“The way I see it, if you want the rainbow, you gotta put up with the rain.” – Dolly Parton
Similar to life and investing in general, alternative investments are not perfect. As we’ve covered thus far in this series (which has only touched on a tiny sliver of the alternatives universe), there exist many alts strategies that come in various structures, and there are always tradeoffs involved (e.g., investment minimums, liquidity restrictions, fees, limited transparency, and drawdown periods). We invest in them because we believe that – overall – there is value to be derived from risk/return/income characteristics that may not be found within the traditional investment realm.
After covering some of the “rain” in Part 5 of this series, in Ms. Parton’s terms, today we’ll try and finish with a rainbow. With that, it’s onto the final three strategies we’re going to review in this series (if a sense of relief is coming over you, that’s the correct reaction).
For Qualified Clients…
Globally Diversified Private Equity/Credit (“GDPE” for short)
There are specific segments of alts where you may find global diversification, but I’d say it’s very much the exception. In that sense, one could argue that this globally diversified private equity/credit strategy is “exceptional.” Aside: I partially wrote that to see if I can successfully navigate the intricacies of our compliance guidelines. Ordinarily, “exceptional” is what they call a “buzz word,” but I’d argue that’s not true in this instance. Sometimes you have to test the waters.
The GDPE fund in question is approaching $10B of assets, so it’s relatively large. It owns many hundreds of private businesses worldwide via direct investments, primaries, co-investments, and secondaries. Let’s touch on each of these very briefly:
- Direct investments: the fund purchases private businesses (exactly what it sounds like).
- Primaries: these are what we often discuss in Blend, which are private equity or credit funds (aka “GPs”) that are raising capital from investors. Just like we do on behalf of our clients, GDPE can commit to investing with other managers, becoming a limited partner (LP) of that fund. The transaction between the fund manager and investors (or between GPs and LPs, in alts jargon) is considered the Primary market, and that’s why these are known as “primaries.”
- Co-investments: these are investments made alongside the GP of a fund. A GP may not want to own 100 percent of a given business within its fund because it would be too large for the fund (there are usually some diversification targets and a limited amount of capital being raised/deployed). The GP can bring in co-investors to raise more money to buy that particular business, but those co-investors don’t have to pay the fees that the fund’s LPs do. To gain access to co-investments, one often needs to be an LP in the underlying fund. So, GDPE’s involvement in the Primary investments (as above) can help drive co-investment opportunities and more cost-effective capital deployment.
- Secondaries: this is where an existing LP of an alt fund sells its interest to another investor. Hence, it’s traded in the “secondary” market, and that’s where the name comes from. An exciting aspect of secondaries is that the seller is usually very motivated (as they would otherwise keep the investment) and willing to sell at a significant discount to the fund’s net asset value. That discount can allow for an additional source of value realization (in addition to the fund’s performance).
By owning many individual companies, GDPE already can achieve significant diversification, but then consider additional factors that add to this feature:
- As above, primaries and secondaries investments are in funds, each of which may have many underlying diversified holdings. These positions account for about 1/3 of the GDPE fund – or billions of dollars, across many holdings and many managers.
- Geography: The fund is roughly 2/3 in North America and 1/3 in Europe (with a small amount of Asia/other). That means a broader opportunity set and multiple currencies across multiple interest rate paradigms.
- Size and Type: The holdings span different company sizes (although mainly medium-to-large), including some private debt to help complement the equity holdings.
- Vintages: private equity funds are often considered in terms of their vintage – or year of inception – because the opportunity set may vary significantly from year to year. GDPE has vintages spread across calendar years since before 2012.
From an underwriting perspective, the fund declines over 90% of primary deals and about 98% of the direct and secondary deal-flow it sees. And GDPE’s data shows that – in the US alone – the private market has about 23 times more companies than public markets, so it is a monumental effort to sort through the potential opportunities in this space.
- Structure: Open-ended private fund (LLC)
- Fund life / Access / Liquidity: Ongoing with monthly purchases and quarterly liquidity (subject to gating).
- Cashflow: There is no specific income focus, but there is an annual distribution of some realized capital gains and other income.
- Pros: Investor-friendly evergreen structure (for those who qualify). Diversified portfolio. No J-curve (J-curves are a common drawback of PE investing).
- Cons: Qualified Client hurdle may be out of reach for many investors. May not be a good fit for those seeking consistent income distributions.
- Where Are We Now? Despite significant growth, GDPE seems to use size/scale to its advantage while still being mindful of quality. As the fund marks-to-market monthly, there was a temporary drawdown during COVID’s onset, but it was much less severe than what was experienced in public markets.
