Three Opportunities in Private Equity & Real Assets

Greg Campion: Private equity markets have not been sheltered from the metaphorical storm hitting markets over the last year plus, as higher interest rates and inflation have eaten into returns and slowed down deal activity. Does that mean it's time to shy away from the asset class or alternatively to lean in?

Mina Nazemi: Despite all the macro headwinds we're seeing in the market right now, we are seeing fantastic investment opportunities in both private equity and real assets.

Greg Campion: That was Mina Nazemi, head of Diversified Alternative Equity at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, three opportunities in private equity and real assets. Mina Nazemi, welcome back to Streaming Income.

Mina Nazemi: Thank you so much. I'm so excited to be here.

Greg Campion: Awesome to have you back. You've been a guest on this podcast a few times, so I always enjoy getting a chance to speak with you. There's so much going on today. It's probably a little more obvious looking at public markets in terms of some of the big themes and trends that are going on. Obviously, we see the numbers moving on the screens every day. We see everybody worried about when is this recession that's been predicted forever actually going to take place? We see lots of talks still about rates and inflation. Maybe it's less clear to investors some of the big themes that are driving performance in private markets and especially private equity and real assets, which we're here to talk about today. I'd like to ask you, before we get into some of your top ideas right now, I'd like to ask you to just set the stage maybe and give us a sense of some of the big themes that you're seeing that are kind of setting the backdrop for the space right now.

Mina Nazemi: Yeah, that's a big topic and as we talk to investors, there's just too much complexity going on. There's a lot of complexity in terms of the macro environment and there's a lot of complexity within their portfolio companies and the managers and the funds that they're invested in. Really the three kind of areas I think that are probably the most top of mind are the denominator effect valuations and inflation is just continuing to be a lingering topic and a lingering issue. So let me just kind of hit it from the denominator effect to start with that, but for everybody who may or may not know, the denominator effect is the ratio of your private markets as a percentage of your total plan size. The denominator effect, in my opinion, has been calculated the same way for the last 20, 30 years despite the fact that private markets has really evolved. What that means is the average investor calculates and adds all of their exposure in private markets, whether it's private equity, real assets, if it's private credit, if it's venture, they lump all of that together as an illiquid asset class, and they do that as a percentage of their plan size. That ratio is what's driving a lot of investors, given where valuations are, to just be overexposed into the private markets asset class. That is really becoming a big problem for investors, because they're outsized, they're above target, and that means they can't deploy as much capital. Our view is investors should really dissect what that number is. They should spend more time understanding the components of that illiquidity, effectively what that numerator is, and understand that the cash flows and the profile of some of those asset classes in that bucket is going to be very different. As an example, venture is going to act very, very different than private credit. Private credit has stable cash flows, you're de- risking, and venture has a very, very deep J curve. Our advice is really to spend time understanding what that numerator is, understanding the risk profile, the cashflow profile before you start making these big decisions on not deploying capital in what should be a very good vintage year.

Greg Campion: Yeah, that's a really good point. You just think about how much the private markets have grown in the last 10 years or so, and to your point, it's such a diverse universe of investments these days that totally makes sense to, it seems like a very blunt instrument or calculation to look at it all in one bucket and say, " Okay, this is where my private assets are today versus my total portfolio size." Well, yeah, you've got everything from income generating assets to really speculative high growth equity inaudible-

Mina Nazemi: Long, long dated.

Greg Campion: Yeah.

Mina Nazemi: No, you say it correctly, it's using a blunt instrument. For that reason, as investors have started to get a lot more sophisticated in their deployment, they need to get more sophisticated in how they monitor their portfolio and how they're really analyzing what their exposures are and how much tolerance do they have for that illiquidity, because their portfolio may have more liquidity than they've maybe even really anticipated.

Greg Campion: The second one you mentioned kind of valuations. What's the theme you're kind of seeing there?

