A family office perspective on alternative investments
At KFP we have always advocated substantially higher weights to alternatives than most wealth managers. To us alternatives are defined as private equity, venture capital, real estate, private debt and hedge funds. In a well-diversified portfolio, alternative investments can provide the bulk of your returns. This is evident from the data where, in the U.S., the college endowment funds with the highest weights to alternatives also have the highest returns. Many refer to this as the ‘Swensen’ model, named after the former CIO of Yale endowment (AUM $25bn). According to Yale’s 2021 report: over the 20 years ending June 30, 2021, Yale’s endowment returned 11.3% per annum, exceeding broad market results for domestic stocks, which returned 9.1%, and for domestic bonds, which returned 4.6%.
Deals and deal-flow
However implementing such an ‘endowment’ model is no easy feat. Whilst most asset classes offer a range of ways to invest in a broad and diverse manner, alternative investments cannot be done passively. Furthermore, there is a huge dispersion between the top and bottom performers. Private markets are simply less accessible, efficient and almost entirely illiquid. They are less efficient because information is not easily available. Only those with the resources to evaluate the deals, and with the in-roads into the deals, can exploit the opportunities in the most efficient way. Furthermore, the deal is less accessible as those with top investment ideas and businesses will seek out the best performing managers of capital to work with – those with the necessary experience, strategic advice, and contacts.
Access to these networks – whether the funds that invest in these companies, or direct access to the companies through personal networks – is the key. One advantage we have capitalised on is the network of our founding families and partners. Their successful and long experience with investing their own money, and the network they’ve acquired over this time, provides abundant and unique deal-flow. The sharing of this deal-flow and contacts amongst our families creates further synergies; for the investor, the company and the entrepreneur. This in turn develops our relationships and network even further. Its not exclusive to only KFP’s families; outside investors may join our network and participate in our club approach.
A different model
Advisors and private banks can lack such access, and often for non-financial reasons. Entrepreneurs and deal originators often prefer investors who can move quickly, with the least bureaucracy and resistance. Private banks and advisors, burdened by internal committees and controls, need time to evaluate and approve. Often the quickest and less resistant path to negotiation is neither the most tax friendly for their clients, or structured in the right way, for banking at scale. Private banks and advisors are primarily and understandably concerned with reducing risk, not necessarily providing returns. As such they will favour an investment that is well-packaged rather than a great deal that doesn’t fit their process.
Our experience
2021 was in hindsight an excellent year for KFP, and our returns were between 30% and 33% for Private Equity and 16% to 16.5% for Real Estate. We also cautiously apply a 20% discount to our valuation estimates reported by the deal sponsor. Our priority is the end result for our families, not overstating the investments along the way. Should the position exit favourably, we are happy to realise an uplift, at the same time ensuring the discount mitigates against unexpected events or a soft market.
A year of change
A diversified asset allocation has proven to weather this year’s storm; despite a volatile year where our equity/bond benchmark is down -8.15% YTD (to 31 July) our founding families remain up 1.5% to 2.5% on the year. However we remain cautious, and the equity market rout and rising rates in 2022 has impacted not just public markets but private as well. The Thomson Reuters VC index, a proxy for the venture capital industry, is down 51% to July 25th. Many companies are reporting that VC investors are no longer willing to support the same valuations they would have just 12 months ago. Even still, the impact of valuations adjusting has only just begun to feed through into private markets. The industry has many vested interests, and there should be no different sets of valuations for private or public companies in efficient financial markets and developed economies. Listed companies are in a more advanced stage of valuation correction – which may further to go depending on the earnings cycle – but as private companies do not trade, valuations are still the ones of the last capital raise.
Our process
Despite the macro backdrop, we are not overly concerned with our private investments. Since we began in 2019 our focus has been on shorter-duration private deals and higher growth niche markets. Our pre-requisite to see a visible exit has meant more deals with visible cashflow, as well as deals largely unaffected by macro conditions. Our businesses continue to report growth, while real estate projects continue to complete project milestones on time.
For most investors, this shorter investment cycle is resource intensive. Analysis, due diligence and investment occurs more frequently as our capital needs to be re-deployed. In doing so, it has helped us mitigate some of the risks that as private equity investors are discovering; highly leveraged deals with long duration and poor short-term cash prospects now suffering from higher rates and deteriorating fundamentals.
Solid foundations
We can’t predict how private equity valuations will evolve over the next few years, but we are confident in our process and approach. We believe that this contraction of valuations will lay the foundation for some incredible opportunities in private markets. From our experience and that of the US endowments, all investors would do well to consider the evidence that alternatives are a core component to meeting one’s long-term financial goals.
This article it is not an investment recommendation nor amounts to investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. The contents of this article is based on data which may include valuation from available sources of information customary in the financial industry, and on information originating from the client or third parties such as banks or issuers of financial products (including unquoted products). Reasonable care has been taken in calculations and valuations based on such sources for the purposes of this publication, but KFP offers no warranty and accepts no liability as to the accuracy and completeness of information derived from any such sources. Reliance on data contained in this article and any resulting act or omission on the part of the client shall be at the client’s own risk, and KFP does not accept any liability for any direct, indirect or consequential loss arising from any use of this article.