Explore new sources of return with alternatives

JON DIORIO: Hi, everyone. I'm Jon Diorio, a Managing Director in our US Product group. Joining me today are Lynn Baranski, who is Global Head of Investments for BlackRock Private Equity Partners, and Jeff Rosenberg, Senior PM of our BlackRock Systematic Fixed Income team. In today’s session, we’ll talk about why we believe investors should reconsider the traditional 60/40 approach to investing and talk about what we see as a major shift in the way advisors should consider approaching asset allocation.

One of the things we often see in portfolios is a mismatch between return expectations and the path of clients achieving those returns. And so, to build more resilient portfolios moving forward, we recommend that clients consider two things. First, it’s the point that the panel was making before us. It’s crucial to find new sources of diversification. And, second, given return expectations for public markets, we think clients should look to allocate to private markets to amplify returns via the illiquidity premium.

So with that, let’s dive into both why and how to do this. Jeff, it’s great to see you. One of the issues I think many of our clients face in portfolio construction is a recency bias. You know, the past decade we’ve seen some of the best risk-adjusted returns for public equities. The running ten year return right now for the S&P is above 16%, which is well above long-term averages, and that’s come with pretty low volatility. You know, on top of that, I think a lot of clients had forgotten the first decade of this century where we saw low returns and high volatility. 

And then, turning to the bond market, we’re now 40 years into a bull run. Interest rates peaked all the way back in September of ’81 at 15.82% and as we look, you know, we’re turning to a point in the bond market here where we’re probably going back to a rising rate environment. So, you know, what do you see here going forward?

JEFF ROSENBERG: Yeah. I mean the earlier panels have talked a lot about this. The thing I want to highlight, you know, it’s pretty obvious the headline today, 7% inflation. You know, Kurt, Mark, mentioned it several times, inflation, you know, higher than interest rates. This is a very different environment.

But there’s another, you know, piece I think investors have to keep in mind that when we think about the diversification properties of fixed income, the old adage that, you know, bonds are a good hedge for your stocks, there’s one exception. And the exception is that bonds are a really bad hedge for stocks when stocks are going down because of inflation fears. That's the exception that proves the rule.

You have one period in the history where you saw that happen and it was, of course, the ‘70s where inflation and the Fed’s response to it pushed stocks lower and you had an annual decline in stocks and an annual decline in fixed income. So, recency bias, Jon, you know, last year you saw your first negative year to fixed income. I think it’s a wakeup call. 

But the bigger fear is if you have an inflation that gets out of hand and the Fed tries to take action on it and that undermines the performance of stocks, you’re not going to have that diversification on a bond. So, we’ll talk about what do you do about that in alternative forms of diversification next.

JON DIORIO: Yeah. Great points, Jeff. And certainly, many bond investors there need to think about those ways to diversify, especially with inflation. Lynn, I want to turn to you. It’s great to see you as well. 

Private markets, that, that’s a big part of this amplification theme that we’ve talked about and private markets are playing an increasingly prominent role in economic growth. And, maybe more importantly, investors that are only investing in the public markets, you know, they’re missing a pretty big piece of the opportunity set just because public markets are shrinking, and private markets have actually been growing. So, talk to us a little bit about what you attribute to the consistent outperformance we’ve seen in the private equity markets.

LYNN BARANSKI: Yeah. Thanks, Jon. You’re absolutely right. And I want to say there are some key differences between the public market and the private equity market that have consistently driven private equities’ outperformance over long periods of time. There are many, but I’ll only speak to three of these.

I'd say first and foremost, unlike private equity, private, unlike public equity, private equity is generally synonymous with active control investing. So, what does that mean? So, before a general partner actually invests in a company, they have access to all the information of a company, all the non-public information. They develop detailed business plans. They focus on operational improvements, tuck-in acquisitions, product line extensions, maybe geographic expansion. And then, they align management’s compensation exactly with those value drivers so that if the company is able to achieve that business plan they put in place, management generally can own up to 10, maybe 15% of the equity of that company and it’s very much an incentive for them.

Second, there’s just simply a wider universe of investment opportunities in the private market. And to put that in perspective, there’s about 1.7, more than 1.7 million of private companies just in the US alone with employees, with more than 50 employees. And this is really the hunting ground for private equity and many of these businesses are fast-growing companies that are disrupting traditional business models and are experiencing at times hyper growth. So, and private equity finds that hyper growth and faster growing companies very attractive. 

And third, and the third point I’ll make is that just, you know, generally we’ve been talking about how markets are expensive today. But in private equity there is still a discount to the public market, sometimes five/six turns discount for LBO purchase price multiples versus where the public markets are trading. So, I like to just sort of sum it up by saying that in private equity, we are able to sort of buy cheaper. We’re able to drive top line growth and EBITDA growth at rates that are faster than potentially the public market. And then, we’re able to sell into the public markets or to strategics, sometimes at higher multiples. And all of this is just a great combination of how we create value appreciation that can really amplify the returns in an investor’s portfolio that we were talking about earlier.

JON DIORIO: Great points, Lynn. And I know a lot of times when clients think about equity allocation, they think about small versus large or maybe growth versus value. But certainly, if you’re not investing in the private markets, you’re missing a big, big opportunity set. 

Jeff, I want to come back to you and sort of really key in on that need for diversification that you were talking about. I think many advisors would agree that there’s a need for it. I think the big question though is how, you know, how do you find these alternative sources of diversification in the markets?