Diversified Private Small Business Lending (“SBL” for short)
In Part 5 of this series, we covered a private BDC that lends money to PE-sponsor transactions in the upper-middle market. This SBL fund, on the other hand, plays in the lower-middle market, which we previously generalized as $5-$50 million of annual revenue, but pragmatically may creep a bit higher than that within this SBL fund. And instead of lending the money as part of private-equity sponsor transactions, it lends money directly to these small businesses. Those businesses intend to use the money to grow, so it’s known as “growth capital.”
The nice thing about lower-middle-market loans is that – while to you or me, the interest rates garnered in this space may seem very high (and as SBL is the lender, that’s a good thing) – to the businesses, it is still far cheaper than giving up equity to raise money. Obtaining loans from traditional lenders like banks may not be as easy for these smaller businesses as it is for their larger counterparts, so private lenders help fill that void. As we’ve discussed in other segments, the ability for private lenders to be flexible on the loan structures (terms, rates, closing timeframe, etc.) can also go a long way toward them winning a bid.
It is vital to point out that this fund mainly provides mezzanine financing; this means it is subordinated to (i.e., has less protection than) other debt in the event of default and recovery scenario. In fact, it’s only ahead of equity holders, so is sometimes considered “equity-like” or “equity lite.” Again, using our prior BDC fund example for comparison, the BDC issues primarily senior-secured debt, which is first in line to seize assets in a recovery scenario. That is all to say that private debt comes in many flavors.
Partially because of the lack of protection in mezzanine debt, another critical factor is the team’s ability to work with the borrowers to help them improve their businesses. And SBL can be incentivized to assist with that growth for (at least) two reasons:
- If the business is doing well, it will make timely interest payments and repay its loan. Working closely with the borrower is a means to help directly protect the best interests (pun intended) of the SBL fund and its investors.
- These mezzanine loan structures often include warrants. And in case you forgot everything you learned on the Series 7 exam (or you never had the pleasure of studying for it), here’s all you need to know for our purposes today: warrants give the holder the right to buy company stock at a particular price (the strike price). If the company stock price exceeds that strike price, the warrant will have value. If SBL can help drive the value of the lendee’s company higher, then the warrants become more valuable; thus, SBL is incentivized to help with growth. If you’d like a deeper explanation of warrants, this Investopedia link should be useful.
The above growth considerations begin to shed light on how important it is to find a good manager in this space. It’s not just the underwriting of the deals but also the consistent hands-on involvement with the portfolio of loans and companies that can protect/enhance investments and make-or-break the fund and the manager’s ability to continue raising funds in the future. And that concept is not only true within this lower-middle market lending arena but also in nearly every segment and strategy we’ve covered in this “historic” series.
The SBL fund has a firm focus on recession-resilient companies with a long track record (often 20+ years) and low leverage ratios. They believe that leverage ratios (e.g., debt levels relative to assets or income) – not company size – are perhaps the most crucial factors in assessing the risk associated with lending money. But, as we’ve alluded to, large companies generally have an easier time obtaining lending than smaller companies – even if the large company has relatively more debt. It’s simply the way the world works, so we may as well use it to our advantage.
- Structure: Private-equity drawdown structure.
- Fund life / Access / Liquidity: 7-12 year fund life, with commitments only accepted until the end of the capital raise period. Illiquid. Capital is returned when the fund enters the harvest period and loans are repaid (at that time, the fund can no longer “recycle” the capital and make new loans).
- Cashflow: Consistent quarterly income is distributed from the underlying interest payments.
- Pros: Relatively high-income levels can be obtained in this space, which helps make the fund life more palatable. Warrants can add upside. Focus on resilient businesses. A small amount of leverage is used at the fund level to essentially offset the fund’s fees (i.e., what would have been gross returns become net returns).
- Cons: Illiquid; not open-ended; leverage at the fund level (it can work both ways!). Qualified Client hurdle may be out of reach for many investors. Mezzanine debt lacks protections afforded to more senior debt.
- Where Are We Now? Income distributions have exceeded targets, and the strategy seemed to continue, largely unaffected, throughout the COVID onset – likely due to the nature of the underlying businesses, loan structures, and hands-on involvement of the team to step in where necessary.
For Qualified Purchasers…
Private Real Estate and Alternative Energy Lending, with a focus on distressed municipal structures (“PREA” for short)
The landscape of municipal entities, projects, and associated bonds is vast. In the US corporate world, there are only around 6000 publicly traded companies, and with the small army of financial analysts and today’s software, there is a reasonable amount of coverage (aka analysis/tracking) on the bonds that those companies issue. However, on the municipal-debt side of the market, there are nearly 36,000 local governments (towns, townships, and counties). That number expands to almost 90,000 once you consider local government units (“special purpose authorities” created by states, including school districts, water/sewer resources, public transportation, libraries, etc.). Start multiplying by the number of municipal bonds that each of these entities could issue, and you get the idea: it’s a massive landscape with many uncovered opportunities if you know what you’re looking for.
