An Opportunistic Approach To Alternative Investing

An Opportunistic Approach To Alternative Investing Thomas K. Philips

T

HIS ARTICLE suggests a new approach to investing in alternative assets.* Historically, most alternative investment programs have begun with a total allocation to alternative assets, followed by a series of suballocations to various areas. For example, a fund might allocate 10% of its assets to alternative investments, and then allocate 3% to venture capital, 4% to leveraged buyouts, and the remaining 3% to real estate. These proportions are typically kept constant over time, and do not change in response to the availability or pricing of suitable investment vehicles in each category. This style of investing is usually rationalized as follows. Alternative assets are likely to outperform publicly quoted assets over time, and therefore it is important to maintain some exposure to alternative asset categories. A well diversified portfolio of alternative assets has low risk because these asset categories are weakly correlated with each other. Finally, it is impossible to tell in advance which categories will do well, making it imperative to participate in all categories at all times. This intuitive argument is often buttressed by an asset allocation study that shows that all portfolios on the efficient frontier contain a diversified portfolio of alternative assets.

*For the purposes of this article, I define alternative investments to be investments that are made through a vehicle for which no liquid secondary market with daily pricing exists (for example, a limited partnership). This definition excludes, for example, marketable high-yield bonds but allows for limited partnerships that supply subordinated debt for leveraged buyouts.

42

/

INVESTMENT POLICY

•

Volume 1, No. 2

An Opportunistic Approach To Alternative Investing

While it is true that alternative assets are likely to outperform publicly traded assets over time, the “diversification above all” approach to alternative investing is wasteful. In particular, funding asset categories with fixed allocations is a poor investment strategy. In this article I show that: 1. The benefits of diversification among alternative asset categories — when portfolio returns are computed on the basis of partnership valuations — are greatly overstated; 2. Substantially all of these benefits can be realized by investing in any one alternative asset category; 3. It is much more important to pay attention to the prospective returns of each asset category and each fund to which one commits capital. In summary, capital should be committed to alternative investments based on both their expected returns and the nature of the current opportunity set. An investor seeking the best return from alternative investments would, as a result, direct most new commitments at a given time to a few asset categories, and invest in the remaining categories only on a very selective basis. Over time, such an investor would build a diversified portfolio of private partnerships with outstanding managements that have had the foresight to launch their partnerships when good properties or deals were available at fair prices in their market segment. MISUNDERSTANDINGS ABOUT THE EFFICIENT FRONTIER

Most allocations to alternative investments are made on the basis of an asset allocation or “optimization” study involving the production of an efficient frontier. It is inappropriate, however, to use optimization to justify fixed-weight allocations that have nothing to do with what Markowitz intended. In his 1952 doctoral thesis, Harry Markowitz observed that investors ought to make a tradeoff between return and risk, rather than just buying the highest returning assets. At any given point in time, then, “efficient” or “optimal” portfolios will contain some assets that are not the highest returning. If the expected returns on assets change, then the portfolio contents should change. What is more, changes in expected return are much more important than changes in risk in determining the terminal value of a portfolio. (The terminal value is, of course, what investors are ultimately interested in INVESTMENT POLICY

•

September/October 1997

/

43

Thomas K. Philips

and is proportional to the geometric-mean portfolio return.) A simple equation, which is outside the scope of this article, shows how the geometric return changes as the expected, or arithmetic, return and risk change. The geometric return increases almost linearly with the expected return, and falls as the square of the risk (where risk is measured by standard deviation and is normally less than one). This effect can be quantified by computing the sensitivity of the geometric return to small changes in the expected return and the standard deviation. For a typical institutional portfolio, with an expected return of 10% and a standard deviation of about 10%, the geometric return is 11 times more sensitive to changes in the expected return than it is to changes in risk. While there are many valid reasons to invest in diversifying assets — to guard against event risk, to immunize one’s liabilities, or simply to reduce volatility — increasing the return of the portfolio is not one of them. The results that are presented in the next section will bear out the truth of this observation. THE HISTORICAL PERFORMANCE OF ALTERNATIVE INVESTMENTS

