-valuation investments getting made, those vintage years have not turned out as great.
…My general thesis is in years when there’s a lot of money getting raised, the returns won’t be as great. And in years when everybody is worried and there is less capital getting raised, then sometimes the returns turn out to be better. Of course, investing into venture is not a game of averages. Really, the macro trend matters less to us in our daily decision process than who it is that we are investing with.
The very nature of venture creates bubbles and bursts.
The very nature of venture creates bubbles and bursts.
The bottom line is that as an investor the one thing I want my venture capitalists to have is optimism. You can’t be a good venture capitalist if you don’t believe you can create something out of nothing, or the potential exists to create something out of nothing. Fundamental to their core is a sense of optimism and a little bit of master of the universe.
Making sure that they can operate in the context of the market, that they can dampen down the optimism, and there’s some arms around it to keep it from getting crazy, is important. However, the market will have bubbles by nature of who the people are and by nature of what the market is.
Do I think we are getting close to bubble territory? Things are over valued for sure. There are things that are going on, that we keep saying we are not going to do again, that are definitely happening. For sure, the venture capital market was in a bubble all the way from 1997 to 2000. It took until March 2000 for it to burst.
These bubbles can last for a while, and it’s hard for me to tell you when the bubble is going to burst. Do I think that things are overvalued, strictly based on long-term potential of some of these assets, I would say yes. But arguably not, if you think about where venture capitalists might or might be able to exit. That timing game is something venture capitalists are going to get caught up in over and over again. We, as LPs, have to be cognizant of that and size it accordingly and make sure that we are comfortable with the level of risk in our portfolios with respect to venture. The ability to navigate these cycles is tough, and it is one of the things that really differentiates a top quartile venture capitalist from an average venture capitalist who will often give back all of the good performance when the market corrects. It will play out, over and over again, in a cyclical way.
Private equity, people often argue that it’s different from equity, but it’s equity. It’s just equity without as much perceived volatility, and with leverage. You have the same market dynamic. Exit values are tied to the public markets even if it is an acquisition. There are tons of different factors that go into making buyouts good or not, such as operational improvement and economic factors, but valuations are tied to public market multiples.
We are concerned about what rising interest rates will do to the buyout space, in real estate specifically because those are leverage markets. We are focusing much more on strategies that don’t require a lot of leverage or have strategies that allow it to have fixed rate debt, if they’ve got to have debt at all. Preferably debt that is paid down and possibly assume-able by a buyer.
We know that when interest rates rise, there will be margin compression. We want people to be disciplined about how they are buying, because we think that the selling market we be very different than the market we are in right now. That naturally pushes us toward turn-around and more distress-y type things, because that’s where the valuations are a little lower. That said, there’s not a lot of it out there. For a variety of reasons, there are issues. That’s how we think about privates right now.
...The market for private equity and venture is a global market, unfortunately. In the past, you could go to different markets and get a discount in valuations. That’s harder to do now. Usually the discount is because of a reason, and you have to know that your GP is good at navigating those reasons or that people are mispricing them.
Global growth is slowing. There are pockets of growth in different places, but where there’s growth, there’s oftentimes underdeveloped markets that make it challenging for you to have good quality exits.
We are biased, quite honestly, to the U.S., because it takes out some risk that we are not as comfortable pricing. You take out rule of law in some respects. Look, things happen here where regulations and laws change that will disrupt your investing, but you have at least a little bit more, or a lot more, of an ability to look through and rely on the rule of law here. We are a U.S.-based foundation, and we mostly invest in the U.S.; we don’t have currency risk that might be a problem for us.
The tendency to be biased toward the U.S. and the way we invest, that’s true about private equities and venture as well. However, we do invest in Asia in our private equity portfolio. There was greater evidence of a strong local market that could support the growth of these companies and improving talent. They are not as developed markets, and there is a ton of risk in that.
In all cases, there is not an asset class or geography, at this point, that we don’t feel strongly that you have to be a good manager and a good asset selector. I don’t know that we can say that we love any one market. We love managers within a market that we think see things differently.
I mentioned that we now run a more focused portfolio of managers. That's definitely a trend we're seeing in the endowment community as well. Getting a bit more into investment trends, it's hard to ignore what's happening across the energy landscape right now. Going into the commodities downturn, we were light on energy across both publics and privates. For privates, we now have significant dry powder to take advantage in this lower cost environment.
...I mentioned venture capital previously, and we’re definitely looking to pick up some growth exposure from our venture capital managers, which tends to be somewhat less correlated. It's more about backing the right entrepreneur. It's less correlated with public equities than our private equity book overall.
We continue to have dry powder with some of our distressed relationships. To the extent that there’s a deeper correction across the markets and in the high-yield market in particular, we have capital ready to invest there.
And I touched on the energy sector. We are not expecting a lot of growth from this sector in 2016, but I do feel like we have reached a point where it is more attractive to be putting money to work in energy.
Venture capital is pretty much about optimism, because you're starting with young companies.
Public markets started off rocky this year, and people tend to be less optimistic in such environments. Venture capital is pretty much about optimism, because you're starting with young companies. In an environment where people are less optimistic, there would tend to be less activity. Venture capitalists might not be saying it explicitly, but I think everyone is wondering about unicorns. If the market is volatile, then it's probably not going to be a record year for funding.
...The U.S. is still very important, and that's not going to end. When the world is volatile, historically people tend to come back to the United States. The U.S. is a prominent part of our portfolio, and that will continue.
Emerging markets are tricky these days, but in my opinion, China is still going to become the dominant economy in the midterm. So China is still a very active spot for us as well.
Specifically within venture capital, we’re beginning to revisit Europe. The valuation argument is stronger if you look at the public markets, however, public markets do play into other valuations. The valuations in the developed markets outside of U.S., such as Europe, are more favorable. We are refreshing our portfolio in Europe, although that doesn’t necessarily mean that is the straightforward answer for every portfolio. It might just be our personal portfolio.
Although young, we're already in the top quintile of portfolio return profiles. We're feeling pretty good about our decisions from an investment perspective, including having passed on many overpriced deals.
We actually love the market as it is today. We think we're very well positioned, and that our selective investment philosophy puts us in a great place to capitalize on valuations. This year, we made many good investments. We were listed the top digital health and health IT investor of all investors, and we did that selectively at good prices with great companies.
Throughout 2016 you'll see continued velocity of deals and increased thought leadership from GE Ventures. We expect our investing to grow, and with GE's balance sheet we can lean into the market. We're a long-term, long-focused investor.
...I think most of the discussion around a bubble has been focused around the consumer and enterprise tech categories. I think what’s different today, is that there's actual revenue tied to most of these companies. For companies that are ad-based, they're actually turning eyeballs into dollars, which is great.
I do think those companies need to figure out their P&L structure and cash use, and map that to their growth trajectory. In terms of healthcare, we've certainly seen some unicorns that won't survive, and we passed on those. I think there has been some irrational exuberance, but those types of companies are rare in healthcare. So, even with a correction, we would commit. Most companies wouldn't be too hurt by it, and most valuations have stayed pretty reasonable across healthcare. It's lifted some boats nicely.
Trusted Answers is a weekly series that delves into some of the most pertinent issues within institutional investing, and shares some of the insightful responses from the 40+ institutional investors we have interviewed in the past year. Take a look at some of our other Trusted Answers.