JEFF ROSENBERG: Exactly. So, what we’re going to, we’re going to make three key points here. First one is let’s distinguish between alternative asset classes. That's what Lynn’s talking about. Earlier, we heard many people talk about that as well, whether it’s TIPS or commodities. And what I'm going to talk about, which is alternative strategies.

Second key point here: What does it mean to say an alternative strategy? So, what we do to deliver alternative diversification is we implement a strategy using long/short investing. Okay. So, it’s not that complicated. It’s different or it’s alternative because it’s not long only. But the key is that the short flexibility, the ability to be both long and short in the portfolio, the short side of our investment strategies allows us to take out market beta, factor exposure, and isolate pure idiosyncratic risk or alpha. 

And kind of the third key point here is the way in which we're systematic investors, so we’re engineering our investment strategies through models and optimizations. What we’re optimizing for is that that alpha has a defensive characteristic. And so, we create an alternative strategy through long/short equity investing, high breadth investing, large, broad portfolios across long and short portfolios. The short side, again, takes out the market beta factor exposure to reveal alpha where the alpha characteristic is defensive. 

How do we get defensive alpha characteristic and what does that mean? It means that our returns tend to be strongest when equity markets are going down, but they tend to be neutral when equity markets are going up so that you capture an asymmetric return, and the defensiveness is captured through a unique insight of investing through the lens of a credit investor. When you think about what a credit investor cares about, it cares more about protecting on the downside than the upside participation. And so, by overweighting those insights in the selection of which companies we’re long, which companies we’re short, we’re able to deliver this defensive alpha characteristic.

When we take that defensive alpha characteristic and we mix it with other strategies in our portfolio, we’re able to deliver this alternative form of diversification, again through an alternative investment strategy. That's our approach for solving this essential problem of getting investors’ alternative diversification in their portfolios.

JON DIORIO: Great points there, Jeff. Very, very key, obviously keeping the correlation low, having that idiosyncratic risk that you talked about, and then specifically making sure that it’s defensive when you need it. I think those are some key points to these alternative strategies.

Lynn, I want to come over to you and talk a little bit more about private markets. You talked about how there’s millions of private companies. So, obviously, when you’re doing research sourcing these capabilities is crucially important. Talk to us a little bit about how investors can think about that.

LYNN BARANSKI: Yeah, absolutely. Sourcing is the game right now and in today’s market more than ever it’s really important that advisors invest their clients’ capital alongside what I would call best-in-class platforms that have established teams with global resources that are able to source and execute on global transactions. Here, you know, at BlackRock we, I say that we have a global sourcing engine. We have local people on the ground sourcing local transactions and they’re speaking the local languages, which is really important as you invest globally. 

Today, we’re seeing over about 200 deals a quarter and our selection rate is 4%. And I would just want to comment that when we go out to talk to general partners and management teams, we really talk about the BlackRock advantage, and it resonates with these managers and GPs. We are lifecycle investors. 

As an organization, we like to invest early as a private investor. Then, we can be there to help a company as it has debt needs. And if they go public, we’re probably going to be one of their largest shareholders. So, companies want BlackRock in their capital stack early on as a trusted long-term strategic partner.

JON DIORIO: Great, great points, Lynn. And I think similar to what we talked about with Jeff on the need for diversification, I think many advisors would argue that there is a need for access to private markets.

But let’s talk a little bit about the evolution. I think, one, it’s been a little bit harder for some clients to access this because of suitability or requirements. So, there’s a little bit of an evolution of structure. There’s also been some sticking points around things like liquidity. You know, many clients think they need more liquidity than they do. You know, for example, I, what we’ve seen in our mutual fund business, you know, where investors have full liquidities, actually the average investor’s holding period is four years. So, talk to us a little bit about what you’ve seen on the evolution of that side of the business.

LYNN BARANSKI: Yeah. You’re absolutely right. Clients have continuously faced these challenges in the past where really private equity has only been accessible to institutional investors and sort of what I would call the ultra-wealthy. I'm really happy to say though that with new and innovative fund structures, we’re starting to see the landscape change. 

And, for example, here at BlackRock we now have a registered private equity vehicle. It’s accessible to accredited investors at minimum tickets of $25,000 and it’s important to note that that vehicle invests side-by-side with our institutional clients. So, there’s no cherry picking or adverse selection. 

So, it’s super-exciting that clients now can access these investments at lower minimums and with no performance fees. And to your point earlier, you know, there are no capital costs. We draw all the money upfront and there are no K1s. So, you can do your tax reporting on time. 

That said, we understand clients do need liquidity. So we, the program that we run does offer quarterly redemptions and purchases. But the goal really is to democratize alts and to give access to this higher returning asset class to all investors, not just the institutional investors.

JON DIORIO: Great points, Lynn. And certainly, at BlackRock we believe that private markets are expanding and investors that don’t engage maybe missing out on accessing this, what I call this total market opportunity and certainly easier structures like this allow access to many more investors. So, with that, Lynn, Jeff, you know, thank you so much for your comments today.

For those who want to engage more, we have an Alternatives Specialist team at BlackRock along with the Portfolio Solutions team that can help you think about constructing an alternatives portfolio, modeling out risk and liquidity, and certainly discussing some potential solutions. So, please reach out to your local BlackRock market leader. 

We also have a tool on our Advisor Center called the Expected Return Analyzer, which can help with modeling and showing potential alternative allocations to clients. So, a lot for us to offer and we look forward to engaging you. With that, thank you so much for joining us today and I’ll hand it back over to you, Liz.

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