[REPLAY] Ana Marshall – Preparing for the New Environment at Hewlett (Capital Allocators, EP. 288)

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2:32Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. My guest on today's show is Anna Marshall, the CIO for the William and Flora Hewlett Foundation, where she oversees a $13 billion pool of capital. Anna joined Hewlett 18 years ago after spending the same amount of time as a direct investor.

3:14She was a past guest in 2019 describing her approach, and that conversation is replayed in the feed. We caught up to discuss what's on Ana's mind going into the new year. We cover inflation, private equity secondaries, liquidity management, China, emerging markets, and ESG. We close discussing where Ana is looking around corners, what's filling her basket of worries, and her plan for the next five years. Before we get going, we've just released the last episode of season one of Private Equity Deals on the Private Equity Deals separate podcast feed. If you're an allocator, private equity manager, banker, or student of deals and businesses, this show is for you.

3:59Search for Private Equity Deals on your podcast player and subscribe. As soon as you do, you'll get access to eight conversations with leading brand name private equity funds discussing an individual deal and the way they practice their craft. The last one is a gem from CD &R, describing a business with aspects of venture, buyout, and growth equity investing alongside their operating partner model. Please enjoy my conversation with Ana Marshall. Ana, great to see you. Great to see you too, Ted. I thought we should dive right in on whatever you are finding most topical on the investment side of the business.

4:42Everybody loves to become an armchair economist. So we can skip the armchair economics if you'd like, since I don't think any of us have a crystal ball, including the Fed. So we can all stop there. Well, before we fully stop there, let's just talk about inflation. Not a projection, but given the potential for a very different macroeconomic environment going forward for a number of years, how do you integrate that into your thinking about your portfolio? I think one thing that's super helpful is to try to forget the last 14 years and try to clear your mind of anything that you thought was a rule of investing in the last 14 years.

5:24because what we're really doing is going back to a world that existed starting in sort of 1991, 1992 through up into the crisis. So it was more of a normalized economy. You had inflation, you had rates at 4%, you had mortgage rates at 7%. The world didn't stop. No one fell out of their chair. It was fine. We all lived fine. We all invested. We all made money in the 90s. We just have to forget the paradigm that we lived in the last 14 years is completely artificial. And I think once you erase that, you start taking it with a lot more call. What are some of those rules that you've told your team need to be unlearned or forgotten?

6:12This whole concept of the math works for any deal at any valuation because the cost of capital is near zero. I think that is probably the most pernicious thing that was learned by a generation of investors. The fact that you can invest internationally without ever thinking about FX risk and the cost of hedging and how that affects your expected return of an asset. The fact that illiquidity premium had been completely obliterated as more and more money poured into private markets and how you need to demand an illiquidity premium to really be able to construct a healthy portfolio long term. So those are just three to take as lessons that were great.

6:53They were fabulous. They made lots of money for the institutions that we all represent. I mean, it was a great time to really grow our endowments. And we were then able to do a lot of really good work. I mean, we doubled the grant budget of this organization, really, in the last six years. All of our institutions and the world was able to be a better place. It wasn't wasted. But for us to be good stewards of capital, I think we just have to unlearn some of those. Are there actions you're taking over the next couple of years on your portfolio based on the belief that we have to unlearn some of these things?

7:31So we're having a lot more discussions with our managers about how are they adjusting their cost of capital? How are they adjusting their valuations? how are they focusing on free cash flow what are they doing in terms of dcfs in case of inflation how are they putting in price increases how are they growing their top lines how are they adjusting their budgets because if you're a buyout manager you bought a company even if you thought you were going to get growth of whatever eight ten percent out of a company but you have five percent inflation or seven percent inflation well eight percent doesn't really look that exciting anymore.

8:07That really is 3 % real. So how are they adjusting their expectations? And then how are they making sure that once the most buyout has floating rate debt? Like can these companies pay their bills when their interest bill is now 2x? So how about you focus instead of on EBITDA, in case you focus on cash flow before the I doubled. And I think for a lot of the generation and of the kids doing the models, they just haven't lived through that. So it's about asking them what they're doing. I'm really curious to ask you what the range of responses you're hearing to that set of questions. Everything from hope that nothing is going to change because by this time next year, the rates will be coming down again, and therefore the cost of financing won't be an issue.