Mina Nazemi: Yeah. The market, we've all seen what has happened in the public markets. The reality is that 12- 31 marks, we in the private markets have seen those valuations hold as a general matter. You do see a bifurcation though within private equity. Managers who are typically on the larger end of the market, so focused on large cap transactions, actually tend to have a higher correlation to the public markets. We did see more of the valuations hit in that segment of the market, but on the smaller end of the market, which is where we play, and the lower end of the market, we saw that the managers were able to maintain the values. The reality comes down to those businesses are typically smaller, under levered compared to the larger end of the market, growing much faster, even despite the fact that you may have interest costs increasing, a lot of those smaller businesses have been still able to maintain and be cashflow positive, while for the larger businesses they've been hit much, much harder. Valuations continues to be a hot topic for investors, and it really kind of dovetails where people think about where the secondary market will be, or people are trying to also think whether valuations will be coming down towards the end of the year. We will see on where valuations are, but it ties into our earlier point on the denominator effect. If there's relief on the valuations, then there'll be more relief on the denominator effect.

Greg Campion: Yeah. Okay. So I want to come back to that point you made about some of the larger funds being more correlated to what's going on in public markets, because I think that when we talk about emerging managers, I think there's a real difference in performance based on some of the proprietary analysis that you and your team have done. But before we get into that, the third one you mentioned was inflation. So how is that impacting the whole picture here?

Mina Nazemi: Yeah, so inflation continues to be an issue for pretty much all companies, all industries. It's where we're seeing most of that impact is really on the labor side. If you think about the US and especially US the majority, two thirds of our US economy is services. Labor is a very big component of that. You're getting now businesses who maybe had wage increases. Now in 2023, you're seeing a full year's cost of that kind of higher hourly rate or salary. So in our view in inflation is going to be stickier, is going to stay here for longer. As a result of that, historically, we've been very, very active on the real asset side where in real assets is typically inflation protection. Our investments and we've made over the years, and again, pre- Covid has really paid off in this inflationary environment and have provided a good hedge in diversification and return for our investors.

Greg Campion: All right. Well, you've done a great job previewing, I think, what we're going to talk about next here. We're calling this episode working title Three Opportunities in Private Equity and Real Assets. I, as podcast host, have the privilege of knowing which opportunities we're going to talk about in advance. The first one we're going to talk about is emerging managers. This is a segment of the market that you've been deeply involved with for many years, and one that you and I have spoken about before on this very podcast. Let's talk about emerging managers. Maybe I want to just mention upfront that you and your team have recently published a paper called Don't Judge a Fund by Its Number. You've done a variety of analyses within this paper, but one of the most interesting parts of it that I found is you look at historical performance of managers by fund size and by number of fund, meaning is it fund 1, 2, 3, 4, et cetera. You tie that back to what that has meant for returns. Interestingly, the emerging managers, which I'll ask you to define in a minute, but emerging managers are over- indexed to the fourth quartile, so the bottom quartile and to the top quartile. I think maybe there's a perception out there that emerging managers are riskier, so maybe people wouldn't be surprised to hear that they're over- indexed to the bottom quartile, but the top quartile may be a surprise. I want to talk about that. Then similarly, when you look at fund number, you have a very similar dynamic where emerging managers, again, are over- indexed to the top and the bottom quartile. Then the funds that have been around much longer, or" brand name managers" who've been out there with many vintages of their funds almost look more like, and I don't know if you would use this terminology, almost look more like market beta or they're very much, much more close to the median. Set the stage for us. Tell us what you're seeing in emerging managers and maybe why there's an opportunity there today.

Mina Nazemi: Yeah, so emerging managers as we define it, is funds that are in their institutional fund one, two, or three. They're typically spin out teams from larger platforms who are starting their own firm. The investors and the managers that we back have experience investing in that strategy. Although within the emerging manager space, you may have teams who have never worked together that are getting capital, why we see that dispersion that you referenced, I'm definitely not surprised. With respects to the upper quartile, these are managers typically who are spinning out, leaving a steady paycheck, leaving carry on the table, sometimes mortgaging their home and betting on themselves to start their own platform and usually are putting a lot of their own personal capital alongside with their LPs in terms of a sizeable GP commitment. You only do that when you have a lot of conviction in yourself and your capabilities and you know that the market is aware of your experience, your track record, and your capabilities. That is precisely why we like this segment of the market. Where you see those under- performers is frankly some of the things that, I've been doing this for over 20 years and it's surprising to see some of these mistakes continue to happen. It's really managers in that end of the market who haven't worked together before, are embarking on new strategies, don't have the discipline to invest in one core area, they get distracted or they get FOMO and want to invest in other strategies. I'm not surprised by that dispersion, but if you really look and if you know what you're doing, it's pretty easy to pick those top quartile managers because of that. On the flip side, what you're kind of referencing is these larger established managers, once upon a time, they were an emerging manager, they were fund one, fund two, or fund three. As they've gotten larger, they'll see that performance instead of going from that top quartile, which is usually how you get to in the next size in the next fund, going more in that middle. To your point, being closer to the median. That's why in our research you'd see that those larger established tend to be more second and third quartile. If we all know you're not investing in this asset class to generate second or third quartile returns, you're investing in the asset class to get that top quartile return. We spend a lot of time working with clients and helping them get access to those emerging managers. It's much harder to underwrite those managers because you got to spend a lot of time understanding track record, experience, and obviously every emerging manager shows up with a PitchBook with an upper quartile track record. You need to be able to decipher who is really a good investor.

