Are Private Markets Worth It? Vanguard's Fran Kinniry on Risks, Rewards, and Realities (EP.202)

0:28We all need to make smart decisions with our money. long time. I'm joined by Fran Canire, a senior investment executive at Vanguard and someone who has had a tremendous impact on the financial advice profession. My introduction to his work was with Vanguard's infamous Advisors Alpha Study, which quantifies the value of using a financial advisor. And it's something, a topic I'd love to get into at another time. But in this episode, I asked Fran to take us on a deep dive into the evolving world of private investments, specifically with private equity and private credit. We'll explore why companies are staying private longer, how private markets have changed, and what investors really need to understand about illiquidity, manager selection, portfolio construction, and risk.

1:16Be sure to stay for the whole episode because Fran also shares some forward-looking insights about the possibility of private assets making their way into retirement plans like 401ks and what that could mean for the future of investing. If you've ever wondered whether private investments belong in your portfolio or how to think about them in the context of a long-term plan, this episode is for you. As always, you can find links to Fran's research and detailed show notes at thelongterminvestor.com. And if you open the podcast app, you will see a link to subscribe to my newsletter where you will get access to insights like these before anybody else.

1:55And now, here's my conversation with Fran Canary.

2:02Fran Canary, welcome to The Long-Term Investor. Great to be here, Peter. I am so excited to have you. You are who I think of as the father of Advisor Alpha. And over my decade plus at PlanCorp, we've had a lot of interactions because you're at the core of so much of the research that Vanguard does that informs not just the products that go out to the people, but the advice that advisors are giving to individuals. And so today, I want to talk about an area that is coming up in more and more conversations, and that's just the world of private investment. And we'll start with private equity. We're going to just jump right in.

2:40Can you help us understand what the core investment thesis is for private equity and how it maybe differs from public market investing in terms of expected returns and risk and accessibility? Yeah, thanks, Peter. And also been a big fan of what you do in our relationship and everything PlanCorp does. So as it relates to private equity, what we're seeing is more and more the ability of companies to stay private longer. There's more and more the ecosystem or the opportunity set, if you will, of public versus private has shifted. And so Vanguard has always believed of owning the market, right? Own the market in its market cap framework.

3:19but you can't do that if you're excluding a large part of the market, which is private equity, right? And so it is just equity, right? You could be a public equity firm or a private equity firm that decided not to do an IPO and they stay private. And so we felt that this spirit of owning the market, wanting to have more diversification rather than less, if you could access private equity. And that's a big if, if you can access private equity well, that it would add diversification to a portfolio because you're including a different asset or sub-asset class that is not in a client portfolio today.

3:57And hopefully do that with returns that are either comparable or above the public equity market. So that's our main hypothesis. And this private equity space, you're trying to generate the excess returns. You're trying to have some diversification benefit. I mean, I guess the excess returns theoretically come from the operational improvements somebody might make or the financial structure or the strategic exits. But there's also this illiquidity premium. Can you discuss what that is all about? Yeah, sure. So the illiquidity premium is not unique to private equity. I mean, some of the listeners may know there's even on the run, off the run treasuries, or some municipal bonds that trade more than others.

4:42And so illiquidity is not unique to private equity. Any asset that has high volume, high trading volume is gonna have tighter spreads than securities that have low volume. And being private equity is private and there's really not a lot of transactions. There has been an illiquidity premium there of about 300 basis points. That's been historical, but as the asset class has grown and volume has grown, we would expect that to shrink. So we're not saying that it would be 300 basis points. But even if it's half that at 150 basis points, and I'm just making that up for the audience, that's something that you would have to ask your investors, do you have to be 100 % liquid?

5:22Most clients, their investable portfolio is 100 % liquid. And do they really need that if there is an illiquidity premium in almost every asset we can find, and private equity has been 300 historically, and let's say it's half of that forward looking, is that 150 basis point or 200 basis point illiquidity premium something that an investor could take advantage of if they have a 20, 30, 40 year horizon? So sometimes investors probably have too much liquidity based on their time horizon and their spending, where they're at in their spending cycle. So it's not just the time horizon, I guess it's also the behavioral wherewithal to stick with it, or if you're using an advisor, maybe that creates some sort of behavioral guardrail.

