PARTICIPANTS
Guest Host
Tom Dicker
Vice President & Portfolio Manager
Richard Lee
Vice President & Portfolio Manager
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Tom Dicker: Welcome to another edition of On The Money. I'm your guest host, Tom Dicker, Vice President and Portfolio Manager at Dynamic Funds. Today we're going to discuss one of the hot topics in investing over the last few years, alternatives. Joining us is Richard Lee, Vice President and Portfolio Manager at Dynamic Funds. Richard is the lead manager of the Dynamic Alternative Yield Fund, and he joined Dynamic in 2022 to lead the Alternative Yield Fund as a succession plan for the founding manager, John Harris. Richard joined us with 17 years of industry experience, starting out on the sell side but for the last 10 years, Richard managed pension and treasury investments for Scotiabank.
Richard has extensive experience in many areas within alternatives, and we're going to talk about all of them today. Richard, could you start us off by taking us to what seem like an overnight success? All of a sudden in 2017, 2018, we're reading about alts in the paper every day. You've got these big alternative asset managers buying up things all over the world. It was almost like this overnight success, but it was, in many ways, 30 years in the making. Could you tell us a bit about what caused pensions and endowments to start down the path of adding alternatives to their traditional stock and bond portfolios?
Richard Lee: I think the story of alternatives really dates back to the '80s. KKR (also known as Kohlberg Kravis Roberts & Co.) raised the first private equity fund, and at that time it was a tiny fund. It was a very niche product but what happened over the next 20 years? Well, there's multiple forces at hand, and let me try to unbundle some of those forces. If you go back early '80s, when interest rates were 15%, I think the US tenure in September of '81 was yielding 15%. Really over the course of the next 35 years, it went from 15% all the way down to basically 30 basis points in March of 2020.
Now, obviously, that was due to COVID and extreme monetary policy, but you had this asset class that was at the core of many pension plans and endowment plans that kept coming down in terms of ability to generate reasonable yields.
Tom Dicker: Fixed income ultimately became, in a way, instead of a risk-free return, it was return-free risk.
Richard Lee: Absolutely. Now, that was great in a low inflationary world but something else also happened. The market structure of the public equity ecosystem also changed. The advent of ETFs and more and more companies coming to the IPO (initial public offering) market a little bit later in the cycle. That combined with this explosion of private investing, this notion that you can just buy a company in a private fund, grow it, incubate it, expand the business lines outside of the public domain, where you could affect more change more effectively, and do things that not necessarily is conducive in the public eye.
Tom Dicker: Not all companies at every stage are conducive to being in the public markets for various reasons, whether it's they have too much leverage and they need to fix their balance sheets. It sounds like private equity came out of filling that void in the market.
Richard Lee: Absolutely. It goes back to what we talked about earlier, which is, declining interest rates and ability to generate sufficient returns, combined with the fact that this asset class was growing and it was becoming a more professionalized, less niche strategy, pension plans and endowments were early adopters of this and it boils down to this. It was the ability to get better risk-adjusted returns, a way for them to really diversify and enhance the portfolio mix.
Now, a final fun stat around this is you look at CPPIB's (Canada Pension Plan Investment Board) asset mix. In 1999, it was 100% fixed income. Fast forward, today, they have 67% in alternatives. It has been a tremendous evolution of their asset strategy, and we're looking to follow that lead because we think the next wave of alternatives is really in the private channels.
Tom Dicker: There were some cyclical headwinds to the fixed-income yields that brought down returns over what was almost a super cycle in the bond market. That headwind for yields and fixed income seems like a tailwind for the alternatives' world. Alternatives did really well off the back of that. Then, obviously, the structural changes in the equity market, whether it's things like the high cost of running a public company certainly changed the value proposition of being public versus being private, and that allowed the private ecosystem to really grow fairly dramatically.
Now we're at this point where rates have started to come up a bit. How do alternatives work? How can alternatives work, and what alternatives-- because alternatives is obviously a pretty big area, not all alts are created equally. What areas of alternatives work in an inflationary environment and a higher interest rate environment?
Richard Lee: Let's try to unpack two things there. One is the inflationary environment and, two, which is alternatives as a category. Let me start with the second one first. There is no universal definition of alternatives, unfortunately, and that creates some confusion. A simple way to think about alternatives is there's four main food groups, private equity, private credit, private real estate, private infrastructure. There's also venture capital, but for all intents and purposes, let's just say those are the four main categories.
Similar to public equity investing or fixed income, certain asset classes and certain sub-asset classes form better depending on market conditions. It would be fair to say during the ultra-easy QE (quantitative easing) era, private equity was the asset class that probably was the main beneficiary of that. Why? Because it's a leveraged finance vehicle, and if you could borrow at 1% or 2%, the benefit to the equity holders is just more magnified as you could borrow cheaply and as well as you operationalize the changes into the company. In today's world, though, it'd be also fair to say that the economic rent has shifted from the borrower to the lender now.
