From the Top

Highpointers

On March 5th, 2011, my wife and I buckled our snowshoes and hiked to the top of Eagle Mountain.? At 2,301 feet, it boasts the highest elevation in the state of Minnesota.? Since that day we have been Highpointers, with a lifelong goal to make it to the highest point in every U.S. state.? I'm writing this on the flight back from Asheville, where we conquered the peaks of North Carolina, South Carolina, and Tennessee, with our two daughters and their grandparents in tow.? For my wife and I, this trip brought our highpoint total to 15.

Now, allow me to seamlessly transition from this personal anecdote to the main topic of this month's newsletter.

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From the Top

The inaugural edition of "The Nord" detailed the reasons behind founding Nord Associates and emphasized why smaller private market fund managers are often overlooked, despite their potential to enhance a portfolio. Future newsletters will be concise, focusing on specific subjects. This month, I've chosen to… begin at the top, exploring the private capital asset allocation decision.? (Nailed the transition!)

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Private Capital in Asset Allocation

Early in my career, a senior member of our consulting firm was presenting to a group of us new analysts on the topic of asset allocation.? The phrase used to describe the traditional mean-variance modeling process is too colorful for print, so I will just say that they were not a big fan.? One reason being that the process failed to properly account for most alternative investments, specifically private capital funds.

Why are private capital funds problematic?? The challenge lies in how the illiquid nature of these investments impacts the three key model inputs: return, volatility (variance), and correlation.

1. Return Assumption:? Private capital fund returns are typically measured on a dollar-weighted basis (IRR) and are not an apples-to-apples comparison to traditional investment returns measured using time-weighted return metrics.? Rather than use average IRR metrics to form an assumption, a common approach is to simply assume an illiquidity premium relative to similar public market investments.? The result is almost always that private market investments have a higher return assumption than traditional counterparts.
2. Volatility Assumption:? Private funds, unlike traditional investments traded on public exchanges, typically value their investments quarterly. These valuations are determined by models and each fund's valuation policy, with valuation changes usually being conservative relative to public market movements.? The argument about what constitutes the “correct value” is beyond the scope of this newsletter.? For a thorough and balanced dive into the recently controversial topic, I’d suggest you listen to the first episode of Capital Decanted hosted by John Bowman and Christie Hamiliton of the CAIA Association.? Regardless of your view on the issue, the current private market valuation process creates a much lower assumption for standard deviation of returns than traditional investments.
3. Correlation Assumption:? Private market securities take time to value, and these valuations are typically reported with a delay. This lag reduces the correlation between private market assets and other asset classes, despite exposure to the same economic drivers.

Having looked over my subscriber list, I’d expect that many of you have run a mean-variance optimization model before.? For those that haven’t, just know that when you feed your asset allocation robot an asset class that has a higher return assumption, lower volatility, and lower correlation, it will want a lot of it.? In the case of private capital, usually more than is realistic given the illiquidity.

So, what happens next?? You re-run the model, but put a maximum amount, or “constraint” on the amount of private capital before running the model. ?Thus, if you constrain private equity to 10%, you get a 10% allocation to private equity.? I have sat through my fair share of meetings with highly qualified investment committees, sophisticated institutional investment staff, and smart investment consultants.? At the end of the day, the private capital allocation is nearly always determined by how much illiquidity an investor is comfortable taking in the portfolio, rather than the result of any highly quantitative approach.

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Nord’s simple approach to private capital allocation in 3 questions:

1. Do you believe you have the capability, using internal and/or external resources, to identify, and access, private capital fund managers that can generate a risk/return premium that is sufficient to justify the illiquidity and complexity private investments will add to the portfolio? ?If the answer is no, you should not invest in private markets.? You can build a quality, diversified portfolio using traditional investment options.?
2. If you answered yes to #1, how much illiquidity are you comfortable adding to your portfolio? This should vary based on factors such as the purpose of the investment pool. Endowments with a clearly defined distribution rate and perpetual life can tolerate more illiquidity, while other investors may require higher levels of liquid assets due to regulatory or credit underwriting requirements.
3. How many underlying investments do you want to manage to meet your allocation target?? Consider whether you prefer more managers with smaller positions or larger bets on fewer funds. Keep in mind that each private capital fund adds operational complexity in the form of tax filings, capital calls, distributions, and ongoing due diligence.?

Commitment Model and Forward Calendar

With these three questions answered, you'll have a framework for what Nord believes is the most critical step in the private capital allocation process: building and maintaining a commitment model and forward calendar. I'll delve deeper into this in next month's newsletter as we continue working our way down from the top.

In the meantime, please reach out if you'd like to learn more about private capital planning and how Nord Associates can develop, implement, and maintain a commitment model that aligns with your portfolio's needs.