8:57That's one end of the spectrum. there's the other end of the spectrum that basically says, well, we're all pencils down because nothing works at these prices anyway. And we're just making sure that our companies can pay their interest bill first and foremost. And everybody from doing spreadsheets at work is now sitting in portfolio companies, helping our portfolio company management teams really sharpen their pencils, pay their bills, pay their interest bill and make it through. So that's the other end of the spectrum. When you were writing your next set of checks, somewhere in that spectrum, you have to decide what resonates most for you.

9:35So where are you fitting in on that range? I think you know where I would fit in on that range. I'm a big believer that the people who we trust with our capital need to be pencils down and really working with the portfolio companies. We have had five to seven years of massive amounts of capital going into buying private firms and taking companies private. And it's time for everybody on the field to really go work those companies. This is not about playing a valuation flip game. In your portfolio, everyone's made investments in the private markets, whether it's venture or buyouts, that have done really, really well for a while, at least until recently.

10:14How do you think about assessing your allocations to these areas when you feel like things have gotten a little frothy? I'm unusual in that we use secondaries as part of our portfolio management process. When you see a market that is getting frothy, and again, we make commitments to our managers, and then they have three years to invest funds for four years. We were seeing the velocity increase so much that we started getting concerned. When you start seeing that, you start seeing your portfolio construction get distorted. So one way to do that is to actively manage your private portfolio. In doing so, what you do is you start looking at secondary markets.

10:57And there is an art to doing secondaries. You can't just throw things out there. You can't just say, oh, it's these five guys I don't like. I'm going to throw those guys out of the portfolio. You really do try to construct a portfolio that somebody else will find useful. And that also, when you take it out of your portfolio, you haven't completely left a hole in your portfolio construction of your own buyout portfolio. I speak about buyout. We've done it in real estate. We've done it in natural resources. There's nothing wrong with the managers themselves. It's rarely performance related. You can't just sell your duds.

11:31That never works in a secondary. It is about whether and how that fits into our portfolio strategy. I'd love to dive in a little more on this because it's a different concept than many in this space, right? It is. Let me add the materiality of it. We don't do secondaries every year. We do secondaries when the strategy calls for it. For example, the classic case is you have a change in your asset class director. Every asset class director has to be able to walk in day one and own a certain amount of their portfolio. and then they might find that the strategy in which they want to take the portfolio is different.

12:10They want to go down market. They want to go up market. They want to go international. They want to not be international. Whatever it may be, as a CIO, you have to respect that there is an actual asset class director, a managing director, that you want to hold accountable for delivering on a strategy. So as a CIO, you have to be able to give them the tools to be able to do that. And the only way to do that is to carve out part of it as a secondary sale and then be able to reinvest that and provide room in the allocation on the portfolio -wide basis for them to go do what they want to do. So that's sort of the cookie -cutter first way of doing it.

12:48The less preferred way of doing it would be if you find yourself overcommitted. Now, I think everybody who is a CIO today that was a CIO in 2008 learned their lesson well. So fortunately, I don't think we have a lot of people that are overcommitted. But usually, if you get overcommitted to a certain asset class, then that would be the other reason to sort of call your portfolio and try to get your exposure down. And the third one is simply for risk management, which is from a risk allocation, your private assets are taking so much more of your risk budget that as liquidity constraints come into your portfolio, and let's say your public assets sell down, you find yourself ever higher in the risk spectrum on your portfolio.

13:36And so one of the ways that you can look at this is to call the allocation and say, okay, we'll keep committing because usually you don't want to stop committing, But we can take $100 million, $200 million here or there. Secondary sales can't really happen in a world for like under $100 million. They don't really go out in more than bulks of like $200, $300 million. And so you try to time the market. You try to be more clever than most. But it's not a bulk of our portfolio we're selling. We're just trying to manage around the edges with these secondary sales. So you almost have three different scenarios.

14:14The first is this internally generated because there's a change in someone on your team. The second is, say, a scenario where there's a public market sell -off increasing the allocation to private markets. And the third are when private markets have done really well and therefore people have gotten excited and the allocations are higher. So two are market -driven and the first is a little more internal -driven. Are there differences in how you think about how to go about the secondary sale in those different scenarios? If it's a risk focus, then you almost have to be really quick -footed because by the time you're sensing that you are going to have a risk issue, then you're going to be too late.

