Capturing Outsized Returns in Private Markets | Brandon Averill, Erik Averill, Justin Dyer | AWM Insights #53
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Episode Summary
In this episode, we take a break from the usual discussions of financial and investment news over the past week to take a deeper dive into private markets. With all the excitement over the past year around individual stock picking, the entrance of new forms of cryptocurrency and NFTs (non-fungible tokens), we thought it’d be good to spend some time on private markets because we think they are where you can capture some of the highest drivers of returns.
Brandon, Justin and Erik discuss what private markets are and why they typically capture some of the highest returns, whether skill is a factor in private markets, and getting access to the best deals.
Episode Highlights
(00:12) Going deeper into the private markets
(1:38) The additional risks that come with private market investing
(4:07) Are public markets more attributable to luck or skill?
(4:40) Out performance in the private markets
(5:09) “Not all venture, not all private equity, is created equal.” – Brandon Averill
(7:17) Due diligence questions to ask
(9:18) How do we actually get access to the top 25%?
(9:48) The building block considerations
(13:01) Understanding your finance goals
(15:24) Putting it all together in a holistic integrated plan
(15:44) What factors should be in place before you consider entering private markets?
(19:52) Types of private markets
Resources
Luck Versus Skill in the Cross-Section of Mutual Funds by Eugene Fama and Ken French
Private Equity Performance: What do We Know? By Robert Harris, Tim Jenkinson, and Steven Kaplan
Stay Connected
AWM Capital: IG | LinkedIn | Facebook | AWMCap.com
Erik Averill: LinkedIn
Brandon Averill: LinkedIn
Justin Dyer: LinkedIn
+ Read the Transcript
Erik Averill (00:00): Hey everyone, welcome back to another episode of AWM Insights, it’s your power three: 2 CPWAs and a CFA, we are Erik, Brandon and Justin, and each week we cover what you need to know to capture the returns you deserve and invest like a pro.
Erik Averill (00:12): And today we're going to take a little bit of a detour of our typical structure, where we're looking of what's gone on over really the past week, and we wanted to spend some time going a little bit deeper into the private markets.
Erik Averill (00:29): And we think that this is such an important conversation to have because of what we've seen over the past year of the excitement of trying to make money by individual stock picking, the entrance of new exciting conversations around cryptos and NFTs, of one of the things we drill down on is our commitment to help you capture the highest drivers of returns. And you have heard us time and time again talking about that we believe so strongly those returns come from the private markets.
Erik Averill (01:07): And so we're going to do a deep dive today. Of course, we're not going to have enough time to cover everything in depth. So make sure you head over to AWMinsights.com, where we're going to load up with additional resources. But with that intro, let's jump right into the conversation of what are the private markets, and why is it here that the best returns show up?
Justin Dyer (01:38): Well we've got to first start the conversation with unpacking sources of return or sources of risk. We talked a lot about that from an equity market perspective, or a public market perspective actually, let's say that, a couple of weeks back. And what we mean there is where do we expect our returns to come from? You're risking money and you expect some form of return for that.
Justin Dyer (02:03): In the public markets we think about it through risk premiums, which is the expected return over and above some benchmark rate. And when moving to the private markets, we think about it from an engineering perspective, would start to get into more of a competitive advantage conversation. What do these individuals who are running these companies, who are making these investments in the private markets have in addition, or over and above the average investor, or the public markets for that matter?
Justin Dyer (02:45): And add to that, the confidence around that. Is this a space, or is this a vehicle where we think the confidence in positive returns, or excess returns, is high? We can get fooled to think that, "Hey, just because we're participating in the private markets, we're automatically going to get a higher rate of return."
Justin Dyer (03:06): Well, no you got to really unpack what's the vehicle you're being invested in? What's the carry? Which a carry is how much money the manager is taking in a performance-fee type structure. So there's all sorts of things to add to the basic building blocks of risk or return in the public markets, which generally start with enterprise risk, or like broad market risk is the best way to think about it. We start to add all these different layers and components of risk when we're thinking about private investments, and at the end of the day we want to have a high level of confidence, probably even higher than the public markets when we're making a private market investment.
Brandon Averill (03:49): Yeah, I think those are really good points Justin. We've hit this over the head so many times, but when you start to look at the data, and this goes back, we do want to be compensated for the enterprise risk, so basically being invested in the public markets.