6:08But something else that you mentioned, and I've heard you say in other conversations, and I've read in your research, which by the way, all listeners, all viewers, I'm going to link to Fran's research as well as some really important thoughts coming from Vanguard and Fran's team in the show notes at the long term investor.com. But you mentioned the importance of manager selection. And even when you said there's this historical outperformance, the dispersion of manager performance is pretty wide. So Vanguard has dipped their toe into this space. How do you feel like investors can improve their odds of selecting a good manager and maybe give people a sense of the difference between a good manager and even an average manager?

6:51Yeah. So like the public markets, your listeners are probably maybe a little bit more familiar with. There's first quartile, second quartile, third quartile, and fourth quartile. Let's just say, hypothetically, large cap growth stocks. And the dispersion is still there, right? Everyone says there's no case for active, but that's actually not true. There's not a case for average active because of zero sum game and costs actually take away. But if you can find top quartile active on the public side, they actually have positive performance after the fees. And Vanguard has been doing active management on the public side, both on equity and fixed income public markets for 40 plus years.

7:32And we've done actually pretty well there. Most of our funds have outperformed the peer group and they've outperformed the index themselves, because if you combine talent and fair costs, you can end up on the right side of the distribution. And we've done that in the public markets on active equity and active fixed income. Taking that same story to private equity, the same thing exists, only the dispersion is 2 to 3x. So you do not want to have the average private equity manager, Peter. You really have to be confident that you're going to have the first and second quartile active managers. Now, the challenge to that is that most of the top managers have been oversubscribed and they're basically closed to new investors.

8:19And so private equity is not something that I think a lot of investors are going to be able to go do on their own. They're probably going to want to partner with someone like Vanguard, who we can actually get the access to world class managers because of our brand, our size, our 40 years of doing this well, knowing that we have 50 million investors that we can pull together to bring to one of these top quartile private equity managers. But you definitely do not want the median or below the median private equity manager. And I'm going to repeat a little bit back of what you've said to this point, because you started out by saying private companies are staying private longer, and this is expanding the opportunity set for private managers.

9:05Now, at the same time, these great returns have attracted a lot of capital. So we have higher capital flows, maybe increased competition for deals to get done, and that increases valuations and could maybe compress future excess returns. I think you said something along those lines, but I'm paraphrasing. I won't be quoting you here. But the thing is, as we see, there's a lot of talk of how private equity and other private assets, but we're still sort of focused on private equity, is going towards the retail investor. Does this dilute returns further? Are there other risks that you think people need to keep in mind as that exposure continues to go downstream, so to speak?

9:49Yeah, I mean, there's only so much excess returns in alpha, right? It's not an unlimited supply of excess returns in alpha that's there. And that's why I actually discounted the illiquidity premium, right? I actually took the illiquidity premium in half as just a hypothetical. And I did that because if more investors are coming in to the space, it should lower that illiquidity premium. So there was a reason why I did that. So you are correct, Peter, that anytime more investors are coming into any asset space, you're going to share those economics more broadly than if they were shared more narrowly, right?

10:25So the largest family offices and endowments and foundations have been doing private equity for 30 to 40 years and have had really good returns for the top quartile, again, endowments and family offices. And as it broadens out and more people are sharing those economics, it will certainly dilute. That doesn't mean that it will flip to negative, right? If you have a positive excess return and two people are sharing it and now you have a positive excess return and four people are sharing it, it's still positive. And so I think that is maybe lower returns as the asset class becomes more democratized, but still a positive experience or positive net outcomes for investors because it doesn't take something that's positive.

