Questions to Ask When Adding Alternative Investments to Your Portfolio with Mike Prescott – Ep 61

[INTERVIEW]

Matthew Peck: Welcome everyone to another edition of SHP Financial’s Retirement Road Map podcast. I’ll be your lone host today, Matthew Peck. And what we’re going to be talking about today is the land in the universe of alternatives. I’m sure that a majority of our listeners have come across the terms like private equity, private credit, hedge funds, real estate, infrastructure. In general, the industry kind of calls them all alternatives. But as I mentioned, you probably have bumped into this, either in your reading or maybe online or whatever that may be. So, we want to unpack that a little bit.

What is private equity exactly? What is private credit? What are some of the questions you should ask when considering adding this type of investment to your portfolio? What are the pitfalls? Like, where does it blow up in your face, right? And so, with that in mind, we couldn’t think of a better SHP-mate to come on board on our podcast for the first time. So, ladies and gentlemen, he’s a little nervous. So, just in case, if he gets a little antsy, that’s all right because this is a big deal. Like, this is…

Mike Prescott: It’s a huge deal.

Matthew Peck: Yeah, absolutely. I mean, this is life changing, what you’re about to experience right now. But all joking aside, we’re joined by Mike Prescott. Mike Prescott has been with SHP for a couple years as a trading specialist, but he’s also a level 2 of a CAIA. Now, we’re going to let you know what that stands for in a minute, but obviously, it’s going to relate to alternative investments and private equity. But he’s also spent over 10 years in the industry itself. And so, he is going to walk us through and walk all of our listeners through what some of these terms are, why we’re hearing more about them. And is it right for you? Is it wrong for you? Is it something? Or just what are the some of the questions that you need to know and ask before ever considering any of this type of alternatives? So, with that being said, Mike, welcome to the show.

Mike Prescott: Thank you for having me. Happy to be here.

Matthew Peck: All right, so let’s first start with CAIA. Tell us what CAIA is. I know you’re level 2. So, I know you’re working your way through it. But exactly what is it? And how does it relate to private equity and alternatives and whatnot?

Mike Prescott: So, CAIA stands for Chartered Alternative Investment Analyst. So, that covers hedge funds, private equity. Anything alternative related is in the curriculum for that exam.

Matthew Peck: Okay. So, literally everything that we’re going to be talking about today as part of that exam and part of that designation, you have to have a good understanding of it.

Mike Prescott: Correct.

Matthew Peck: All right. Well, then, as I said, what better gentlemen to have on the show that are going to walk us through. So, let’s stay on the highest level as we can, and then we’ll kind of dive into each particular category. But to start there, again, start very simply, walk us through what are alternatives and what are the different types and what do they mean? So, let’s start at the highest level and just take them one at a time.

Mike Prescott: Okay. So, alternatives are pretty much anything outside of a stock or a bond. It can relate to private markets with private equity, which is an investment in a company that is not publicly traded. There are many types of private equity firms. There’s also private credit, which is private debt. So, you invest in a company that provides financing to companies that may not qualify for traditional bank loans. So, those are less liquid, as in all these investments, they are less liquid than publicly traded companies because they don’t trade every day. That can include infrastructure funds that invest in infrastructure projects, like airports, roads. It could also be hedge funds, which they have lots of different strategies of hedge funds. But they can employ short-selling strategies or using derivatives, like call options, put options, any different types of mechanisms that they think will drive returns. It can also include just investments in physical real estate. So, you invest in the asset manager and they manage the properties. And you get income through rental payments and also, capital appreciation if the property value increases.

Matthew Peck: Okay. So, if we take it sort of one at a time, we have private credit, private equity, hedge funds, real estate, and then infrastructure. Would you say, I mean, I’m sure there’s some other guys here and there, but pretty much those five are, you call them, the five horsemen of the alternative space.

Mike Prescott: Yes, correct.

Matthew Peck: Okay. And I’m sure there’s again variations within them. But back to, if we’re talking about private equity or private credit in real estate, I mean, how would you categorize that for the client itself? So, let’s just say, Evan, for example, our producer, right? He says, “Okay, I understand what a stock is. I understand what a bond is.” Would, obviously, the private equity be kind of like a stock and then private credits like a bond? Or I guess, would you slot them into those types of kind of understanding for our clients? Or would you say, no, these are really a different animal altogether?