Modeling the performance of an alternative investment strategy is fraught with difficulties. In public markets, performance is measured using a two step process: 1. Define a realizable investment strategy; 2. Measure the time-weighted rate of return of this strategy. The liquidity afforded the investor by public markets allows one to enter, add to, or exit an investment at any time. It follows that almost any investment strategy is realizable, and consequently that the measurement of investment performance is a relatively straightforward matter. The investment strategy that underlies almost all performance measurements of public market vehicles is the following: Commit a fixed amount of capital to the strategy at inception and reinvest all cash flows such as dividends and distributions into the strategy; measure the time-weighed rate of return in each sub-period; and then compound these returns to obtain the time-weighted return for the entire period. In private markets, however, a very different situation prevails. Investments must be made through partnerships that cannot be exited until they terminate; very few funds are open for investment at any one

44

/

INVESTMENT POLICY

•

Volume 1, No. 2


time; and the distributions from earlier funds that one has invested in cannot be internally redeployed, but must be reinvested in other funds that are currently open for investment. Put together, these factors make it virtually impossible to use the investment strategy that forms the basis of public market performance measurement. To further complicate matters, information on returns and distributions in private markets is tenuous at best. Finally, the option-like fee structures that are so prevalent in partnership agreements make it virtually impossible to specify the gross and net performance of the vast majority of partnerships without Option-like fee structures referring to their actual statement make it virtually impossible of cash flows. to specify the gross and net In view of these limitations, I performance of the vast model a pension plan’s investment in private markets as follows. First, majority of partnerships. the performance of each alternative asset category is calculated in isolation. To do so, the returns and distributions are computed for a large sample of funds that are broken out by “vintage year” (the year the partnership was formed). Then, the effect of adding alternative investments to an institutional portfolio is determined using the following procedure: 1. Assume that the pension plan has $1 billion of assets that are invested in a 60/40 stock/bond portfolio, with the stock component being represented by the Standard and Poor’s 500 Index and the bond component being represented by the Lehman Brothers Government Corporate Index. Initially, there is no allocation to alternative investments. 2. Assume that at the end of each year, the plan sells $20 million worth of equities and invests this money in alternative assets. Distributions from existing private partnerships are redeployed into new partnerships, so that the total capital deployed into alternative investments in any year can be substantially greater than $20 million. Furthermore, all commitments of capital to the partnerships are assumed to be drawn down (that is, used by the partnership for investment in portfolio companies) immediately. Because most alternative investments have equity-like characteristics, the alternative investment allocation

INVESTMENT POLICY

•


/

45

Thomas K. Philips

is taken from the equity allocation rather than from the fixed income allocation. In addition to simulating the performance of strategies that invest exclusively in a single alternative asset category, I also examine the performance of a balanced strategy that invests $20 million along with any distributions in each year in equal proportions into each of three alternative investments: venture capital, buyouts, and real estate. In the model for this strategy, new capital is allocated in equal proportions to the asset categories, but each distribution is allocated to the asset category that generated it. This investment strategy is designed to raise a plan’s exposure to alternative assets from 0% to 10% over the course of a decade (assuming that alternative investments generate equity-like returns) and is a better model of a pension plan’s alternative investment strategy than the standard method in which all of the allocated capital is deployed at the start of the program. Note that while $200 million (that is, 20% of an initial $1 billion) is reallocated to alternative investments over the course of the decade, the percentage of the fund that is invested in alternatives rises only to 10% because, in this simulation, the overall fund doubles to $2 billion in the same period. The data for venture capital and buyout funds are drawn from the Venture Economics database, which contains the returns to the limited partners, net of all fees and expenses, for funds of each kind. Venture Economics depends on limited partners and some general partners to report voluntarily the annual returns for funds that they participate in or manage, and is more comprehensive for venture capital than for buyout funds.1 While any study of private equity returns is constrained by data considerations, the Venture Economics data are the best available and in general conform to the actual return experience of my former clients for whom accurate return data are known. The data for real estate funds are drawn from a database maintained by RogersCasey Alternative Investments. The database contains 101 funds that were raised between 1980 and 1992. As one might expect, it contains more funds from the early to mid 1980s than from the late 1980s and early 1990s, as the poor performance of real estate in the latter period made it very difficult for funds to raise money. My hypothetical pension plan’s results are assumed to be identical to those reported by Venture Economics for venture capital and buyout funds