With deep municipal experience, the PREA team can create value from situations that others cannot. For example, say a town decides there is a need for a senior-care facility within its borders. It can offer a sweet deal for a local developer to accomplish that goal: build us the facility we (the town) want, and we’ll finance 100% of the project by issuing municipal bonds. Now imagine that project goes terribly wrong: it’s over budget and unfinished. Bondholders stand to be wiped out, as there’s no senior care facility to generate revenue and repay them. It’s a total mess for the town, but it’s a perfect opportunity for PREA.
The team needs to dig into the bonds to analyze the terms and structures precisely. They also need to build a relationship with the town to understand its perspective on the situation. The goal is ultimately to create a win-win-win scenario for the town, its residents, and (of course) PREA’s investors. There may be several ways to go about correcting the situation, but it involves many moving parts, including:
- Working with the town to assess the existing bonds and – if needed – retire the old bonds and issue new ones with a more appropriate structure.
- Incorporating the needs of the town and its residents into the restructuring plan.
- Taking a controlling interest in the project or property.
- Assessing the real estate project at hand, including remaining cost, completion timeline, etc.
- Understanding the business opportunity of the care facility – quality, services needed, lease-up challenges, resident demographics, private vs. public pay, etc.
Hopefully, the complexities related to the above are apparent, but it’s worth pointing out other features of PREA. First, properties or projects can sometimes be taken over by buying a controlling interest in the bonds that finance them. Thus, instead of usually lengthy real estate transactions, with closing timelines of 60-90 days or even longer, control can be assumed in the time it takes bond transactions to settle (effectively three days!). There are also inherent tax advantages. By working closely with towns to help them achieve desired outcomes (and fix major headaches they face), PREA can help create favorable tax outcomes (like tax-free income) through some creative municipal debt structuring. It takes the right team, but – if approached correctly – fragmentation, distress, unusual, and structurally complex situations can be pretty rewarding.
Balancing the more arduous real estate undertakings with lending/specialty-finance projects allows PREA to target a more consistent cashflow component for investors. This approach can also help mitigate the J-curve phenomenon (where the fund value initially declines due to initial construction/improvement costs that don’t immediately translate to increased value) common to private equity real estate. Those finance projects are approached with a similar lens of risk mitigation, municipal integration, and “win-win” outcomes the team incorporates for other holdings. And in the spirit of “doing well while doing good,” the team’s mission is to help improve energy infrastructure, communities, and society while also targeting attractive outcomes for investors. It is undoubtedly a form of impact investing, but perhaps not in the way that initially comes to mind when hearing about ESG (environmental, social, and governance) and SRI (socially responsible investing) initiatives in headlines these days.
- Structure: Private equity drawdown structure. Illiquid.
- Fund life / Access / Liquidity: 7-12 year fund life, with commitments only accepted until the end of the capital raise period. Illiquid. Capital is returned when the fund enters the harvest period and loans are repaid and/or properties are sold (at that time, the fund can no longer “recycle” the capital to make new purchases or loans).
- Cashflow: Consistent quarterly (tax-advantaged) income is distributed from the underlying interest payments and property cashflows.
- Pros: Usually, about ½ of the income is tax-advantaged. Ability to provide win-win solutions in very specialized situations. Income distributions help to make the fund life more palatable. Less J-curve than in many other PE funds. Social impact.
- Cons: Expect some degree of J-curve. Qualified Purchaser requirement is the most difficult to achieve for investors. Illiquid. Long fund life.
- Where Are We Now? We’ve followed the team through difficult circumstances pre-COVID (e.g., a hurricane hitting a tourist destination); they have since been able to demonstrate the importance of sound risk-management throughout the pandemic, but also uncover additional opportunities because of the distress that continues to work its way through the system (this is ongoing). Distributions and increases in overall valuation have remained consistent throughout the fund’s life.
And, just like that, we’ve come to the end of this “historic” series, covering a brief history of alternatives, my experience thus far with the Alts space, and 12 private strategies along the way. I hope it’s been helpful, informative, and not too dull. If history teaches us anything, it’s that change is constant. The best Alts strategies of today will very likely not be the best Alts strategies of tomorrow, and we’re always on the lookout for new ideas to solve for our clients’ income, growth, and risk-management objectives. And while the strategies themselves may change, I expect that much of our historical approach will remain intact: do your best to know what you own; manage risks (e.g., markets, liquidity, concentration, leverage, etc.) appropriately; and be sure to diversify because no one knows what (or who) can go wrong.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