11:08If the multiplier is positive and you divide it by two, four or 200 or 400, it's still going to be positive. You mentioned that private equity investing has been happening for several decades. Private credit has been happening to some extent, but it's usually been on big bank balance sheets. We're seeing private credit growth exploding in recent years. Do you mind talking through a little bit of what is driving this growth and why it is such a highly talked about asset class right now? Yeah, as we talked about with private equity, the ability of stay public longer, right? So there's actually two to three X private equity companies as there are public equity companies.

11:50On the private credit side, coming out of the global financial crisis, the banks were normally the lender of first choice for a lot of these, we will call them below investment grade or high yield private bank loans. But given that they needed to clean up their balance sheets, they did not want a lot of this credit on their balance sheets because of the regulations coming out of GFC. You're seeing a different version of private credit. The underwriters and the ecosystem there of the capital system has changed. And so that's opened up, as you mentioned, a much larger ecosystem and a very swiftly growing part of private credit that is now available to end investors, institutional or family officer accredited that are there.

12:40And it has exploded. But again, I want to be clear, it has similar characteristics of high yield or below investment grade. So the question there is about portfolio construction and portfolio. It's not your typical investment grade bond experience. And so if we were to look at the risk adjusted returns in private credit, are they superior to public fixed income markets? But then is it a question of if your fixed income portfolio doesn't even own high yield today, how would someone mentally make the leap to suddenly include private credit to their portfolio? Yeah, I would say everything I said on private equity, I'll double down on because there is not an index or a beta, if you will.

13:25And so manager access, always start with access. Do you feel you're going to have access to the top managers? Can you select those managers? Because there is no beta or index. You can't own all of them. And so it's really going to come down to manager selection there. Secondly, again, I think most people that have multi-asset class portfolio construction have to think about that. if you have a 50-50 equity bond, 60-40, 70-30, you really want to think about what does your fixed income look like? Do you want your fixed income to be a ballast to try to help in equity contagion? Or do you want your fixed income to have some equity beta to it?

14:08And we know that high-yield private credit will perform very, very differently than, let's call it, treasury bonds in an equity sell-off. And so it gets a little more complicated than private equity because private equity are going to fund from equity. And if you're 60-40 and you take the money out of equity and put it into private equity, the experience is probably not going to be all that different on a max drawdown. A 60-40 and you're going from all investment grade bonds to either high yield or private credit, the experience is going to be a lot different. And so thinking about how you fund private credit, just because it has credit in the name does not mean it will perform like bonds in equity contagion.

14:50I do worry about that, of what will max drawdown look like in a bear market of 70, 30, 60, 40, if the bonds look like they have a lot of equity beta in them. Well, and in those max drawdown periods, when you're in a private vehicle, Your liquidity is not assured. And so seeing a drawdown on a statement doesn't mean you'll be able to get out. No, there are a lot of people who would argue that is one of the benefits of some of these private investments is that in some of these investments, they're going to price more frequently than a traditional drawdown fund, where if I'm investing and I make a capital commitment and the company's drawing for my capital every so often, that's a different experience than what I think the growth of these vehicles have been in, which is more in these semi-liquid funds where you can get some liquidity and some more frequent pricing, but the fund has the right to say, sorry, we are keeping your cash.

15:47We can't meet all these withdrawal requests. And so I guess, let me ask you this. Unlike private equity, private credit provides some current income, and you've already touched on this a little bit, but I typically think of the reason you're going to evaluate adding something to a portfolio is going to be, it's either making your return better or your diversification better. How does something like providing current income change the case for including private credit in a portfolio for diversification purposes? Yeah, I would say the first question I always answer that with Peter is, is it a taxable client or a tax exempt client, right?

16:25So how an endowment and foundation, which is tax exempt, may look at it very different than a family office or a high net worth client. And I don't think oftentimes allocators really think about this as an after-tax question, because the last thing you want to do is accelerate or boost your income and then pay ordinary income tax on that. You'd be much better off following what is known as a total return strategy, which is generating a cash flow from selling your assets that are as close to market or even at a loss, realizing the loss and trying to rebalance. And so we really think long and hard about if you're working with high net worth clients or taxable clients, trying to increase your yield and certainly private credit and high yield bonds and others will do that.