What that means is asset classes like private credit is going to be the winner in this environment. Again, that's going back to our earlier point of alternatives is a wide generic term, and there's lots of different sub-asset classes. It's not all to say that certain private equity styles and strategies like structured equities or secondary equities, these types of sub-asset classes can work. To your point, we think that private credit is going to be a very key asset class going forward in this environment where rates are going to be a little bit higher, and perhaps inflationary impulse is still here to stay. We think the lender will benefit at the expense of the borrower.
Tom Dicker: What you're saying is borrowers in a low rate environment when credit was really loose did extremely well. You were heavily incented to borrow more because your cost to carry was really low, so it allowed you to accumulate assets and income. Now the lender, i.e., you if you are in the private credit business, if you're in the alts business, you as the lender can extract higher returns from borrowers now as credit availability has-- [crosstalk].
Richard Lee: Absolutely.
Tom Dicker: Is that what you're getting into? Okay.
Richard Lee: Absolutely.
Tom Dicker: That resonates well. I think it's very consistent with some of the things that we're seeing in the financials market where credit conditions are starting to tighten. When conditions change, the winners and losers often change. It sounds like private credit could be one of the winners in this next stage of the economic cycle because they have raised a lot of money but haven't necessarily deployed it. Is that a reasonable assessment?
Richard Lee: Absolutely. When there is a drawback of liquidity and capital by the traditional lenders that we're seeing in today's environment, the regional banks, this is a golden opportunity for alternative financers to provide that capital and really fulfill that gap in the market that's happening. I would actually go back to the great financial crisis. The genesis of private credit. One of the reasons why we think this asset class has a bright future is because one of the unintended consequences of the great financial crisis is that the banks were no longer able to provide this type of leverage financing to small and medium businesses. This created a massive gap in the marketplace.
If you are a user of capital and need a loan to buy another company or to grow your business, unfortunately, because of the new regulatory rules and the capital rules, the banks that were traditionally the financier of this type of debt were no longer available, and hence, this was the genesis of private capital. That trend is only going to be magnified, in my opinion, because of the recent turmoil that we've seen in the regional banks and there's, obviously, some discussions while it's early that even the regional banks will face more regulatory scrutiny. This is creating a significant gap in the marketplace and all the private alternative managers are looking to capitalize on this opportunity.
Tom Dicker: Richard, could you help us understand private credit a little bit because I think a lot of our listeners wouldn't be familiar with who the players are in private credit. When we're thinking about this private credit market which is a very foreign concept, can you break it down for us? Who's in that market? Who are the big players? Who are they lending to? What's going on in the private credit market?
Richard Lee: Just to keep things simple, the most common players or largest players in this industry, they're names like Ares, Apollo, Oaktree, Blackstone. All the large alternative asset managers now have developed a strong private credit franchise. Now, just to elaborate further on the role that private credit is playing, I think, let me tell you a simple example that happened last summer. A lot of people know the company called Emerson. It's a large industrial conglomerate. They decided to spin out their Emerson climate solutions business.
Now, let's go back to what would've happened pre alternative world. Normally, a company of this size, there's a division. It was a large enough company. I think the enterprise value was something like 5 billion, where it probably could have IPO'd or spin out that equity to shareholders and probably could have financed the traditional investment grade or high-yield public credit market to refinance their capital structure. That would've been the normal, traditional way a company like this would've refinanced.
Fast forward to what happened last summer, the public markets were a little bit episodic, and a lot of companies couldn't access the public markets. What did they do? They sold the business, the equity, to Blackstone. Now, Blackstone needed to finance the capital stack. What did they do? They called up numerous private credit managers and financed the entire debt stack in private hands, and the economics were quite attractive.
They probably financed that LIBOR plus 600, 700, plus fees, so the private credit manager who was providing that capital could earn almost 10% unlevered. Those economics are now only available to the private credit lender. The public credit investor didn't have access to that paper. That's another example of how companies are relying less exclusively on traditional financing channels and now are at least able to access the private channels, and as investors, the only way to access those types of returns on your capital is through the alternative channels now.
Tom Dicker: That leads me really well into my next question which is how do regular investors get access to these investments and these returns?
Richard Lee: This is where things get interesting. When I ask most advisors and clients, it's really difficult to ask individuals to lock up their capital for 10 years with a blind pool risk. Most people probably are hesitant. It's still a new asset class, and it's illiquid. Your money is locked up but there's other ways that you can capture this opportunity. For example, what we've created with the Alternative Yield Fund, we're trying our best within the public market space to provide indirect proxy exposures to capture some of these benefits and these new and evolving asset classes. Let me just give you an example. One of the ways you can capture private credit exposure is through companies called BDCs, Business Development Companies.
