Don’t Be a Buckethead
Arbitrary definitions are limiting your investment options, our columnist argues.
I recently sat on a panel discussing how to sell alternatives to registered investment advisers. One of the panelists ran a hybrid strategy, and he discussed his frustration with trying to market to investors who never knew how to classify his fund. Was it a hedge fund? Was it private credit?
And since the RIAs didn’t know where to put it, they were less likely to use it in client portfolios. He lamented that all these “bucketheads” could never seem to figure out where to fit his fund in an asset allocation context.
Having been an allocator across multiple buckets, it is a pain I know all too well.
Previously, I was a senior hedge fund researcher at a large investment consulting firm. (Full disclosure: I’ve been gone a very long time, and the firm today is much different.)
At the time, my team continually came across investments that didn’t fit cleanly into any of our database’s classifications of alternative investments. Maybe it was a flexible credit strategy that invested in both public and private debt, or maybe a hybrid structure that had elements of both a private equity fund and a hedge fund.
If the strategy didn’t neatly fit into the categories available at the time — for instance, distressed debt or long-short credit — it would go into a catch-all bucket labeled “Other.”
Frankly, many of the most compelling ideas I came across wound up as “Other” in the manager database. The problem: No client ever called up asking for our best “Other” ideas; no institutional investor ever ran a manager search looking for “Other.”
Without a better bucket, “Other” is where good ideas go to die.
Perhaps my biggest “Other” lament is GP stakes, a strategy that seems nearly ubiquitous today.
A few years after leaving the consulting firm, when I was working at a pension fund, I met Sean Ward from Dyal Capital Partners, then a part of Neuberger Berman. Ward was buying stakes in hedge funds. Out of the first six hedge funds in his growing portfolio, I had led investments into half of them for the pension.
As I got to know Ward and his partner, Michael Rees, I came away more impressed with them and the strategy they were building. Revenue participation in existing funds was a very compelling return stream for either an absolute return or private equity mandate.
Coincidentally, at nearly the exact same time as I joined another pension to build a private equity portfolio, Dyal pivoted to buying stakes in private equity funds instead of hedge funds. Of their first six PE funds, I had underwritten investments into three of them as well!
The problem we had at both institutions was how to classify what Dyal was doing. Was it a hedge fund of funds, which would go into the absolute return portfolio? Or was it actually private equity? Direct or a fund of funds?
This wasn’t merely some abstract intellectual exercise of nerdy bucketheads; there were practical implications. The only way to get any investment approved by the board was to have an asset class director spearhead internal due diligence and have an approval memo authored by the external specialist consultant for that asset class.
The hedge fund consultants didn’t want to cover it because it wasn’t really a fund of hedge funds, and the PE consultants didn’t want to cover it because it was minority investing, cash flow distributing, with no clear path to exit — things that didn’t look like traditional private equity. No memo, no investment.
We couldn’t invest because we couldn’t fit it into any bucket.
While I understand the irritation of the managers that can’t seem to figure out which bucket to sell into, I don’t feel too badly for them. After all, most GPs have done just fine for themselves.
For asset owners, on the other hand, it’s hard to overstate how frustrating it can be to find great investments and not be able to capitalize on them for clients and constituents, over and over.
So what’s the solution? Well, I’ve written about breaking down investment silos in the past, but I think it’s important to highlight the benefits of this to the asset owner, not merely the investment team.
By breaking down asset class silos, investment officers can focus on the underlying risks and drivers of return across investment opportunities. And this can allow them to access superior returns per unit of underlying risk.
Most investments have some combination of characteristics, but by and large these risk and return factors can be bucketed into four main categories: capital appreciation, income or yield, inflation sensitivity, and diversification benefits.
All investments — alternatives and private assets included — provide some combination of these characteristics. While it is certainly important to have the requisite expertise to evaluate legal wrappers and fund structures — what is the liquidity, how does the distribution waterfall work, what are the all-in fees and expenses, is there an asset-liability mismatch? — in my experience, it’s far more important to focus on the underlying investment risk and return.
Those legal wrappers should be thought of as guardrails, not buckets. The goal should be filling up the portfolio with as much of the four main investment objectives as you can while not overextending on liquidity, commitments, sectors, strategies, or other such considerations.
Regardless of the wrapper, investors would be best served by allocating new dollars to the most capital-efficient sources of those returns and constraining new commitments to private fund structures based on an illiquidity budget.
This might mean both evergreen hedge fund and private drawdown credit vehicles going into a fixed income allocation. Or maybe uncorrelated, esoteric private assets being utilized in an absolute return context alongside traditional hedge funds. The whole point should be to optimize the risk-adjusted return of the portfolio, and I don’t think a fixed and limiting view of alternatives based on arbitrary technicalities permits this.
As James Carville might say, “It’s the return profile, stupid.”
Yale didn’t start with a target asset allocation to private equity; David Swensen and his team invested in great return-generating equity strategies that just happened to be private, and they did what they needed to fit them into the portfolio. Turning a descriptive asset allocation framework into a proscriptive decision-making process ensures the constantly adapting and evolving world of alternatives will leave you further behind the first adopters, who often capture much of the alpha.
After all, they call them “alternatives” — not “sames” — for a reason.
And if you want to continue to successfully invest in them, you can’t be a buckethead.
Christopher M. Schelling is the founder and chief investment officer of 512 Alternatives, a boutique consulting firm dedicated to helping wealth managers, family offices, and small institutions understand and access alternative investments.