14:57Because it does take time to pull together a secondary. I mean, it takes your internal team to pull together all the stuff. You need to hire a banker. You need to shop it out there. I mean, you need to talk to all your GPs. You have to have really close relationships with your GPs. So this is where the concentrated portfolio that I have really is helpful because we do have those working relationships with the GPs where we can have the conversation to explain to them why we're doing it. The conversation, for example, at the beginning of this year was, we think the Fed's going to raise rates. We think we're going to find ourselves with a declining equity market.

15:32We think we're going to find ourselves over our skis because your returns have been so great. Like my NAV has gone up so much. I'm finding myself beyond where I need, I want to be in risk. I need to cut risk. This is part of the way I'm cutting risk. Please understand that this is a risk management thing. It's not you. Like we need to manage our fiduciary duty. And so you just need to be handling it in a more proactive way. And that gives you the room to be able to continue to commit. Because I think not being able to commit because you are already over your NAV is actually a really big mistake because some of the best funds are actually invested during down years.

16:16And so you don't want to miss those years. So there are a lot of people that wouldn't broach their GPs because they probably live in perpetual fear that they want to make sure they're in the next fund. What have you found that receptivity to be over time when you've had these conversations across the board in your portfolio? They usually come after years of a really strong relationship and transparency. We tend to be super transparent. And I think also the fact that we have such a stable team. I've been here for 18 years. The GPs know me and they know my word and they know that if I'm telling them that I need to bring down risk or that I have a new director who wants to see things a little bit different, I think they understand that.

16:56We're constantly evaluating them on how they manage their firms and their teams. And I think they have a healthy respect for knowing that I also have to manage this place and the portfolio. You mentioned at the onset that there's a bit of an art to putting together this secondary sale so that it's attractive and works for someone who's buying it. What are some of the features of what's worked for you in that regard? Usually if it's partnerships that a lot of people know, where people don't have to do an extraordinary amount of work, in order to understand the assets. At the end of the day, yes, they're firms and they're funds, but they're a bunch of assets.

17:36So people need to be able to underwrite the assets. And the easier you make it, the better it is. That doesn't mean that's all you sell. I mean, you can sell other things, but I would say we're in the fortunate position where we haven't had that many funds that don't stand up for themselves. In a different situation with a new portfolio, I probably would have been the buyer of a lot of our portfolios that I sell. I just happen to have a very mature portfolio. In the optimal sale that you've done, how much lead time does it take to go from the idea that we need to trim through a secondary to actually executing?

18:14From the idea of portfolio management to actual getting together a list is probably a month, and then a month for the banker. And then depending on the workflow of these bankers and when they can do it, and then the workflow of the buyer universe. And I mean, the buyer universe has grown tremendously in the last 15 years, but even they have a cadence as to when they're super busy and when they're not, and when they can take a look at a new deal or not. So you just have to be mindful of that. And so start to finish, how long does it take? So the fastest I think we've ever moved is six weeks, eight weeks.

18:55The longest has been five months. Are there other ways that you've thought about liquidity management across a multi -manager portfolio outside of the traditional way of thinking about investing in and redeeming from managers and making commitments and getting distributions? The one thing that we all forget is that cash has a great deal of value. And the more illiquid your portfolio, the more value your cash port has. At least now you have a yield on your cash, which is a huge benefit now, but it has option value. Learning the lessons from a way. Many of us have credit lines in place to be able to fund the granting parts of the organizations, but you can't use credit lines to lean into a dislocation for lots of tax reasons.

19:41If you think a dislocation is coming, you need to have cash to be able to even get a chance at that. And I just think it helps to bridge the cash flow because cash flows are episodic. We all solved these beautiful cash flow models, but we've all lived through periods where we get distributions well in excess of those models. And then we've lived through periods where you're just like, oh my God, where the hell am I going to get my next distribution? In organizations like a foundation that don't have incoming cash flows, that means that my cash flow for granting and expenses for next year, if I don't get anything from the private portfolio, it has to come out of the public portfolio.