Mike Prescott: I mean, they are a different animal altogether, but that’s a good way to look at them. If you think of a private equity, you’re investing in a private company. So, the management teams, they are actively involved in the management of that company, whether it be board positions or even more active. They may use their own employees to help run that company. So, you are investing in that company. And as that company grows, they plan on selling it or taking it public. And that’s where the big payouts come from private equity firms.

In private credit, it is debt. I mean, they are issuing loans to companies and they get paid by principal payments and interests. So, it is very similar to a bond, but it’s also a lot riskier because there is a higher chance of default and they have to actually find good companies to lend to. And so, it’s a good lens to look at it through that think of private equity as more of a stock like option and private credit as more of a bond.

Matthew Peck: And then how about the other three? Like, hedge funds, meaning a different animal, and then real estate infrastructure just wouldn’t necessarily fall into any category. I mean, that’s why all the alternatives for reasons, so we don’t necessarily have to slot them in, per se, but just didn’t know if to help people wrap their heads around the universe, would you slot them in? But it sounds like private equity kind of gets slotted in with the stocks. Private credit kind of gets slotted in with the bonds. But then hedge funds, real estate, and infrastructure truly are alternatives in your opinion.

Mike Prescott: Yeah, in my opinion, they’re their own animal. Especially hedge funds, they can employ so many different strategies where it’s kind of hard to pinpoint exactly where you should slot them in.

Matthew Peck: Right. Which is, again, I think we will try to get to that level 2 on some of the sort of differentiators, right? But staying at the high level, before we kind of explore private equity a little bit more, private credit more, so forth and so on, what are some of the universal features of these? Meaning that sometimes like, for example, we’ll sit down the client and they’ll literally come in with a questionnaire to say, look, hey, I pulled this from the website or I pulled this from the internet to say, these are the 10 questions I need to ask a financial advisor before I consider hiring them, right? And these are great questions still.

And by the way, I do recommend, as a quick sidebar, side note, that I do recommend it, anyone that is looking for an advisor, there are very helpful questionnaires online.             Like, for example, you should ask a potential financial advisor. You should ask if they’re fiduciaries. You should ask how they’re paid. You should ask who their custodian is, right? So, these are kind of put into the category of questions to ask when considering, whether or not to hire a financial advisor. Okay? In that vein, what questions would someone have to ask when considering any of these investments?

Mike Prescott: I would definitely ask what the minimum investment is, what the fee structure is, the lock-up periods because some of these investments, they have a significant lock-up period where you can’t access your funds for upwards of 10 years. So, that is definitely a question that I would ask. And the fees can be structured differently. There’s usually a management fee, and then there’s usually an incentive fee as well. So, I would try to get a good understanding of what those fees are and have them explain to you.

Matthew Peck: And tell me what the fees because I hear like 2 and 20, right? Isn’t that a very well, many of many rules of thumb that a lot of the– and I’m not sure if that’s all, if that’s just private equity or private credit or whatnot. But when it comes to fees, people throw out that term 2 and 20. What does that mean?

Mike Prescott: So, 2 and 20 fee is a 2% management fee. So, whatever assets you have with the manager, it’s 2% annually. And then incentive fees are any returns over a certain watermark. So, they have to hit a certain point for the returns. And then 20% of after that watermark is the incentive fee.

Matthew Peck: Okay. So, if I do that math, so some of these management fees, I mean, in some of the companies, by the way, it’s like KKR and Stepstone and Apollo and BlackRock and blah, blah, blah, blah, blah, I mean, and quickly, I should say too, part of obviously the services that we have here at SHP is to do this type of scrubbing for the fees and, if and when, it is something that a client is interested in, or at least, wants to learn more about, as I mentioned, what we’re offering and you specifically are doing a lot of that due diligence and that scrutiny. So, I certainly want to make sure you get an advisor that is very knowledgeable and a firm that’s very knowledgeable in this space, also, before ever considering it, I should add too. But to go back to that 2 and 20, the fees, now, it is specifically on private equity or is that pretty universal as well?

Mike Prescott: So, the 2 and 20, those fees have come down quite a bit. I mean, it’s usually one and a half to one and a quarter management fee, and then anywhere from some funds to still have the 20% incentive fee, but I’m seeing them closer down to 10 to 15 these days.