46

/

INVESTMENT POLICY

•

Volume 1, No. 2


and to those achieved by the funds in the RogersCasey database for real estate. In addition, all funds that closed in a given year are assumed to have been open for investment whenever the pension plan had capital to invest. As the real estate database contains only the total return (income plus capital appreciation) for these funds, the funds are assumed to start making distributions in their third year and to distribute 30% of their endof-year market value to the limited partners in each year. Exhibit 1 summarizes the results of investing $20 million each year, along with any distributions received from prior investments, into a given asset class. Exhibit 2 displays the results of this investment strategy when applied to an institutional portfolio that starts out with a 60/40 stock/bond allocation. To allow a fair comparison, performance figures are shown for both the 1981–1993 and the 1984–1993 periods. While venture capital and real estate data are sufficient to allow performance comparisons over both periods, the data on buyout funds are too spotty prior to 1984 to allow inclusion in the study. Buyout funds dramatically outperformed both venture capital and real estate funds over the 1984–1993 period. Even though the risk (measured by volatility) of buyout funds was higher than that of venture capital and real estate funds, investors have been more than compensated for the added risk that they have taken on. Observe that the volatility (as measured) of all these strategies is substantially lower than the 25% to 30% volatility that is assumed in most asset allocation studies. This is a direct consequence of the fact that alternative investments are revalued infrequently, typically when a new round of financing is obtained. Exhibit 1. Performance of Alternative Asset Categories ASSET CLASS

TIME PERIOD

ANNUAL RETURN

ANNUALIZED STANDARD DEVIATION

Venture Capital

1981–1993

4.3%

6.6%

Venture Capital

1984–1993

2.9%

5.9%

Buyout Funds

1984–1993

20.8%

12.8%

Real Estate

1981–1993

6.8%

4.8%

Real Estate

1984–1993

4.7%

3.9%

33% venture, 33% buyouts, and 33% real estate

1984–1993

8.5%

5.4%

INVESTMENT POLICY

•


/

47

Thomas K. Philips

The poor performance of venture capital and real estate funds over this time period is reflective of a fundamental difference between public and private markets. In public markets, when securities become overvalued, buyers balk and short sellers act to depress prices, bringing prices back to an equilibrium level of valuation in which expected returns are commensurate with risk. Consequently, returns in public markets are unlikely to be consistently poor for extended periods of time. In private markets, no such disciplinary mechanism exists, and prices can stay at elevated or depressed levels for long periods of time. This effect is further exacerbated by the short-run inelasticity of deal flow, which causes prices to rise in sympathy with the availability of capital. (The terms of most partnership agreements require them to be completely invested by the end of the commitment period.) Investors must therefore be doubly careful when entering into partnership agreements, as they take on both the risk of the general partner’s professional competence and his ability to source deals at reasonable prices for an extended period of time. Considering the venture boom of the late 1980s, today’s investors may be surprised at the low returns to venture partnerships that were formed in the 1980s and held through 1993. An updating of this study would probably show higher returns to venture capital and possibly to real estate. The low returns of the period studied, however, are cautionary evidence for investors who have been persuaded by recent returns that venture capital is an easy way to make money. Exhibit 2 shows that all three alternative investment strategies reduce the volatility of the total portfolio. However, the table contains two big surprises: 1. The buyout fund strategy reduces portfolio risk more than either of the other two strategies. This is especially surprising because the volatility of buyout funds is greater than that of either real estate or venture capital funds. 2. The risk and return of the equally weighted alternative investment strategy lies between that of the buyout fund strategy and the venture capital and real estate strategies. Notice that the additional diversification has little effect on the volatility of the portfolio, but it substantially lowers the return because of the inclusion of poorly performing asset categories! As might be expected from the results in Exhibit 1, the only portfolios that outperform the 60/40 stock/bond mix are the stock/bond/buyout

