Unlocking the Alternative Investment Market ft. Harry Melandri Kim Flynn

0:03It's a brilliant, brilliant event and you'll come away with lots of new ideas and a better understanding of this incredible exponential world.

0:16You get to speak to the smartest people, people like you trying to figure this out, but also the people on stage. They're the experts.

0:28So we get all of that, all in one place, in Singapore. What more can you ask?

0:39See you at Token 2049.

0:54Hi, I'm Harry Melandry, and today I'm joined by Kimberly Flynn, who's the president of XA Investments, the registered funds division of XMS Capital Partners. Welcome to Real Vision, Kim. How's it going? It's going well. Thank you, Harry. It's a wonderful end of summer here. Okay, wonderful. So Kim, tell us about yourself and about your business. So we're a Chicago-based asset manager that focuses on alternative investments. And the platform that I run has sort of two parts. One is that we have our own proprietary funds, which are alternative income oriented funds. And we also have a business where we consult and advise alternative asset managers who historically were managing private funds and did not have any registered funds.

1:48So they weren't able to access individual investors or make their strategies available. So our consulting practice allows them to sort of learn the ins and the outs of registered funds, which includes the likes of mutual funds, ETFs, and the space where we focus, which is listed closed-end funds and interval and tender offer funds, which are terrific structures that allow this access to alternatives. Wonderful. And can you tell us a bit more about interval funds? Like, assume I'm stupid. Everyone else does. So why should you be the exception? What's an interval fund? What do you mean by closed-end funds?

2:29Just in case people don't know what those things are. Sure. So everyone I think is familiar with mutual funds and ETFs and closed end funds because there frankly are a wide variety of registered SEC registered closed end funds. One type that people are probably familiar with are business development companies, BDCs. Another type is a listed closed end fund. I built many of those at my old firm, Nuveen Investments. And so a lot of those listed closed-end funds housed things like municipal bonds or preferred securities. They're known as being income or yield-oriented vehicles. This third category of registered closed-end funds is a bit of a misnomer.

3:15They're called interval funds, which speaks to the liquidity window so that shareholders, to the extent that they want to exit an investment, they do so at an interval window. Interval funds are continuously offered in the same way that a mutual fund is sold. So that's why I say it's a bit of a misnomer because they're not really closed. They're open-ended in the sense that people can go into the funds and they grow over time. But the category of interval funds has gotten a lot of media attention in the last two years because leading asset managers like Apollo, KKR, Blackstone, Cliffwater, Stepstone, these are institutional alternative managers.

4:06they have launched interval funds. And the reason they're doing so is they want to access the growing part of the market, which is the retail marketplace. And so they want to serve a different clientele than they have in the past, which was largely pensions and endowments and large institutions. Now, what's the advantage offered to retail investors, that grabbing part of the market? Why should they be looking or interested in these products? Well, let me describe the types of alternative investment strategies. And I think it explains the benefit in part. So an interval fund can house anything from private equity to venture capital to infrastructure.

4:55One of the largest categories is private credit, things like direct lending or asset-backed securities. So there's a wide array of alternative investment strategies, and typically investors are seeking higher returns, higher yields, and the benefit of the diversification potential inside of a portfolio, which likely includes a mix of other public or more liquid assets. And so investors, this is attractive to them because these assets, oftentimes less liquid cannot be put into a mutual fund or an ETF package. And so that's why it's really brand new access that these product structures offer. So the key here is a lack of liquidity, the underlying asset.

5:44That's absolutely right. Which is like, if you think about what you know about mutual funds and ETFs, highly liquid securities designed that way so that investors can get in and out of the fund easily. An interval fund, some of them allow access going in on a daily basis, but the interval speaks to the out, which is that to the extent that you do want to sell your shares and get out of the fund, you are going to be limited to an interval of, let's say, once per quarter. and to the extent that other investors want out of the fund, there may be a queue of other investors ahead of you. And so shares upon redemption are subject to proration.

6:29So you may only get partial liquidity. And think about why that makes sense if you're a private equity investor or an infrastructure investor, given the long time horizon for the investment or deployment of that capital. it does the first thought that comes to me is this concept of the conservation of liquidity but you can't create liquidity where it doesn't exist um so yeah yeah what you're trying to do is repackage it in a way to concentrate it on certain dates so there's an exit on a certain day and it's concentrated on that um and then the the asset manager knows how much liquidity he's meant to draw up and he has the opportunity to go and look for i don't know banking possible you know uh lines of credit or other other investors to come in and use that entry and date as a as their entry while you're exiting and something but the the it seems to me like i recall investing in in CEFs, closed-end funds back in the 90s.