Brandon Averill (04:07): And then we've hammered home the competitive advantage. And there's a great paper called Luck Versus Skill in the Cross-Section of Mutual Funds, really in thrilling title there, by a Eugene Fama and Ken French in The Journal of Finance. And what they did is they dissected the public markets, and basically came away with the conclusion via the evidence is that there is no real skill that can be identified. It is more attributable to luck.
Brandon Averill (04:40): However, like you mentioned, when we flip over to the private side, an equally fascinating paper in the journal of Finance, Private Equity Performance, What do We Know? What we start to see is that there is actual evidence of out performance in the private markets, and like you said, it could come from the engineered risk, of leverage, illiquidity, meaning tying your money up. You can't actually get access to your money, or the skill of the manager.
Brandon Averill (05:09): And as you kind of dive a little bit further into that, I think we'll hit on this throughout the podcast today, is not all venture, not all private equity is created equal. And we'll start to see that pretty pervasively throughout the evidence. But we start to see that that top quartile outperforms far and away above the rest of the field. So it seems that skill certainly does exist in those private markets, it's just making sure that we're taking the right considerations when we're trying to evaluate them.
Justin Dyer (05:43): Yeah. And then add to that too the persistent nature of it. So what persistence is, is the continuation of those out sized returns, right. Do we have a confidence that that private equity out-performance that Brandon referenced, is that going to persist into the future?
Justin Dyer (06:05): And obviously we don't, we say it ad nauseum here, time and time again, we can't truly predict the future, but we're going to really test it and say, "Okay, are there valid drivers or valid reasons to expect this all to persist in the future?"
Justin Dyer (06:19): The one thing I would also add kind of as a caveat to this too, is we also have to think about this from a cost of capital and this kind of gets into access, and we'll talk about this a little bit where some of these out sized returns that you see or hear about in venture capital and private equity are due to the fact that there were only a limited number of players in the past.
Justin Dyer (06:44): And they were the only players, they had the access to the best investments. They had access to the best capital, and therefore their returns, kind of as a result of that, look fantastic. That's not necessarily true anymore. It does seem to appear that there's still the ability to get excess returns versus the public markets in private equity or venture. However, there's a lot more access out there. There's a lot more products being put together and pitched to retail investors and all that stuff.
Justin Dyer (07:17): And that's not necessarily a bad thing, it's important to keep in mind as the investor, "Okay, well, why am I getting access to this? Why aren't they going to the big institution that would write them a $200 million check instantaneously, as opposed to a collection of individuals that are going to write arguably big checks, but small relatively speaking?" So it's also really important to keep that in mind and something we all always have in the back of mind as we're doing our diligence on some of these investments.
Brandon Averill (07:48): Yeah, I think that's a really good point. And I think access, things are becoming a lot more accessible, and that certainly does, I think kind of muddy the waters a little bit. But when we take a step back and you think about access in it's true form, like why am I getting, to your point Justin, why am I getting access to this?
Brandon Averill (08:09): If I'm a cloud company, I'm the founder of a cloud company, I'm the founder of the next Zoom, and I want funding, am I going to run down to the buddy that I have that maybe is in the clubhouse because I know he can round up some money, I can get him excited, or is it better for my business to go try to pitch Byron Deeter at Bessemer who created The Cloud 100, who's invested in every successful cloud startup, seemingly that we've seen, and know that, "Hey, if I can convince Byron," now he is on what's called my cap table, he's on my fundraising list, how much easier is it going to be for me to develop contacts, to raise money in the future, et cetera?
Brandon Averill (08:50): So it's not a knock on people. I think it's going to be really interesting, it's just what do you bring to the table? And we hear this time and time again, these big funds, they can turn down the big institutions because especially in today's environment, capital is not the problem. There's plenty of capital flowing around. So it's what else could you potentially bring to the table to help kind of further things along?
Brandon Averill (09:18): And so I think when we start to evaluate how do we actually get access to that top 25%? And think about it if you were that person accessing those deals, are you equipped to be in that top 25%? I think that's a really good lens to start to look through when you start to see deal flow coming. Because we hear about it all the time, everybody thinks they have some special insight into deal flow, but I think you need to be careful out there.