48

/

INVESTMENT POLICY

•

Volume 1, No. 2


Exhibit 2. The Performance of Various Investment Strategies STRATEGY

TIME PERIOD

ANNUAL RETURN

ANNUALIZED STANDARD DEVIATION

60/40 Stocks/Bonds

1981–1993

13.70%

9.52%

60/40 Stocks/Bonds

1984–1993

13.75%

9.14%

Stocks, Bonds + VC

1981–1993

13.27%

8.83%

Stocks, Bonds + VC

1984–1993

13.33%

8.63%

Stocks, Bonds + Buyouts

1984–1993

15.28%

7.80%

Stocks, Bonds + Real Estate

1981–1993

13.66%

8.80%

Stocks, Bonds + Real Estate

1984–1993

13.49%

8.66%

Stocks, Bonds + 33/33/33 VC, Buyouts, and Real Estate

1984–1993

13.93%

8.32%

fund and the equally-weighted mix. The portfolios containing venture capital and real estate underperform the passive stock/bond mix by between 0.04% and 0.50% per annum. Worse still, venture capital funds performed poorly over the entire time period under consideration; the overall results cannot be ascribed to one or two particularly bad years. In fact, the primary reason that the overall results are not as bad as Exhibit 1 would suggest is that, because the strategy slowly builds up exposure to alternatives, the portfolio’s exposure to these asset categories was much less than 10% on average over the period simulated. The portfolio with an equally weighted mixture of alternative investments outperformed the passive mixture by 0.18% per annum, and this outperformance must be attributed largely to the buyout fund exposure. The data in Exhibits 1 and 2 clearly identify the problem: diversification among alternative asset categories can dramatically impact the return of a portfolio without providing a corresponding reduction in volatility. This observation is the driving force behind the opportunistic approach to alternative investing that I advocate, and to which I turn next. AN OPPORTUNISTIC APPROACH TO ALTERNATIVE INVESTING

All the aforementioned problems can be solved by an opportunistic approach to alternative investing. This approach has been practiced by RogersCasey Alternative Investments in making its investment recommendations to clients since 1988. The choice of 1988 as a starting year for

INVESTMENT POLICY

•


/

49

Thomas K. Philips

this study is not arbitrary; it is the first year in which a member of the current team of professionals at RogersCasey was employed by the firm. Unfortunately, it is not possible to reconstruct their investment recommendations in earlier years, so as to allow direct comparison of the results of these recommendations with the results of the fixed-weight portfolios tested in the previous section. The key insight that underlies the opportunistic approach is essentially this: at any point in time, the expected returns of asset categories can differ significantly, while the diversifying benefits of most asset categories will be similar. Therefore, to maximize the benefits of an alternative investment program, investors ought to avoid investing in those asset categories and partnerships which have poor prospective returns and a limited opportunity set relative to the capital available for investment. Over time, the asset classes having the highest expected returns will change. Therefore, the portfolio will be biased towards one asset class or another in any given year, but a mature portfolio constructed using the opportunistic approach will include all asset classes. For example, as of early 1995, RogersCasey’s investments were concentrated in buyout and real-estate funds. Only one year earlier, in 1994, the same firm invested in one real-estate fund, one timber fund, one distressed-debt fund, three venture-capital funds, and four buyout funds. Exhibit 3 shows the changing distribution of asset classes in the RogersCasey meeting log over 1988–1994,2 and Exhibit 4 shows the total amount of capital raised by all funds in the private-equity industry, broExhibit 3. Meetings With Managers by Asset Class: 1988–1994 100% 90%

■ International

80%

■ Timber

70%

■ Direct

60%

■ Oil & Gas

50%

■ Special Sit.

40%

■ Real Estate

30%

■ LBO/Mezz.

20%

■ Venture Cap.

10% 0%

50

1988

1989

/

INVESTMENT POLICY

1990

1992

1991

•

1993

Volume 1, No. 2

1994


ken out by asset class. Clearly, neither distribution is stationary, and the changes reflect the variation over time in the fund raising activities of partnerships. One sees, for example, the dropoff and subsequent reemergence of leveraged buyout funds, the dropoff in oil-and-gas funds, and the emergence of real estate and international private-equity funds. My test of the opportunistic strategy assumes that the investor participated in all of the funds recommended by RogersCasey. In fact, RogersCasey’s clients typically invested in a subset of the recommended funds, for various reasons. Some clients were wary of real estate and venture funds after their poor performance in the late 1980s; others shied away from buyout funds because of negative publicity; still others had reached their maximum allocation to alternative investments. In any event, the record of funds that were recommended (as opposed to actually invested in by clients) is the most accurate representation of the opportunistic strategy that I have, and is therefore the one analyzed. The funds for which data are available were classified into six subsets, one for each vintage year.3 For each subset I construct an “index” by constructing an appropriately weighted mixture of the Venture Economics benchmarks for that vintage year. Exhibit 5 compares the performance of the RogersCasey recommendations to that of the benchmark by vintage year. The measure of performance is the annualized internal rate of return from inception to the end of 1993.4 Exhibit 5, along with Exhibits 3 and 4, presents a fairly complete picture of the opportunistic approach to alternative investing over the six