Matthew Peck: And then over what percentage? So, again, almost gone to the 2 and 20, that’s easier math, they’re not as bad anymore.

Mike Prescott: And every fund is different, every asset manager is different. They pretty much charge one.

Matthew Peck: And then what’s that kind of, what’s their hurdle though? So, if they are automatically getting 2%, let’s say, again, on average and we’re talking general, what amount do they then get that 20% or what was that profit hurdle that they would then get over and above?

Mike Prescott: So, it’s usually anywhere from 5% to 10, let’s say. They have to have 5% to 10% return, and after that, return marks.

Matthew Peck: They’re 20.

Mike Prescott: Correct.

Matthew Peck: Got it. Okay, all right. So, certainly, understanding the fees is going to be crucial. Now, you mentioned a little bit about how much to invest. What’s that range? And how does that work?

Mike Prescott: Yes. That kind of depends on the structure of the fund. So, there are really three types of structures that these funds fall under. There’s the evergreen structure, which is usually a fully funded fund that is normally in a private equity. So, that is usually a minimum investment of anywhere from 25,000 to 50,000. And those funds usually also require a little bit extra paperwork as well.

And then there are interval funds which you can buy daily. You trade like a mutual fund with the buying aspect, but there’s usually only quarterly liquidity. So, if you want to sell out of that fund, it is only quarterly. And the minimum investment for those is anywhere from 1,000 to 10,000. And then you have the bigger funds which have the capital call structure. And their minimums are significantly higher, anywhere from 100,000 to 500,000.

Matthew Peck: So, 100,000 to 500,000 just to enter the club, basically.

Mike Prescott: Yes, correct.

Matthew Peck: Interesting. Which is also why the SEC has specific guidelines, too, on who can actually do it, correct? So, if we have the different– yeah, as we go through this world for our clients, that’s the other definition because there’s things like accredited investor, qualified purchaser, all of that. So, if we have the access, like how much you put in, and then now we’re talking liquidity, there’s also limitations on who can actually do it.

Mike Prescott: Correct.

Matthew Peck: So, walk our listeners through that.

Mike Prescott: So, you need to be an accredited investor at least for most of these structures, which means you have to have a net worth north of $1 million. And some of the bigger, the capital cost structure funds that have those massive minimum investments, you have to be a qualified purchaser, which is a net worth north of $5 million. So, these funds are definitely not for everybody, but they can definitely help people that want some diversification if you have a higher net worth. So, there’s potential higher returns, but definitely, potential for higher risk as well.

Matthew Peck: Absolutely. And I think, too, it goes back to the fact that not only some of them have a high buy-in, but also, the person themselves has to be sort of liquid in other ways because as you mentioned, it’s quarterly redemptions, and then they limit how much you can quarterly have or some of the other ones that are anywhere from 7 to 10 years, as you call it, the capital call structure, I mean, those are ones that you don’t really receive anything back for anywhere from, yeah, again, 5 to 10 years. So, you better have other assets on the side because that sort of sunk in that fund for that time no matter what, I mean, within reason, right? I mean, do I have it correct or is there anything else that you need to kind of clarify?

Mike Prescott: No, you have it correct. I mean, those funds, they last for 10 years and they mean it. You can’t get out of them. There may be other ways out of there. There is a secondary market, but you’re not going to be selling for the full value of that fund.

Matthew Peck: Well, and also part, so in the industry’s defense, what they say is they say, okay, well, if, let’s say in the private equity side of things, hey, we’re going to buy this company, take it private, and turn it around. And that’s going to take time. It’s going to take time to sort of invest and clean up the balance sheet and develop a new product, whatever that may be. And we can’t have people knocking on our door asking for money back or whatever that may be.

Or the idea of fire sales, where it’s like, okay, let’s say people start to pull money out, and if they’re pulling money out when the market is down or wherever it is, whether it’s the private equity market, the real estate market, whatever that may be, suddenly, if they allowed for redemptions at any point in time, then the asset manager might be forced to sell an asset at a depressed price and hurt everyone, hurt everyone involved. So, that’s their argument to say as to why it’s structured that way. That’s also why it’s of interest to people because, and the term that gets used in the– and actually, this is more universal too, I should say, is what’s called non-correlated, right?