Justin Dyer (09:48): Yeah, and before we even get to that point, we have some building block considerations. Okay, what's the merit of this? We've somewhat touched on that where we think, "Okay, in general private equity, venture capital, has demonstrated some ability to outperform." Okay, that makes sense. Okay, then we say, "What's the confidence?" We touched on that a little bit. We're going a little bit more in depth on access. Makes sense. We need to ask ourself the question of liquidity. How long are we willing to tie up money? Does it make sense to say, "Okay, well in a downside scenario, in some venture capital investments, you're saying, 'Hey, maybe it could be 10 years before I can get all of my money back,' and are we comfortable with that?" You may or may not be right? These are all considerations that kind of go into this.
Justin Dyer (10:38): Another interesting way to think about it too. Is, is there a public market proxy, or is there a public market equivalent that we could implement that gives us a very similar type of return profile? You actually see a lot of academic studies that show, "Hey, in some cases in the private markets, all you need to do is invest in small cap companies, and do it on margin, introduce leverage there, and you're going to get the same type of return stream." And you'd potentially rather do that because the costs are really low, and there's no illiquidity, and just something to keep into consideration.
Justin Dyer (11:19): And then one of the things I like to think about quite a bit, and we've been thinking about a lot here lately, is the portfolio construction aspect of it. If you're just being pitched a private investment because it's sexy and it's cool, and there's no consideration on how it folds into your broader portfolio, you're dealing with an amateur. You're dealing with somebody who's really trying to sell you a product in my opinion. And they're trying to just attract you in because, "Hey, we got this sexy access to this cool investment, and you should put a hundred thousand dollars into it," or whatever the case may be.
Justin Dyer (11:58): That's okay, but it really is not benefiting you, and it's not being done in a way that takes into account your desired outcomes. And we talked about that a ton, where we're going to look at a total portfolio approach when we apply this. If you make a commitment to an investment and it's going to take them four years to call all your capital, chances are you're going to be holding that amount in cash to meet that capital call, and there's a huge cash drag on these returns.
Justin Dyer (12:29): That's something we think about. So the way we can implement is we minimize cash drag, and almost can eliminate it in some cases, because we're really, really thoughtful in folding private investments into a broader total portfolio strategy.
Erik Averill (12:46): Yeah. One of the things I love listening to you guys talk about here is you're really starting to break down why are people compensated for the risks, which creates the returns in the private markets?
Erik Averill (13:01): And what I wanted to take a step back and look at is just to reorient that we're not saying that all of your money should go into the private markets. What we are saying is is that if you define success as, "All I care about is the highest returns," all of the academic evidence says you should be in the top quartile of early stage venture capital, that produces the highest returns.
Erik Averill (13:30): As you've heard us say so many times on these podcasts though, your definition of success is, "Can I achieve the priorities and the life that I want to live?" And so the takeaway is not, "I should not invest in the public markets," it's that, "I should have a strategy and understanding of what my priorities are, and if part of that says I have enough money to try to outperform and capture higher returns, the only logical rational place that I should attempt to do that, that has any academic evidence behind it, is in the private markets."
Erik Averill (14:10): And so we want to protect you against the amateur moves of trying to pick individual stocks inside the public markets, or making the other mistake we see a lot of times is when there's a missed understanding of where returns come from, people get scared of the public stock market, and they start to confuse, "Well, maybe I want to go invest in private real estate instead of the public stock market, or Bitcoin instead of the public stock market." And you actually are comparing two apples to oranges things.
Erik Averill (14:49): The public stock market is a location, an actual place where you can access types of investments, same thing with the private markets, real estate, Bitcoin technology companies are what you invest in, not where you invest. And so I think it's good to just orient us as listeners to understand that it's about the locations, public versus private. It's like a golf course. I can go to a public golf course, or I can go to a private golf course. And these barriers start to introduce where some of these returns come from.
Erik Averill (15:24): In a holistic integrated plan, you most likely should have access to money in both the public and the private markets. And so I just thought that that was an important framework to bring to the forefront of this conversation.
Brandon Averill (15:44): I think it's a huge point. Make no mistake about it, I don't think there's anybody out there that shouldn't have the vast majority of their assets in the public markets. That is certainly not what we're saying. The only time you should be accessing the private markets is if you can fulfill a few criteria. Like you said, Erik, if your essential priorities are met, probably if your important priorities are met, now we start to look at "Okay, if it interests you, if you want to take take this chance that you can find some out performance here, then maybe you introduce the concept of private markets," but then all those other filtering questions come in.