Committments ($ millions)

Exhibit 4. Capital Raised by Asset Class: 1984–1993

16,000

■ Buyout

14,000

■ Venture

12,000

■ Mezzanine

10,000

■ Other

8000 6000 4000 2000 0 1984

1985

1986

1987

1988

INVESTMENT POLICY

•

1989

1990

1991

1992


1993

/

51

Thomas K. Philips

years ending in 1993.5 Not all the investments were successful, but the majority were, and this is reflected in the performance figures. It should be emphasized that this investment program was not difficult to implement; all the funds in question were looking for new investors at the time they were raised, and every one of them would have welcomed a $5 million or $10 million commitment. Exhibit 5. Performance of RCAI Recommendations vs. Venture Economics Benchmarks: Annualized Internal Rates of Return from Inception to December 1993 1988

1989

1990

RCAI

18.28%

15.42%

2.38%

Benchmark

11.15%

4.75%

-0.03%

1991

1992

1993

1.43%

0.34%

-1.13%

-2.89%

-10.65%

15.35%

One reason that many alternative investment programs yield unsatisfactory results is that investors’ appetites for entire asset categories are often conditioned by recent experience or by non-financial considerations. For example, in the early 1990s it was very difficult to raise a buyout fund because of all the bad publicity that buyout funds had received, and many otherwise excellent funds found it nearly impossible to raise capital. Similarly, the collapse in real estate prices made it extremely difficult to raise a real estate fund in the early 1990s, even though bricks and mortar could then be bought for less than their replacement cost. While the cyclical nature of these capital flows is a nuisance to general partners, it offers the rational investor an outstanding opportunity to enter into partnerships when the assets to be purchased are available at fair prices and favorable partnership terms can be negotiated. Such terms include, but are not limited to, using distributed cash (not unrealized or undistributed gains) as the basis for the hurdle rate calculation that determines the manager’s carried interest; management fees that decline over time; transaction fees that are offset against management fees; and favorable termination clauses. Exhibits 6 and 7 display scatter plots of the internal rates of return (IRR) of venture capital and buyout/mezzanine/other funds contained in the Venture Economics database from inception to the end of 1993 versus the capital raised by all such funds in that year. For example, one data

52

/

INVESTMENT POLICY

•

Volume 1, No. 2


point in Exhibit 6 shows, on the vertical or Y-axis, the annualized IRR of the 1984 venture capital cohort from 1984 to 1993, and on the horizontal or X-axis, the amount of money raised by venture capital funds in 1984.6 Exhibit 6. IRR from Inception to December 1993: Venture Funds Formed in 1981–1993

IRR

12.0%

◆ 1988

10.0% 8.0%

◆ 1985

◆ 1981

◆ 1989 ◆ 1987 1983 ◆ ◆ 1984 ◆ 1986

6.0% 4.0% ◆ 1982

2.0%

1991 ◆ ◆ 1990

0.0%

◆ 1993

◆ 1992

–2.0% 0

1500

1000

500

2000

2500

3500

3000

Capital Raised ($ millions)

Exhibit 7. IRR from Inception to December 1993: Buyout Funds, 1984–1993 IRR

40.0% 35.0%

◆ 1985

30.0% ◆ 1993

25.0%

◆ 1984

20.0%

◆ ◆ 1990 1991

15.0%

◆ 1986 ◆ 1987

10.0% ◆ 1988 5.0%

◆ 1989 ◆ 1992

0.0% 0

2000

4000

6000 8000 12,000 10,000 Capital Raised ($ millions)

14,000

16,000

18,000

For venture capital funds, if we exclude the post-1989 vintage years (because funds formed after that date had not had enough distributions by the 1993 ending date of this study to provide confidence in the IRR),