And some of them explain a little bit of what non-correlated means that when people are putting together a portfolio, if your stocks are zigging, you want something that zags, right? You want them to move independently of each other because if everything is correlated, that means everything falls when the markets fall, and everything moves up when the market moves up. The idea of portfolio construction and using alternatives or whatever that may be, or just stocks and bonds and cash and CDs and more of the traditional instruments is to create balance. So, if one thing goes up, one thing kind of middles along or vice versa, so that you’re always somewhat positive or you’re always relatively stability of the portfolio. And that’s something of our attraction with alternatives. So, would you agree that when it comes to their non-correlated nature?

Mike Prescott: Yeah, I would agree with that, for sure.

Matthew Peck: Because specifically, I think, and I’m going to focus a little bit on infrastructure. I feel that people always talk about infrastructure because talk about time horizon, now, you’re investing in these massive projects that take, I mean, years to build.

Mike Prescott: Years to build, and they’re around for a lot longer, too. So, if it’s something like a road or something or an interstate, it’s a toll, and it’s continuing to generate profit for the life of that toll.

Matthew Peck: Yeah. So, in the sense that, yeah, the money really comes after the fact, when it comes to that, and that’s the whole idea of, obviously, the long tail on that, but also the idea of the whole non-correlated part of it because a lot of these are what’s called mark to market, right? So, what is mark to market? And what is that? Because they talk about NAV, like daily net asset value. So, how does that work? So, if a client has these, and this is the only idea of non-correlated, I mean, do they see movement on their statements? Or how does that work in regards to their expectations after the fact?

Mike Prescott: It depends on the funds. The interval funds are mark to market daily.

Matthew Peck: Okay, what does that mean? What is mark to market?

Mike Prescott: Oh, I mean the price of your investment in that fund. So, say, you buy in for $1,000. How much is that $1,000 worth? And for the interval funds, you can see that daily.

Matthew Peck: Okay, so they have daily sort of transparency in a sense, right? So, you know exactly. So, on the interval funds on sort of the ones that are a little bit more liquid, you’re able to see the value pretty much on a daily basis.

Mike Prescott: Correct.

Matthew Peck: Okay.

Mike Prescott: And usually, it’s for the other funds. The evergreen, it could be monthly. And for the bigger funds, the capital call is usually quarterly.

Matthew Peck: Quarterly, okay. All right, so it really has no movement, no movement, no movement. And then on their quarterly statement, they’ll see move up or down, depending on what’s happening underneath.

Mike Prescott: Correct.

Matthew Peck: Okay. And I think that goes back to the idea of non-correlated where a client for three months, 90 days, doesn’t see any movement whatsoever. Let’s say the market’s moving up and down because, again, it’s daily mark to market on more liquid traditional assets and they reflect current prices, where the movement on the other funds, you’re not going to really see for 90 days. So, you look at your portfolio and say, oh, it hasn’t really budged that much, depending. So, you have at least that, I don’t call it, reassurance, per se, but you have that type of stability, at least temporary stability in the portfolio, which I think, again, that goes back to the non-correlated and why they’re attractive.

I would also add that the markets themselves are growing. And so, let me just sort of offer up some amazing statistics, specifically in the private equity, right? We talked, and Mike mentioned about how the private equity space works is that, at first, in general, now, obviously, there’s plenty of differences here, but company comes in, takes a company that’s public, and takes it now private, takes it away from the public marketplace, takes it private, to clean it up, and then eventually to spin it off in some way, shape, or form.

This is happening more and more. So, from 1988 to 2018, so for roughly about 30 years, the number of public companies fell 37%. So, think about that. When you guys are looking for stocks to buy or for any of our listeners who are looking for stocks to buy, the number of people in the public market, the number of choices that you have has declined 37% over the past 30 years, close to 40 years now. Okay?

At that same time, the number of private companies grew by 44%. Okay, so what does that all mean? Well, it all means that the private market space, private equity, that side of the marketplace, the marketplace that you maybe never have would have given thought to is actually getting bigger and bigger and bigger over the past 30 to 40 years. Now, why is that? Well, there’s many reasons, but one of the big reasons is the fact that back in the day, when companies needed to raise money, they would have to go to the public marketplace. They would have to do what’s called an IPO or initial purchase offering and sort of raise capital in the public markets.