7:33Right. And naturally, the lack of liquidity on the underlying asset pool meant that when everyone wanted to sell to get out, you got a big discount in the asset value developed, which is what rationed us for getting out. You double took on the 20 % discount, double took again on the 40 % discount, which I took the 20 % discount. Yes. So listed closed-end funds, as you mentioned, they can trade at premiums and they can go to discounts. And it's largely about supply and demand. And so moments like March of 2020, where there wasn't much demand, you did see listed closed-end funds. You also saw ETFs deal with massive redemptions.

8:24And you saw because listed closed-end funds don't have to stand ready to redeem, what happens is the price goes to a discount. So people get liquidity, albeit at a discount. They may not be happy about it, but at least they have the liquidity that they need. Now, interval funds, because they are non-listed closed-end funds, the liquidity, the benefit is, it's a trade-off here because the liquidity is at net asset value, not some publicly traded price on the market the way a listed closed-end fund is priced. An interval fund, it is in and out at net asset value, but the out, you have this gate effectively, this sort of limited amount of liquidity.

9:08And I think you expressed it in a very thoughtful way. Asset managers need to think long before they launch the fund and frankly, well before an event in the market like a 2008 where you had liquidity dry up for a long period of time because you have to have means by which to navigate those volatile periods in the market. And so, for example, what some private equity funds will do is they'll have a companion asset class like public securities, maybe private credit, something that's more liquid so that they can provide the liquidity that's been stated. Now, I think you're also kind of speaking to expectations.

9:51And the reality is, is that a lot of investors, their preference is for highly liquid portfolios. And so there definitely has to be some tolerance, if you will, for a small portion of your portfolio. to the extent you are interested in alternatives, the time horizon for that investment is probably going to be different than how you think about the more liquid side of your portfolio for these very reasons. Right. So I think I've forgotten who, or maybe Harley Bassman, somebody said like no bad bonds, only bad prices. And I think the same is true for asset classes, right? No bad asset classes, only excessively large allocations to them.

10:34Yes. Yes. Well, people actually fail to realize how illiquid bond markets, municipal bond markets, even treasury markets can be, right? And so bonds are sort of, just one example is that there can be episodic illiquidity. So in those moments, right, when the market demands liquidity and buyers step away, there's not a lot you can do. And so it really, it is about having your asset allocation model in your plan. And frankly, this is, I think, what good wealth managers do is they counsel you through, frankly, what you are willing or able to tolerate. And some investors, frankly, for behavioral reasons, are probably best sitting in 100 % liquid assets, but you are giving up potential return if you have that kind of portfolio.

11:32Let's talk about that potential return, because if there wasn't some advantage to the alternative space, this whole conversation makes no sense. You have to be able to see an advantage. So where are these advantages? What is it that people are missing out on in the public markets that they can get in the alternative markets? Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks.

12:13Feel ready? You can move to real money with as little as$100 once your account is approved. And the great thing is that in addition to crypto, Plus500 gives you access to a wide range of instruments. S &P 500, NASDAQ, gas, and much more. Explore equity indices, energy, metals, Forex, and beyond. With a simple and intuitive platform, you could trade anytime, anywhere. Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone.

12:49Not all applicants will qualify. Plus500, it's trading with a plus. Well, let's stick with the private equity example, because I think there's so many Americans that are interested in that, you know, getting access to private companies, partly because U.S. companies are staying private longer. But the historical return going back, you know, let's say over a 20-year rolling period for private equity is about 14 % on average. And that compares to the S &P 500, which over time, the anticipated returns from a S &P 500 portfolio, maybe in the 8 % to 10 % range. So you're picking up incremental return versus public equities to the extent you invest in private equity.

13:41Now, bear in mind a 14 % return, that's the market, right? And one of the things I think in preparation here that we talked about with alternatives is manager selection is even more important in the private markets. And so there's a wide range of possible returns. And the higher returns are going to be achieved by managers with long track records managing institutional pools of capital. And so, frankly, I think a lot of their managers are always happy to share their impressive track records. But there is a wide range. And that can be if you're, if unfortunately you've picked a manager that doesn't, you know, performs on the other end of the spectrum.

14:26So you have to be very careful with manager selection. And that contrasts with the public markets where there's a really tight clustering of performance, frankly, around the benchmark. You don't see that in the private markets. But nonetheless, it's compelling. People are looking for return pickup in private credit. They're looking for yield pickup. There's a lot of retirees, income-oriented investors that want more from their income portfolio. And frankly, just think about the last two years, real estate is an area where a lot of investors have allocated, partly because I think there's a comfort with some of those tangible assets.

