Manager experience key in private markets

By Jayson Forrest

Private markets provide investors with the opportunity to enhance returns, but illiquid strategies can be complex to navigate and difficult to access. Fred Pollock (GCM Grosvenor), Hagai Netser (Koda Capital), and Nehemiah Richardson (Pengana Credit) explore the challenges of implementing private market assets in portfolios.

Sitting under the alternative assets umbrella are private markets, which continue to gain in popularity with investors, as they seek to invest in privately-owned companies. The six main asset classes within private markets include: private equity, private credit, venture capital, private infrastructure, private real estate, and natural resources.

“Over the last 15 years, we’ve seen a definite trend towards private markets, with increasing inclusion of private equity and credit in many wealth portfolios. Investors recognise the diversification benefits that private markets bring to a portfolio,” says Hagai Netser — Head of Core and Opportunistic Portfolios and Partner at Koda Capital.

As part of an IMAP Specialist Webinar discussion on ‘Private Markets’, Hagai believes private markets are a compelling asset class. As a significantly larger asset class than listed markets, private markets provide investors with a much greater and broader range of opportunities to invest in.

“Globally, there are about 55,000 listed companies, while there are approximately 350 million private companies. So, accessing that opportunity set allows for greater outcomes for investors,” says Hagai.

Along with the diversification benefits that private market assets can bring to a portfolio, there are also other key reasons that make these assets attractive to clients. These include:

* Inflation hedging — investors can enjoy the benefits of potential inflation hedging, particularly for select infrastructure, real estate and natural resources strategies.
* Reduced volatility — valuations for private assets typically happen less frequently compared to public assets, which means they don’t tend to experience the same market volatility as public markets.
* Return potential — industry research shows that private capital markets have historically outperformed public assets over the long-term by tapping into non-economic risk premia (the illiquidity premium).

While it may be argued that the reduced volatility in private markets — as a result of less frequent valuations of companies — may disguise the true level of risk for this asset class, Hagai believes private market assets do go through a rigorous process with third-party valuers.

“Private market valuations are as good as listed market valuations, which means that any risk of these assets is not disguised. However, the illiquid nature of private markets can affect the valuations of private market assets, which is something to be mindful of.”

According to Fred Pollock — Managing Director, Chief Investment Officer at GCM Grosvenor — the illiquidity premium (the additional compensation investors receive to encourage them to invest in assets that cannot be easily or quickly converted into cash at fair market value) is a hotly debated topic within the industry. For Fred, the illiquidity premium definitely does exist, which compensates investors for having their capital locked up and for the lack of options this creates for them.

“Typically, this premium ranges between 50 to 150bps over time. However, the proliferation of private market funds has actually worn down the illiquidity premium.”

In comparison, Fred says the risk premia (the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset) never goes away. The risk premia is being paid for by the utility of the function of the asset class itself, whether that be private credit or venture capital. 

“The risk premia is what an investor is paying for in the asset class,” he says. “It’s the risk-return you’re expecting from the asset. And it’s the job of the manager to try and produce alpha on top of that.”

When working with managers in the private equity and private credit space, Fred says there are a number of key attributes GCM Grosvenor looks for in managers, which are different between the two types of managers.

“Both types of managers are fundamentally different,” he says. “Private equity managers have domain expertise and they tend to be better at knowing the management teams of businesses. Typically, they have a plan of action to take cashflows from a business and increase those cashflows over time. That’s how almost all of the value is going to be produced and that’s what you should be looking for in a private equity manager. You should also care about their approach to portfolio construction and risk management.”

However, when it comes to the private credit space, Fred says the attributes of managers are completely different.

“Private credit managers know everything that can go wrong with assets in that space, and they know how to deal with market adversity. They typically have experience and a long track-record working in this space. Great private credit managers also have a focus that is mostly on the downside, and they are generally better portfolio managers than the equity managers,” he says.

“That’s because they have negative convexity (when the downside is greater than the upside) in their trades, so they don’t have a lot of upside in what they’re doing. Therefore, they tend to have portfolios that are grounded and better protected through diversification.”

Fred acknowledges that both private equity and private credit managers bring different skill sets to the table, which are largely complementary in a whole-of-portfolio approach.

When considering managers across both asset classes, manager selection definitely matters for Koda Capital. It looks for managers that know companies intimately, have strong opinions, and have experienced management teams in place.

“When constructing portfolios, manager experience is a key consideration, which is particularly important in private credit to protect on the downside. And in private equity, manager conviction is also important,” says Hagai.

“Additionally, in the private credit space, you want to focus on everything that can go wrong with an investment and/or strategy. So, you want to ensure you’re investing with managers who have previously gone through hard and challenging times. We want to work with managers who have a proven track record of successfully navigating challenging times in the market.”

When putting together a private credit portfolio, there are a number of challenges that portfolio constructors need to deal with, says Nehemiah Richardson — CEO and Managing Director at Pengana Credit. He says there are two broad thematics that must be considered.

Firstly, private credit is an illiquid asset class. This means when constructing portfolios for different types of investors, you have to construct a portfolio that has relevance through cycles.

“To achieve that, you have to have wide diversification, and you want to get rid of any idiosyncratic risk. That’s why Pengana is geographically dispersed and we’re a multi-manager, because we don’t want to take single manager risk in credit. Through different types of cycles, you want to be able to capture relative value opportunities, which are more easily captured in liquid markets.”

Secondly, Nehemiah says investors have different requirements and needs. For example, some people just want the income, others want to accumulate, while others want both. He believes the challenge is to construct a portfolio that has some level of liquidity in it for investors who want yield and have shorter timeframes for investment, as well as illiquid assets for the other investors who don’t mind having their capital locked up for accumulation purposes.    

“For Pengana Credit, to achieve this is a significant liquidity management exercise, as well as a big exercise in not just choosing the right managers but also building different liquidity risk-reward profiles of the different types of strategies, and putting them in different buckets in order to satisfy different investor needs,” says Nehemiah.

“So, for people who want income with some growth, we’re able to accommodate that, while for people who just want income, we can structure portfolios that generate income with no accumulation. We’re able to do this by the way we allocate across our portfolio, which is not an easy thing to do without having the right structures in place.”

Hagai agrees that liquidity is a key consideration for most private investors. However, he also emphasises the importance of currency hedging when implementing illiquid strategies.

“When investing in private equity (or equities in general), you expect a significant upside on your investment. So, short to medium-term currency fluctuations are going to be less of an issue in the context of the expected total return from a strategy,” he says.

“However, when it comes to private credit, if investors are expecting high single or low double digit returns, a currency move can wipe out two-thirds of that return profile over a quarter. Therefore, not hedging out this type of risk is suboptimal. So, currency hedging is very important when investing in global private credit, which can be challenging to do on a client level.”

Fred Pollock is Managing Director, Chief Investment Officer at GCM Grosvenor;

Hagai Netser is Head of Core and Opportunistic Portfolios and Partner at Koda Capital; and

Nehemiah Richardson is CEO and Managing Director at Pengana Credit.

They were part of an IMAP webinar panel discussion on ‘Earning the illiquidity premium: Obtaining the diversification benefits — Private markets’.

The session was moderated by Adam Myers — Executive Director at Pengana Capital.