Well, because there’s so much money now in the private marketplace, they don’t need to go public anymore. And going public is good because you can raise some capital, but going public can be very difficult for startup companies or whatever that may be because it’s heavily regulated. Shareholders or everyone, it’s a very noisy place. Now, some would say it’s a good thing. So, we can sort of root out any bad actors there. But at the same point, going public, being a public company is a lot more stressful than being private. So, that’s why the idea of that, all these companies, there’s less public companies out there is because they don’t need to go to the public marketplace anymore. They can shop and stay within the private. There’s all this money here, like we were talking about. I mean, I’m not even sure if we have a slide here, Mike, about the growth in private equity, too, I mean, or about the amount of money that’s in there.

Mike Prescott: Yeah, it’s in the trillions, I know that. I don’t have the exact number, but I think it was 6 trillion last time I looked.

Matthew Peck: Yeah. And I’m sure that’s been growing over time. And then also, look at the growth in the private credit. So, to go back to what we mentioned earlier, that Mike had mentioned earlier about kind of like these leveraged loans or thinking credit, just think credit cards, the ability to lend somebody credit to get them through or to start up their company or to build a new plant or whatever that may be, well, in 1994, only 28% of the private credit or the credit marketplace was offered by non-banks or sort of these alternative investments. That has since grown 75%. So, 75% of in the credit marketplace is now private as well.

So, again, it’s just assets are moving in these two areas, whether it’s private equity for– and again, I’m simplifying here, whether it’s private equity for stocks or that type of your equity in companies, or whether it’s credit in regards to lending and loans and more debt instruments, these markets are growing, and the money that’s being put into there is obviously growing as well. And that’s really why, Mike, I wanted to have you on to the podcast was because, look, our clients and investors, in general, or general public, I should also add, needs to understand this a little bit better so that they know a little bit about how this universe works. Like, again, what questions to ask if they’re ever even considering it to even start, right? Not to mention, are they even qualified in the SEC’s guides, like we were talking about accredited investors and qualified purchasers. I mean, there’s so much here that, and again, it’s growing, that well, I really wanted to begin this process, begin this journey of taking our listeners through this world because it’s only getting bigger and better. You know what I mean? So, I did want to share those types of things.

And then part of that, too, it made me think about the whole private equity thing because we’re talking about how, it’s these more companies that will come in, take a company, take it private, turn it around, and then maybe spin it off. In private equity, people also think in terms of like, ooh, some like AI startup. Does that exist too in private equity? Or do you know what I mean?

Mike Prescott: Yeah, that definitely exists too. I mean, that’s…

Matthew Peck: That’s like a startup fund, venture fund.

Mike Prescott: Yeah, venture capital is what that falls under. And those are early-stage companies with potential growth, but they’re not there yet. And those can be a shot in the dark. There’s so many small companies out there. Not all of them come to fruition, but that’s why private equity managers are important because they are better at weeding out potential bad eggs and can potentially find diamonds in the rough that they can turn into giant companies in the future.

Matthew Peck: So, now, does an investor know that if they’re saying, I’m interested in private equity, then you would go down and say, okay, well, there’s different categories of private equity?

Mike Prescott: Yeah, definitely. There are the buyout funds which you mentioned. There are these venture funds, which are the startups, the early-stage companies. And then there’s growth equity, which could be an established company with rolling out a new product or there’s something on the horizon that can potentially make them much more profitable in the future.

Matthew Peck: Okay, I see. So, literally, even within the private equity space, there’s different sort of themes and variations in private. And are they similar with private credit or no? Or is that kind of like, it’s pretty much standard, but it’s who they’re lending to is important or whatnot?

Mike Prescott: Yeah, who they’re lending to and the terms they offer because some of them are secured, some of the loans are secured by that company’s balance sheet or their office space or whatever.

Matthew Peck: Yeah. Other type of collateral.

Mike Prescott: Yeah, some type of collateral and some of them are less collateralized. So, that’s another important question to ask. What are the loans like? What are the loans on your books look like?

