Aug. 17, 2023: Private markets and what lies ahead for family offices
PEER-TO-PEER INSIGHTS: Lazard’s Casey Whalen talks private markets and what lies ahead for family offices
Casey Whalen formerly served as the CEO and CIO of Truvvo, a strategic advisory firm. Truvvo merged with Lazard Asset Management this past spring to create what is now known as Lazard Family Office Partners. Whalen talks with Crain Currency Editor Kristen Oliveri about how family offices can actively participate in private markets and how real assets and inflation come into the equation.
Let’s talk active participation in the private markets. Can ultra-high-net-worth individuals benefit from this approach?
Yes. We believe ultra-high-net-worth investors, who can handle the illiquidity, can greatly benefit from participation in private markets. In many ways, skilled private investors have the potential to add more value in private markets, where they have the ability to be strategic and enhance a company’s earnings stream away from the scrutiny of public market shareholders. Because of this, these investments have the potential for higher expected returns.
Private markets — across venture capital, buyouts, real estate and natural resources — play an important part in a UHNW client’s portfolio and, when managed properly, can provide sufficient compensation for the illiquidity and risk, as well as diversifying the type of equity risk.
However, private markets exhibit the largest dispersion of returns among asset classes and require expertise to discern among the plethora of investment options. Evaluating and securing access to the best private managers is paramount in the successful execution of a private program.
Where do real assets fit within that picture?
Real-assets exposure can serve a number of key functions within a client’s portfolio, including as a source of diversification with several different subasset classes that are less correlated or noncorrelated with broader public and private equity markets, downside protection through hard-asset ownership, current income and protection from unexpected spikes in inflation.
Importantly, we focus on real asset strategies that have the potential to generate attractive returns through cash flow and add operational value at the asset level, not betting on higher commodity prices or valuation environments to reach the return targets.
Can you provide an example of how someone can invest in real assets successfully?
We believe real assets are best accessed through the private markets, where you can control the asset and directly benefit from the cash flow while being less reliant on capital market forces.
We like to back experienced teams with repeatable strategies and differentiated operating capabilities. Timing the market is all but impossible; however, strategies that are disciplined about buying assets below replacement cost, creating value through more efficient operations (revenue enhancement, capital improvements, cost initiatives, etc.) and taking advantage of windows of liquidity have proved successful. Access to efficient financing and prudent use of leverage has always been a staple of our real asset managers but is even more paramount in today’s environment.
We prefer smaller managers who are aligned with LPs, driven by performance-based incentive fees as a wealth creation opportunity, and who show discipline in asset growth.
Family offices are primarily worried about inflation at the moment. What can they do about it?
The largest components of CPI growth are related to housing, energy and commodity costs. We have worked with our families to position their portfolios to take advantage of several themes that confront these areas: affordable rental housing, scarce global resources and energy transition. We expect that these areas should provide portfolios with some level of inflation protection.
When it comes to affordable rental housing, we continue to believe in the long-term fundamentals of the workforce housing space (multifamily and manufactured housing), especially as supply of all types of housing continues to lag and demand for flexible and affordable living space has surged. Post-2020, we have witnessed a number of factors supporting continued rental growth, including outsized wage growth, significant home price appreciation and increased cost to build new apartments.
As for energy transition, the transition from fossil-fuel-dominant to renewable, intermittent generation will not be a straight line and creates opportunity for more flexible assets that will be necessary in the medium term as the grid evolves to a higher percentage of renewables.
When you look at the latter half of the year, how should family offices be positioning their portfolios?
Unlike the last couple of decades, as maturities come due and companies or assets need to be refinanced, some capital structures with higher leverage could become challenged and facilitate ownership transitions. Family offices can take advantage of these dislocations by investing in strategies like hedge funds, where managers can invest both long and short; and in the private space, as that marketplace goes through an expected period of change and transition. Having patient and thoughtful capital while backing experienced and skilled teams can allow families to take advantage of the dislocations while further diversifying their portfolio risk.
MORE INSIGHTS: Evaluating smaller and emerging managers
By SUSAN WEBB
Smaller and emerging managers can be a significant but overlooked source of alpha. Often hungrier and full of well-researched, actionable investment ideas, many first-time fund managers outperform established managers, who can become complacent while wedded to outdated positions.
At Appomattox, we have spent two decades evaluating and allocating to early-stage managers. We define small funds as those with less than $100 million in assets and emerging funds as those with less than a two-year track record. How do we evaluate those funds without a longstanding track record?
PRISM AND PATTERN RECOGNITION
We look at emerging managers through a prism. Like a venture capitalist evaluating a startup, allocators must look at several factors to evaluate a manager with little to no independent track record. In the absence of a performance road map, we seek a trail of breadcrumbs that focus on key evaluation factors and nuances: the team, experience, resources and incentive to perform.
The intangible factors and nuances driving a manager’s success — such as hunger, drive and a desire to win (within the law) — are hard to quantify. The art of selecting a successful emerging manager involves pattern recognition. Meeting hundreds of managers over the years and investing in them at an early stage builds up the pattern recognition that is helpful in separating the wheat from the chaff. There is a scarcity of talented investment managers. Finding them early can reap huge rewards.
We ask numerous penetrating questions and seek verification: Where did the manager begin his or her investment experience? Was it on a Wall Street trading desk, a large hedge fund or mutual fund complex? How much decision-making power did the manager have? What is the reputation of the people and firms where they worked?
Not all financial firms train their people well and ethically. Allocators need to know these nuances.
Is the manager pursuing a strategy that was deployed successfully before? Does the manager have the assets under management (AUM) to pursue that strategy successfully?
For example, a manager investing in bank debt and other illiquid credit instruments will need at least $50 million to $100 million AUM and potentially $300 million to $500 million to properly diversify the fund. There are ways to mitigate such large capital outlays by investing in more liquid credits or in special-situation equities, but that entails a different set of risk management parameters.
OUTSOURCING AND INFRASTRUCTURE
Are all critical roles filled internally or outsourced to reputable professional service providers? Who is running the business and managing the business risk? Are there checks and balances in place? How long have the founder and key team members (if more than one) worked together?
For hedge funds, is there a plan to use the prime brokers and other providers as back office? Who is willing to prime the fund matters a lot because most prime brokers can dual or multicustody assets. Does the manager take advantage of those resources? Smart outsourcing stretches management fee income and enables the firm to grow.
How much of the manager’s own net worth is invested in the business? Does the manager have the capital reserved to pay staff and survive the first few years to generate a track record? Do they have seed capital to execute their strategy?
A longer-term business plan to reflect the manager’s thoughtfulness and ability to execute a growth plan is an essential component in evaluating a manager’s investment approach and ability to manage a business. A manager accustomed to the resources of a large firm for trading and/or research might struggle without access to information and systems that accrue to large firms. The commitment of an active seeder can accelerate an emerging manager’s growth and should be part of the considerations when evaluating a longer-term plan. Managers should be realistic about the challenges of capital-raising and business growth.
Evaluating an emerging manager by applying an extensive and penetrating process, loaded with verification points, mitigates risk while offering opportunities to add alpha to a portfolio. A great deal of the business risk can be addressed by improved back-office and risk infrastructure that is now accessible to managers in the early stage of business. We believe that allocators who are tenacious, inquisitive and knowledgeable in the evaluation and selection process will be well-rewarded.