15:06And real estate provides typically some level of income and then additional return on top of that. So a lot of those real estate investors have shifted into other parts of the private markets, including infrastructure and private credit, because they're looking, obviously, people have been concerned about commercial real estate recently, post-COVID. And so they're looking for other types of alternative income. And that's why we've seen really a large growth in the category of interval funds on offer. So this sounds a little bit like putting all those two components together. It sounds like people have a comfort with physical assets or a preference for physical assets, which is what you're tapping into in this space.

15:54You know, in my long career, I've never built or marketed or been involved with a real estate fund. So I'm not a real estate expert, but it has always surprised me when I speak with financial advisors and individual investors, how many people use tangible investments. Maybe it's a portfolio of rental properties. Maybe it's a farmland that was inherited or passed down. And I think that people, when you can look and see evidence, you know, in the way of, you know, a senior housing facility or, you know, a farmland, you know, here in the state of Illinois, it's easy to get your arms around what it is, what's inside the portfolio.

16:42That's a little bit harder when you're talking about things like private credit, like asset-backed lending or direct lending, you know, it's kind of a step removed. And so that's why I do think that tangible assets are so appealing because I think every American who owns a home or rents a home, you understand kind of the economics of real estate from that perspective. So I do think there is that understanding there. I think people think they understand. And it's been a source of all of my greatest errors. Overconfidence has allowed me to lose ungodly amounts of money in really stupid ways in the past.

17:27What I would say, though, is there's a Groucho Marx comment, which always comes to mind in these moments, which is I wouldn't want to be a member of any club that would have me. And that seems particularly true for things like private equity. I mean, I'd love to be in Bono's private equity pool. He's done very well. But I think we get invited to different private equity pools. And my private equity experience was not Bono's private equity experience. I guarantee it. I think you've got a very important point, particularly for private equity, maybe even more so for venture capital, because a lot of those opportunity sets are capacity constrained.

18:07And so, you know, you want to be asked, are you getting the good stuff? And, you know, if these firms, you know, if it's not the same strategy as the institutional strategy, you know, you have to question, do you want it, right? Right. And so that's why I do think we were talking about that, that index return for private equity being at 14 percent. But there is such a wide range and an access and capacity constraints are a big part of it. And I actually think to your point, that is why areas of the market like private credit and infrastructure, where there's less dry powder, if you will. Although, frankly, infrastructure has been raising so much capital the last year, a lot of the firms like KKR and Apollo who have raised big infrastructure pools, you know, they're in the process of deploying that, you know, and they're buying things like, you know, wind farms and airports and toll roads.

19:07So big, big physical assets. So I think you do want to question any new opportunity with respect to how much capacity. And it comes up a lot in the REIT and the BDC market because a lot of those products are evergreen in nature and they can get quite large. And I do think you should question, you know, I think people think that there's safety in numbers or there's comfort in a larger fund. But you do wonder if some of these big, massive funds are pushing up against those capacity constraints. And if and when they do, you know, eventually you're going to see it in your returns. So one part of me, one of the things that occurred to me as I was thinking about this, doing various chores and giving kids breakfast, stuff like that, was this question of what the fee structure is.

19:59Because, you know, never mind the quality, tell me about the fees. Sure. What is the fee structure? How is this going to look to a retail investor who pays attention? I'm that cheap, but I ask about fees. Terrible. Well, it's smart to do so. There was just a recent Wall Street Journal article, Jason Zweig covered the interval fund space. And he was particularly critical about fees because they are significantly higher than mutual funds and ETFs. And as we know, mutual fund and ETF space, fees have been coming down significantly. So this is sort of a contra trend in the marketplace. um the what i'll say is that the i'm going to quote the average but the average fee doesn't tell the whole story so the average interval fund management fee is 119 okay so that's already above you know 100 basis points um but i would say the mode the most frequent observation for management fees that we see in the market is about 150.

21:06And if you're talking about private equity, if we continue with that example, there are particularly some of the sophisticated managers with a lot of skill. I'll give an example, like a Hamilton Lane, for example, they are charging two and 20 in this registered product structure, just as they do in their private funds for institutional investors. So in one way, it addresses your concern or objection, you know, is the manager giving me the same strategy? Yes, they are. And the fee is the same. So I think that there are plenty of market participants and innovation trying to bring down fees. And we're seeing it across a variety of different alternative strategies.