20:20And so they're not sort of paying in their fair share of outflows. So you have to use cash as that sort of buffer to help bridge the cash flows, or you're going to distort your actual asset allocation much worse. What have you found is the appropriate steady state allocation to cash? We have probably about 50 % of the portfolio in illiquids. So we have about, I would say, 4 % to 5 % in cash, some so that we can bridge what should be the contribution to pay out, and some so we can lean into dislocations. And will you flex that 4 % to 5 % higher if you sense that there may be dislocation opportunities on the come?

21:05I tend to not be that tactical. I mean, I'm moving around a super tanker here, but it really comes to trying to preserve the intended asset allocation more so than providing the opportunity. As it turns out, because usually the dislocation comes in public markets first, you're going to not want to sell your public assets in order to fund payout as it is. And so the more you can defend even your existing allocations, I think is a really good use of cash. So let's turn to where you're seeing opportunities. So far, not much. The private markets have done what they do, which is they take forever to actually get reality checks.

21:53For the most part, the marks have been way slower and way less than I would have expected, even for this stage. given the increase in the cost of capital. So I think those are still to come. So I don't think there's any bargains to be had. And I think that's why you've just gotten paralyzed markets. Even if your cash flow model is wrong on distributions, you're probably not going to get any capital calls anyway, because no one can really fund anything in the debt markets. So for the time being, it won't be a huge squeeze for people because there won't be any capital calls. You still have the period of sort of adjusting down valuations that hasn't happened.

22:34I would say the opportunity set to come will be good. That has implications for the actual values of everything that was bought in the last five years. But that's still all to be played out in the future. Public markets, the rotation seems to be, I don't know that it's almost complete, but it has been fairly harsh. And so do I feel like we can jump in and take advantage? I think there will still be people who need to source their payouts and their capital calls from public markets. I mean, you still have institutional investors that whether they reallocate back to fixed income, or they have to fund cash flows, or they have to fund private market capital calls without there being the benefit of distributions.

23:21I still think that hits your public credit and public equity markets. So you've spent a lot of time in your life in emerging markets. It does feel like it's become a tale of two, China and the rest of the world. Would love to get your take on both. So why don't we start with China? The cyclical China bounce as it reopens, I think is well -deserved and I hope it lasts. the secular tension with the U .S. just hasn't been fixed. And I don't think there is any intent on the U .S. side to fix it. So I think it is a different market from the market that we so enjoyed. I mean, when we started in 2004, investing in China, we had a wonderful run for 15 years and great global companies were created.

24:15And I think more global companies will be created in sectors that the government really wants to sponsor. I think it will become ever more challenging for us to be able to benefit from that just simply because from the US side, there is greater consensus of whether it's containment, whether it's competitive edge, whatever it is that we want to call it as policy in the United States. So how have you approached your existing investments over there? Much of our exposure is in illiquid venture. So there isn't much I can do to the process. We only have two venture firms there. Our two venture firms there are actually quite entrenched in building the self -resilient sectors that the government wants.

25:06So I think they will create really interesting companies. So we're quite excited about that. It's sort of like the FX risk. When you've been investing without thinking of geopolitical risk as one of your main things, you then have to add it into your underwriting. So that just makes the hurdle rate higher for a China investment. And when at the same time your US investments start to correct in the US and the private markets, then that will look more interesting without taking that FX or geopolitical risk. We all have to put the money to work. It's a relative game. I guess the tough question that then has to get asked is when these two firms go to raise their next fund, do you feel differently about the investability of those firms in China, given what's happened over the last year?

25:55So fortunately, they had just raised. And so we have three years to figure out what happens in the US -China relationship and whether some of these structural shifts can actually be broken. Even if it's just getting more working groups going between the two countries, that's an improvement. So there are things to watch out for more than just the headlines over the next three years that we'll be focused on. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? Partner with a company that's been defining the future of dealmaking for nearly two decades instead.

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27:32From a relative valuation, they're the cheapest they've ever been. Part of the thesis in China was always about relative growth. Once you break that, do you then get a market similar to Korea, where it's a market that is always cheap. It just goes through stages of relative cheapness to relative less cheap. And you can trade those markets super well. In the 90s, we used to do it all the time. and those are the markets where you look at a trading range. The companies are doing fine. You can track the companies. They're still earning. So you can actually have a fairly high conviction in the valuations as being real and then trade it what I call from knees to shoulders.