17:16But the after tax returns on a lot of these vehicles are sometimes near 50 percent. So you have all the risk of the investment, but you're giving up 50 percent of the return if you're a taxable entity. So I think that would be the first question I would have to ask is, is it a tax exempt entity or is it a taxable family? Well, there's no doubt with any of these private investments, if they were free, like no cost, and they were tax free, this would be a slam dunk. The fact of the matter is, though, that they are high cost and they do generate taxes. And so I'd love to focus a little bit on implementation and some practical considerations.

17:54just starting high level, you know, for an investor who is interested in private markets, how do you think about a percentage allocation and what makes sense within a broadly diversified portfolio? Yeah, I'll start with the private equity side. We think of it very similar of risk return characteristics of public equity. And so we have kind of come down on this 20 to 30 % of your high risk bucket. So let's call equities high risk. So hypothetically, if you were 60, 40 stock bonds, 20 of the 60 would be 12. And so you would be 48 public, 12 private. And as you know, Peter, you're hardly ever going to be at 12 because you're doing capital calls, capital's coming back to you.

18:42And so with private equity, you almost have to try to get to 12. So So it's almost like a dollar cost averaging strategy. And if you decide I'm going to go into private equity and I'm going to try to get to 20 % or that 4812, you're going to get there very slowly through almost like a glide path of funding. And then capital is going to come back. And so it's a pretty active process to keep that 4812 close. And you'll probably never even get there. So which is fine. You're just trying to get some kind of like maybe you're a 5010 or 528. but something around 20 % of the equity. When it gets the private credit, it gets really challenging because, again, I would say, can you put it in a tax qualifier?

19:25I would not want to put it in a taxable entity. Do I have shelf space to put it in my IRA, 401k? Is it even allowed in those vehicles? And then even funding it, how do I fund it knowing that it may perform like equity or equity-like features coming out of there? So the private credit is a little more challenging to think about how you would fund that there. And I mentioned how traditionally people have had to just make direct fund investments, which requires a lot more management of cash flow, and it makes it harder to fill up allocation buckets the way that most investors think, if I need mid-cap stocks, I just go buy the amount of mid-cap stocks I want.

20:05It doesn't really work that way in private equity, private credit. But there is more access now via things called interval funds or tender funds or business development companies, or as people refer to them, you'll hear the word BDCs, listeners, viewers, that's business development companies, private market mutual funds. There's some liquidity there, but I guess, how do you feel like individual investors should be thinking about the best ways to access private equity and private credit? Yeah, the best way to think about it, first off, is there are different regulatory, you know, there's qualified, accredited.

20:41So those would be your first criteria as to what vehicles or structures do you qualify for. Once you get past that hurdle, you have to think about, do you want to have an interval? How much liquidity do you want? Or how much liquidity, again, do you need? The more liquidity that you are probably taking on, such as an inter-fund or some of these liquid alternatives, you should expect the illiquidity premium to potentially go much lower than if I cannot ever access that. So you could be giving away some of those returns. You may also not be getting the same type of investments that would be in a fully illiquid, locked up, never get your money back versus something that has semi-liquid into it.

21:30So I think you really want to do your due diligence on not just the structure, but what is on the inside of the structure, meaning what are the managers in there? What are the assets in there? What are the investment risks and return? Because it can change the whole profile just by changing the structure. And you mentioned it's really important to perform your due diligence. A lot of our audience are advisors. A lot of our audience are do-it-yourself investors. And some of our audience are people who have advisors. For those who are relying upon advisors to perform the due diligence, what are the questions that they should be asking their advisor about their private offering?

22:11First, I would say working with a professional advisor, especially in this space, is very, very helpful because as a direct investor, you would have to say, do you have experience in this space? Do you have the time to do all of the diligence? So working with an advisor, I think, is critical because then they are the fiduciary and they're the ones actually doing all of the diligence for the end client. But if I were asking the advisor, I would ask them what qualifications do they have? What kind of experience do they have? How long have they been doing this to make sure that they indeed have the qualifications to do the due diligence?