INVESTMENT POLICY

•


/

53

Thomas K. Philips

the correlation between capital raised and the subsequent return is 0.04. In the case of buyout and mezzanine funds, if the anomalous 1993 data point is excluded, the correlation between capital raised and the subsequent return is -0.85. These numbers must be interpreted with some caution, as most of the funds in our sample had not been liquidated by the end of 1993, and their IRRs will change with time. They are, however, indicative of a general trend in fund-raising by partnerships. The negative correlation between the capital raised by buyout funds and subsequent returns can be explained. If partnerships raise capital when portfolio assets are cheap, there ought to be a strong positive correlation between the amount of capital raised and the subsequent returns. The very weakly positive (for venture funds) and strongly negative (for buyout funds) correlations acThe excess of capital forces tually experienced suggest that capital is instead raised when it is prices upward (as deal flow readily available, often following a is relatively inelastic in the period of good performance. This short run) and sets the stage excess of capital then forces prices for a reduction in returns in upward (as deal flow is relatively inelastic in the short run) and sets subsequent years. the stage for a reduction in returns in subsequent years. It is precisely this trap that investors should try to avoid. One of the first questions one should ask when investigating a fund is whether a sufficiently rich set of reasonably priced opportunities exists in its market segment. The investor should proceed further only if the answer is yes. SUMMARY

The opportunistic approach to alternative investing described in this article produced generally favorable results for the clients of a prominent consulting firm that used it over the six years ending in 1993. The central concept of the opportunistic approach is that one ought to allocate capital preferentially to the asset categories that have the highest expected returns at a given point in time, rather than rigidly allocating capital to all asset categories. While easy to describe, the opportunistic approach must be executed carefully, as it requires in-depth knowledge of the conditions

54

/

INVESTMENT POLICY

•

Volume 1, No. 2


and opportunities that prevail in a number of alternative markets. Execution has, however, been the key aspect of all alternative investing for as long as such investments have existed. I believe that if properly executed, such a program will produce results that will prove more than satisfactory over the long horizon.

NOTES 1. The Venture Economics database of venture capital funds covers over 60% of the funds in existence and 78% of the total capital committed to venture funds over the period 1981–1993. Their database of buyout funds, on the other hand, covers only about 37% of the funds in existence and 45% of the total capital committed over the period 1984–1993, and this is reflective of the early developmental stage of this database. 2. RogersCasey log of meetings with funds, and outcomes, 1988–1995: YEAR 1988 1989 1990 1991 1992 1993 1994 1995* *First quarter only

MEETINGS

OPPORTUNITIES PURSUED

FUNDS INVESTED IN

171 193 205 153 234 219 233 51

19 11 4 6 15 8 – –

5 4 0 0 3 4 11 5

3. If no Venture Economics benchmark exists for a fund (as in the case of timber funds), the fund’s return is its own benchmark, and this “benchmark” is used in computing the return of the overall, aggregated benchmark. 4. Year-by-year internal rates of return were provided by the funds. Of the 63 funds that RogersCasey requested information from, 30 or slightly under half responded. Funds that declined to participate in this study did so primarily for one of two reasons: either they did not release performance numbers to non-investors, or the fund had not as yet had any realizations, precluding the computation of a meaningful internal rate of return. 5. Note that RogersCasey’s selections between 1988 and 1992 outperformed their benchmarks by between 2% and 11% per annum. The 1991 vintage-year data point should be viewed with caution because it consists of just two funds, one venture capital and one mezzanine. The 1991 benchmark is also suspect because the Venture Economics database of mezzanine funds contains only one

INVESTMENT POLICY

•


/

55

Thomas K. Philips

fund formed in that year. The severe underperformance in 1993 reflects the remarkable 23.9% first-year performance of the funds in the Venture Economics database of venture capital funds. Most of the funds in the 1993 cohort are late-stage funds, which tend to have their best years early. Over the first half of 1994, the return of these funds was -0.6%, suggesting that their first year (1993) return was anomalous. 6. The buyout, mezzanine, and other categories are lumped together because that is what Venture Economics does, and the returns of real estate and their “other” funds are not plotted because the data is spotty at best.

56

/

INVESTMENT POLICY

•

Volume 1, No. 2