Matthew Peck: Well, which actually brings a good question, too, I mean, how do you scrub these guys like, when you take a look at them, whether it’s private equity or private credit and whatnot, I mean, yeah, what are some of the more kind of inside baseball or what are the questions that you ask and what tools do you lean on to truly scrutinize and scrub to make sure that whichever one that you would eventually recommend, if, hypothetically speaking, how do you arrive at that recommendation, if you will?

Mike Prescott: So, we use a third-party provider that will vet all the funds. So, they have a rating system where they, it’s called the Mercer rating system, and that is third party. And then if they pass through those tests and they look like a good fund, we’ll meet with them. The asset managers just get a feel and kind of dive more under the hood to see what the fees are, what the structure is, what the companies they’re investing are, or who they’re– in the case of private credit, who the companies they’re loaning money to are. So, we start with the screener, and then we kind of dive deeper by meeting with the actual asset managers and trying to talk to as many people as we can.

Matthew Peck: Oh, it’s fantastic. Okay, so which kind of wraps it up there in a sense, I mean, I’d like to kind of pivot in the sense that if, and I think in terms of the DIY or some people that do it themselves and whatnot, and God bless them. I mean, I don’t blame them. I enjoy this world, whether it’s the investment world or the financial planning world and whatever. And I can never fault him for it because I do it every day and love it, right?

But it’s that level of research that you just mentioned, right? Starting with the screener and sort of a platform to kind of go shopping, then learning, then getting a third-party sort of rating on these particular offerings, then sitting down and meeting with the different managers, I mean, for any of our clients that are retired or any of our listeners that they’re retired or kind of do-it-yourselfers, it’s like, are you spending that amount of time doing that research?

Mike Prescott: It’s a lot of work.

Matthew Peck: Yes. Because it changes too, because that part, too, a lot of these things, a fund can just close down, right? It’s not closed down in a bad way, but they can just say, nope, we’re not taking any more new investors and we have to move on because, oh, that’s the other thing. Oh, great, sorry, I’m just going to get into it a little bit. But like, because it’s also different vintages, right? So, with certain funds, they’ll say, okay, that fund is now closed and off it goes. And then they’ll open up a new fund to new investors. Is that kind of how it works?

Mike Prescott: And with some of those funds, you want to see what the last vintage did, how did they perform, and their last round of investing. And so, you want to find a manager who has proven through a few different vintages that they can actually earn you a profit.

Matthew Peck: As I said, just a lot of work because not only is it a growing marketplace like we’re talking about, I mean, as mentioned, a number of companies, just to repeat, the number of companies that you can actually choose to invest in has fallen by 37%. So, the market, the private equity market, the private credit market, money is flowing into that, for better or for worse, right? And we’re not saying it’s a good or bad thing, but just more it is a thing. And so, it just goes to having, making sure that you have an advisor in your corner looking at all of this and vetting and all of this and making sure if it does or does not work into your plan, right?

And so, that’s why I just love about what we do here at SHP, a shameless plug here, but it’s just more that the ability to look at the entire situation. What is your tax situation? What is your income situation, expenses, liquidity needs, so forth and so on, overall diversification and correlation and all this word that I would sort of– the definitions and the vocabulary that we went through, you need someone on your side to scrutinize all of that, to make sure it’s a good idea, to make sure it fits in the plan, to follow these trends that we talked about. And so, that’s some of the value that you receive at SHP, and I certainly hope that everyone that does have an advisor, is receiving similar value. If not, obviously, give us a call.

But no, Mike, this is a great primer on this space. Like, Evan and all of us were talking offline, I mean, we could literally have one whole session, just dedicated to private equity and the different options that are there and then the different diversifications within private equity and the different providers, etc. So, wouldn’t be surprised if Mike comes back on, if you don’t mind.

Mike Prescott: Okay. No, we’re barely scratching the surface of this one. So, this can go a lot deeper.

Matthew Peck: That’s a fact, all right. Well, Mike, thank you so much for your knowledge, obviously, for your service here at SHP. Again, we’ll not be surprised if you get brought back on here. If these trends continue, we know that private equity and private credit, infrastructure, etc., is just going to continue to grow and we’re going to need boots on the ground to walk our clients through that. So, yeah, for that, we absolutely appreciate it. And thank you for everything you do there. And really, for all of our listeners, I really hope you enjoyed today’s session. And stick around for the next one. And hope everyone has a great summer. Take care.

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