22:48And are they getting access to a lot of these managers? As I said, most of the top quartile private equity managers have been closed for a decade. And so it's very, very hard. It's easy to say you need top quartile managers. But if this asset class has been around for 20, 30, 40 years, and you're just coming into it now, you just have to ask about what kind of access am I going to get to some of these world-class general partners, many of which have been closed. There's a ton of research out there that show that a small percentage of the managers are responsible for the large percentage of the returns.

23:25And one thing that I think advisors don't necessarily understand, and so I'm the chief investment officer of a firm that has somewhere around$7.5 billion worth of assets. And if I know that there is going to be not just a top quartile, but a top decile private equity manager, they may not even want my money. They want permanent capital. They're very selective about their clients. And so you've said the word access and you've said the word selection a number of times. I think people underestimate what access really means, as well as what the best managers think of when it comes to long term capital.

24:03We may have a multi-decade horizon, but I think what's difficult about our job, and Fran, we have a private allocation, and so I understand some of the access issues. And some managers are happy to consider our long-term capital. But if I knew who the best manager was, they want Yale's money. They don't want somebody even with$100 million net worth. You know, they want something even more permanent. I guess it's a hard transition, but when I read the tea leaves of the space, I'm to understand that the Department of Labor might sometime in the next 12 months or so say that you can have something like a private equity in a retirement account, in a 401k account.

24:42I have to assume based on what I sort of read in industry news that that means that someday someone like Vanguard might put a private equity fund in a target date fund. Now, I'm not asking you to confirm or deny, but in a world where perhaps multiple major asset managers are doing that, how would you tell the average investor to interpret the inclusion of something like private assets in a target date fund? Yeah, I'll talk about it hypothetically. And thanks for the question. If you think about what would make private equity work, one could lay out a hypothetical that a TRF would be a great place.

25:23And the reason I say that is because we know how old the investor is. So I've always used the example of my son. He's 28 years old. He's just starting his career. So he's going to work for, let's say, another 30 years, hypothetically. And he doesn't need access necessarily to his 401k plan. So he meets a lot of the criteria, probably doesn't need 100 % liquidity. If he's working with a target retirement plan sponsor like Vanguard, he knows we're probably going to be able to get access because of our size, our reputation. You mentioned about having Yale versus PlanCorp, right? The private equity firms want a large, steady annual buyer of their vintages.

26:06And so we would, given our size and our brand and our diligence and how we have sourced managers for 40 years, we tend to get access to some of the best managers and we're pretty good at selection. So all the stars have to align, right? So you have a very long horizon investor. He probably doesn't need 100 % liquidity. It's already illiquid because you would have a penalty to withdraw it early, right? So you know that this is almost a portfolio that's going to be pretty stable for the next 20 or 30 years. The other thing is putting it in a multi-asset class where you only have one price. I've done a lot of my career on behavioral finance.

26:45And the irony is like if you use something like the total stock market, which owns all the public equities, it has all the dogs, right? It has all the worst performing stocks, but it also has the Nvidia. It has all the best performing stocks. People don't go in and want to get rid of the bottom decile stocks because they only see one return. When we look at the total world portfolio, same thing. There's countries that are just so poor that if the client owned all of the countries, they might have this behavioral tendency to sell the underperformers, double down on the winners, but when they hold them collectively and only see one nap.

27:20So by having a private equity sleeve within a target retirement fund would also meet that criteria. So it checks off a lot of criterias. Last criteria is as it would start the glide path down. Now my son is 28. We're going out 30 years now. He's 58. Hypothetically, I can take the private, I can just stop funding it at some point in the future. So when he hits retirement, it's at zero. So it meets a lot of the criteria there. I'm not saying whether we would or would not, but it does check a lot of the boxes if you can think about it in that structure of being a good structure. That's really interesting.