21:55private equity and venture capital. I do expect the fees to remain fairly high, just as we were talking about. And maybe that's okay, as long as people understand that. Some of these incentive fees can be complex because you pay based on performance. So the fee is lagged. So it doesn't show up necessarily on the fact sheet or the expense table. You do have to read the prospectus to understand what full freight you're going to be paying. Yeah, you know, so what popped into my head was that everybody out there can see the value of having semi-permanent capital or longer persistent capital, maybe the best phrase.

22:40The longer the duration of the capital, the more you can lock up high, I guess it's not alpha, its beta high beta assets and and and leverage those beta assets um to take your fees out of it so for the asset manager it makes a lot of sense but how what does the retail investor get back in some in some cases like i can see the retail is getting access to a product he wouldn't otherwise get and the asset class is so attractive um you need to do it but that that's the issue isn't it? Who's getting what in this game? Yes. And so if you think about all of the participants in the market, motivations vary.

23:26And right now, I would actually say that most investors either are not aware that these opportunities exist, or they may be introduced to some of these products by their financial advisor. And so many of them probably don't, maybe they, if you look at the average asset allocation today, it's about 2%, 2 % to 3 % to alternatives. So I think some people might argue that they're doing just fine without alternatives. The question is, if you think about it going backwards in time in the 80s and 90s, even just up until a couple years ago, the U.S. public equity markets had such robust, sustained growth over a long period of time.

24:20And I think academics have long argued, oh, you need international equity, you need European debt, you need these different types of diversifiers. And I think that some of that advice has been ignored. And U.S. investors end up with very U.S. equity dominant portfolios. And so that means that, you know, typically the average investor has too much exposure to U.S. public equity. And, you know, we were reminded of that in 2022 when neither bonds nor stocks performed. So I think that was an opportunity for advisors to have the conversation with the end client Because frankly, the end client has been largely satisfied with the historical performance of public equities.

25:11So the question is going forward, will the U.S. economy and the public equity market be the place for growth? And I think a lot of folks argue that with private companies staying longer, that U.S. investors are missing out on a lot of the growth. SpaceX is an example. There's a lot of other unicorn-type companies. But there are real regulatory and market-driven reasons that these companies will continue to stay private. So we want to be able to access that growth. And private market opportunities allow us to do it two different ways. We talked about private equity. There's also one of the biggest categories of growth is direct lending.

25:59And so as banks have stepped away from providing loans, not just to us consumers, banks have stopped providing loans to corporations. And so there are private investors, large private investors who've stepped in to fill this direct lending gap. And so direct lending, the liquidity is also not there. You can't put direct lending assets into a mutual fund. They can be wrapped up in a BDC or an interval fund. And so that's another way if you're probably more income oriented as opposed to total return oriented, direct lending might be appealing because you're participating in, you know, sort of the economics of middle market U.S.

26:49companies. And that's another way to kind of tap into the growth of the private markets. So I mentioned the Groucher Marx saying, and I do try and live my life by that. I would not want to be a member of any club that would actually have me. There's obviously a paradox in there. But you make a fine point. Like, why do we have access to Tesla, but we don't have access to SpaceX? And being the kind of perverse-minded person that I am, I can't help but think that SpaceX has got to be the better trade. because I don't have access to SpaceX. He doesn't want to sell me equity in that thing. He does want to sell me equity to Tesla.

27:32I want the one I can't get. So that's one thought that occurs to me. Now, in the case of the BDCs and the banking assets, I know why that opportunity exists, which is we have bank capital adequacy rules and bank regulation. And over the last 40 years, this kind of lending has not been considered particularly profitable by banks. So they've allowed other – they often originate the loans. In many cases, they don't, but they have in the past originated loans and they sell them off the balance sheet. Now BDCs originate themselves, I think. They do. But it does make me wonder, because back when I was young, banks were massively pro-cyclical assets.

28:25Like when things were great, they made a lot of money, and when things were terrible, they suffered a lot of defaults. If I own the BDC, am I going to suffer defaults when things are bad? Yeah, absolutely. Anytime you're investing in middle market credit or to that extent, below investment grade credit, there is going to be some level of default and then eventually potentially loss. And so that's why, you know, the case that these direct lending firms make is that active management is really important to mitigate loss in the event of default. And, you know, we've been in a period of time where, you know, defaults have been very low since 2009.

29:12And so I think that there is some anxiety, I think, in the market regarding kind of where we are in the cycle today so that, you know, we may see higher defaults. And the reality is defaults will happen, particularly with below investment grade credit. And the question is, sometimes losses can be mitigated based on, you know, to the extent that the company goes in default sooner rather than later. The worry I think right now is a lot of these companies are sort of limping their way into default. And so losses could be higher because they're sort of less of what's valuable left at the point of default.