Brandon Averill (16:29): "Okay, I want to play in the private markets," we'll shoot, "I want to play major league baseball." Guess what? I can't hit a slider, we all know that, and that's why I'm here talking now as opposed to actually playing.
Brandon Averill (16:40): So it's, do you have the ability to go play in the major leagues? Do you have the ability to go access the top quartile investors in the venture space? I think that's really the process you have to start to go through. And it's somewhat tongue in cheek, but it's actually a really accurate analogy in my opinion.
Brandon Averill (17:02): So I think you even talk to some of the most successful venture investors out there, I won't name names, but I've had conversations with them. These are people, hundreds of millions of dollars, that have created great wealth in venture, and as soon as they see a lot of these liquidation events, they take that money, they go put it in an index, or a structured kind of dimensional fund advisor portfolio, or they go buy farmland, or something like that, but they get the heck out of the venture space. Because you don't want to be over concentrated there, because it's also the place of highest returns, but also the highest possibility you might lose everything.
Justin Dyer (17:42): Yeah right. It gets back to this idea of total portfolio approach, if you're just doing these deals off, you're concentrating some sizeable risk in your portfolio.
Justin Dyer (17:56): Another consideration too, is how much of the portfolio, assuming your situation checks all these boxes we're talking about, essential spending needs, or essential priorities, important priorities, then the excess capital, okay how much is that? Of that amount what's a prudent amount to private markets? You hear anywhere between 10%, 20% potentially of your overall portfolio in private markets makes sense. Well then it also makes sense to say, "Okay, I'm going to put together a game plan over the next," let's use five years for sake of example, "That over the next five years, I am going to take advantage of private investment opportunities as they come up," as opposed to put it all in the first opportunity that comes your way, which again is concentrated risk.
Justin Dyer (18:49): And so do you have the capital to participate in, and the portfolio management wherewithal to manage the flows that comes with committing to something over the longterm, the five-year period? And again, at the end of the day, kind of to Brandon's point that that final conclusion is a pretty hard spot to reach. Most people don't, in our opinion, have the structure in place, and the assets, and the wherewithal, and the ability to participate over the long-term to get that diversification, if you will, throughout private investments, most individuals don't have that final piece.
Erik Averill (19:29): Yeah, this has been so helpful, just even having this conversation of there's so much more we can go into depth. When we say the, "Private markets," as we reiterate, that's a location. There are tons and tons of different types of investments in the private market.
Erik Averill (19:52): So we could do a whole podcast, which we'll do in the future on real estate. Within real estate we could break that down for multifamily, to commercial, to residential. Then you could take the conversation over to private equity. What type of companies? Are we taking public companies and moving them private? Are we now talking about cryptocurrency? Are we talking about early stage startups? And so when we talk about the private markets is you have to have the right access. Something on the public markets is you have to have the allocation in the proper way, globally diversified, low cost, tax efficient. And so we hope that this has been a helpful start to the conversation around this.
Erik Averill (20:38): And I just want to reorient, you guys that are listening, guys and gals, you are the best in the world at what you do. And something we're so passionate about here is what does it take to be a professional? And apply what it takes to be a professional in your given industry and craft, is it's not shooting from the hip. It's not taking fliers one off in the amateur space. It's, there is a process, there is evidence and there's academic research that says, "This is what's going to lead to elite outcomes. This is what the professionals do," and we're here to help you avoid the mistakes of the amateur. And I think that that's what we are so scared of.
Erik Averill (21:25): What we've seen over the past year is that when the markets move up higher quickly, you can literally throw a dart against the dartboard and have some success, but the risk comes when the tide goes back out. And so that's why this conversation is so important to us, is you guys have worked so incredibly hard for your money, that if you are going to introduce risk in your guys's portfolios and risk your priorities, we just want to make sure you're getting compensated with the returns that you deserve.
Erik Averill (21:59): And hopefully the takeaway here is have a plan in place, make sure you're meeting with your certified private wealth advisor, that your CFA is the one that's directing the type of investments that are going into your portfolio. And so once again, we'll make sure to link in the show notes to a few of those research papers that Brandon mentioned, some other resources that Justin's mentioned. You can grab that over at AWMinsights.com. And until next time stay humble, stay hungry, and always be a pro.