Tom Dicker: Are these publicly listed companies?
Richard Lee: Absolutely. These are publicly listed companies that we've got to know, and they're oftentimes associated with all these private alternative managers. For example, Ares has a BDC company.
Tom Dicker: This would be a subsidiary of Ares?
Richard Lee: This would be a subsidiary of Ares. You can gain exposure to private credit through these types of companies while allowing our investors and clients the flexibility in a mutual fund structure. That was the whole premise of creating the Alternative Yield Fund, was how can we, to the best of our abilities, capture some of these structural trends that's happening but make it easy so that mom and pop can easily access this megatrend that we're seeing in alternative capital formation?
Tom Dicker: When I've looked at BDCs in the past, I've always found them to be a little bit tricky to analyze and it's certainly an area where I would say to a retail investor who was just looking at them, "Caveat emptor." You really need to know what you're buying, not all BDCs are created equal. How do you get comfortable with them, and what are the bits of advice you give to investors who are looking in this area?
Richard Lee: True active management and market intelligence is paramount. When we look at a BDC, oftentimes we also know the parent company. We often have insights into their other private vehicles. For us, we are able to get really deep, I would say, competitive knowledge advantage on understanding how these companies and management teams underwrite their risk. For us, we are able to understand these companies in great amount of depth and I agree with your assessment that these are not types of companies that I think the average person can just buy and hold.
It takes a tremendous amount of active management experience and knowing how to differentiate between what a good BDC and a poor BDC is. The other point I would also make is that you can also purchase BDC equity or BDC debt. For us, there's times in the cycle where you want to own the BDC equity or there's times when you want to own the BDC debt, depending on what your view is on interest rates and also the credit default cycle. Those are types of active management knowledge and experience that we've developed to make sure that we are playing on the appropriate part of the capital stack.
Tom Dicker: Maybe we should switch gears a little bit and talk about some of the many other areas within alternatives, which are also growing pretty quickly, some of which faster than others. Can you maybe talk a little bit about the areas in alternatives that are go and no go for the Dynamic Alternative Yield Fund? When some people talk about alternatives, they're talking about commodities or venture capital. What are the go and no-go areas for you and the way you invest?
Richard Lee: When we think about alternatives, and again, this is a why universe, but for us, the way we define alternatives is really those four buckets that we were talking about earlier, infrastructure, real estate, private credit, and private equity. In our opinion, venture capital and more exotic products like commodities or hedge funds, while they may have some place for certain types of investors, for us, the core of alternatives is really those four buckets that we talked about.
That's not too different to all the other endowment funds and pension plans. If you look at their asset mix, it's very geared or centric to those four buckets, and largely because those are the areas where it's really the most well developed and the risk tolerance for some of those venture capital funds, as we've seen in the last year, those are the risk profiles that we would not feel comfortable taking for our Alternative Yield Fund.
Tom Dicker: The alt industry has grown dramatically. I think when we were talking earlier, and remind me of the numbers, but I think it was around a trillion in the alternative asset industry in 2007 compared to something like 16 or 17 trillion now. Are those numbers roughly right?
Richard Lee: The market as it stands today is about 15 trillion. If you go back to 2006 timeframe, it was about 5 trillion. We've seen a tremendous amount of growth, and according to some industry projections, this asset class in totality will grow closer to 23 trillion over the next 5 years. This is an asset class that has grown tremendously. Here's the fascinating part. All of that growth was really predominantly driven by institutional money managers, pension plans, endowment funds-
Tom Dicker: Sovereign wealth.
Richard Lee: -sovereign wealth. We think the next 10 years or 20 years is going to be driven by private wealth. We think that the penetration, particularly in Canada, I've recently heard a stat that it's 0.1% alternatives as a percentage of total AUM.
Tom Dicker: This is for individual investors?
Richard Lee: Individual investors. Yes.
Tom Dicker: People with their account with an investment advisor, 0.1% of that [crosstalk].
Richard Lee: Absolutely. If you use US as a comparison, the latest stat I heard is that US is closer to 8%. The point being is we think we're really at the top of the first pitching to the first batter, and we see a tremendous amount of runway here. It's rapidly evolving by the day. Even when I first started looking at private seven years ago compared to now, the ecosystem continues to grow and evolve. That's why we're so excited about the Alternative Yield Fund.
Tom Dicker: There has been a tremendous amount of growth in alternatives, especially over the last cycle when rates were fairly low. You saw, as you mentioned earlier, a lot of new alternative asset managers show up, 15,000. That sounds like a lot of people out there chasing returns in the sector. When I hear of a really long bull market, you always get worried about excesses. One of the things that's on the top of my mind, WeWork, which was a private equity company that had, at one point, a valuation of over $40 billion.
It looks like it's pretty close to being de-listed from the stock exchange after going public in a SPAC (special purpose acquisition company) with a valuation dramatically lower than where they were valued at just a few years earlier. Not all is always rosy in the private equity world. How do you think about some of the excesses that may have taken place over the last few years, particularly during the COVID years with respect to the investments that you've made? What are the areas within the alternative world that you have concern with?
Richard Lee: We talked earlier about venture capital on the riskier end of the spectrum in private capital investing. I would say that area of the market was a primary beneficiary of when US tenure was 30 basis points, and everybody thought interest rates were going to be zero forever. Fast forward today, we realize that all good things come to an end at some point. That was an exact prime example of the excesses that people probably over-extrapolated the benefits of venture capital investing, for example. Will there be more moderation of returns in private capital, particularly, let's say, venture or growth equity? Absolutely, because cost of capital is being repriced as we speak today.
Now, having said that, I do think the long-term trajectory of this asset class will continue to be very favorable because it's also important to realize that not all alternatives are created equal, as we mentioned earlier, there's going to be some winners and losers like every asset class. We talked about how that economic rent has shifted from borrowers to the lenders, so private credit. We didn't talk about real estate debt or infrastructure debt. These asset classes are now growing and coming, and I think those are the areas that I think could really benefit from this new world that we live in.
I do believe that there's a bit of a sea change here that's happened in the markets and the markets starting to realize that yesterday's playbook isn't going to work for tomorrow's environment. I think other asset classes less dependent on cheap money and excess valuations will be the winners, just like other asset classes across the public landscape as well. It's no different.
Tom Dicker: I recognize that me calling out one bad example in a venture capital area does not mean all areas of alternatives were in excess. I was maybe just trying to get at this idea of when there's growth, there are always some areas of excess whenever you have a long bull market. It sounds like we've avoided the areas like venture capital where the worst of the worst excesses probably took place. We're more in a position right now with both the way the fund’s invested and the way our investments are positioned with lots of cash to take advantage of the current environment.
Richard Lee: Yes, that's a fair assessment. I think it's important we be intellectually honest about future returns for sure on just any risk assets. When borrowing costs for some of these private businesses are close to 8, 9%, naturally, the returns for the equity shareholder will have some challenges, for sure. Now, I think this is where active management is extremely important. When you look at the private equity landscape as an example, the dispersion of returns from first quartile and second quartile, third quartile, fourth quartile, is significantly wider than other asset classes. For example, public equities, the first quartile manager versus the fourth quartile managers is not that big of a difference versus private equity managers.
This is where, I think, the true contenders versus pretenders will shine. Anyone who had a private equity mandate in the last five years during the QE era looked like they were all first quartile managers, but I think going forward, there's going to be a wider dispersion of returns and we'll see who are really the true first quartile managers versus other managers who may have just benefited from cheap financing and hyper risk appetite.
Tom Dicker: I want to bring it back to your clients. I know you just came back from a bit of a marketing tour talking about your new mandate taking over the fund. The feedback from that was really, really positive but you had a lot of conversations with clients. What did you come away with as the one area where clients have the biggest misunderstanding about alternatives and what alternatives are or what they're for?
Richard Lee: I would say there's one key message that I wanted to leave with every investor and client was that alternatives is now becoming core. It is no longer a niche strategy. We like to use the words alternatives is now the third leg of the stool. What do I mean by that? When I think about the future of investing, I truly believe that alternatives will become a critical component of portfolio construction.
A lot of people, still to this day, believe in the 60/40 model, which for the last 40 years has worked but, in the future, there's this asset class that's now $15 trillion. If I'm thinking about, how do I optimize my portfolio and maximize my opportunity set, I think alternatives will be a key component that a lot of advisors and investors will start to look to because it provides that much-needed diversification.
When the US 10-year was at 15%, it made all the sense to have a 60/40 mix, but even at 3.2% where it stands, I think we could all agree that it's not going to provide that same degree of ballast for people's portfolio, going forward. We're not even talking about the inflationary pressures that we face today. That in itself suggests that we need to think about the future model of the 60/40. In my own humble view, I believe the future will look like something like 40/30/30. We think this asset class will be an increasingly important element, another important leg of the stool.
Tom Dicker: Private equity and private credit, those were alternatives in the '80s and '90s just like Pearl Jam was alternative rock in the '90s, and now that's pretty mainstream. Private equity, private credit, like Pearl Jam, after you've been around for 30 years, all of a sudden, you're in the mainstream. Richard, that was a great conversation. I learned a ton about alternative credit, about your philosophy, about the importance of active management of alts. I want to thank you very much for coming in and joining us today. That was a great conversation.
Richard Lee: Thank you for having me.
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