Greg Campion: Yeah. Yeah. The other stat in this piece, and by the way, I'll link to this piece in the show notes of this episode if you're listening and want to read it yourself. The other stat that jumped out to me is of course part of the emerging manager universe, we have women and diverse managers, and perhaps there's a perception out there, and this is what you referenced in the paper, there's an assumption that investing in diverse managers may compromise returns. That, to me, suggests that maybe you're making this investment for other reasons besides returns alone. In fact, when you look at the data that you and your team have compiled in the analysis, you show that women- led funds are notably over- indexing in the first and second quartiles. The numbers are pretty staggering actually when you look at them.

Mina Nazemi: You shouldn't be surprised, women, as a female PM. No, absolutely. We first and foremost believe in investing in areas that are been overlooked and female and diverse managers have been traditionally overlooked in the market. As we're making investments on behalf of our client, we're doing it for, our primary reason is for financial return. That's what our research really shows is that women, female managers outperform in the over- index in that top quartile and that second quartile, and even more staggering is almost very few of them are in that fourth quartile or even the third quartile. That means if you pick a woman out of a hat, you have a higher likelihood of outperforming the market. That's what that research shows. Historically, not a lot of women have gotten access to capital. What that really shows is that investors are really missing out on investment opportunities by overlooking female managers.

Greg Campion: In theory should be, if investors follow where historical returns have been, it should be quite a growth market one would hope in the years to come. Before we move on, emerging managers, anything else you wanted to mention just in terms of current dynamics? Why now? Because everything we mentioned I feel like is more of an evergreen type story for emerging managers, but I'm curious.

Mina Nazemi: That's a great, great question. People would think that during a challenging financial market, which is basically what we're living in today, there would be fewer emerging managers. The reality is there are going to be more managers. We saw this post GFC, it was the same dynamic where you had really great talent who perhaps was in a bigger platform. They were strong performers, but they had a lot of peers or other strategies where that was not performing as well. They knew that being there long term would not be financially successful for them and would not meet their personal financial goals. Strong teams, strong talent end up spinning out during this period. Also, because they know you're buying in a market where valuations are lower than they've historically been in the last, call it five years. Why now is because of that, right? You're going to have great talent spinning out. Two, you're investing in a point in time in the market where valuations are going to be lower than on a relative basis. Then I would say just kind of finally, if you think about these smaller emerging managers, they tend to focus on the smaller end of the market, which will continue to be an area of out performance, where it's easier to change a business and grow revenues, improve operational efficiencies, et cetera. The combination of all those things is why we believe in emerging managers, but especially why now.

Greg Campion: Yep. Makes sense. Often periods of volatility and stress are some of the best investing opportunities.

Mina Nazemi: Absolutely. And for limited partners, this is an opportunity for you to come in on the ground floor with some of these GPs, negotiate better economics for yourself, negotiate better economics for subsequent funds. You're coming in with great talent, locking in some good economics and lower fees so that you get the benefit of supporting them during challenging economic times.

Greg Campion: Speaking of general partners and limited partners, I think maybe that's a nice transition to the next opportunity that we wanted to talk about, and that is continuation vehicles. Again, we have discussed this on this podcast before, but I will ask you to start from the beginning in terms of defining them. I will note, you and your team have been very active with writing research recently. You've also written a piece on this, and we can link to that in the show notes as well. Continuation vehicles, what are they and why are they attractive right now?

Mina Nazemi: Yeah, so for those of you listening, if you're not familiar with a continuation vehicle, what a continuation vehicle is really almost like a combination of a secondary and a combination of a co- investment. Think about it that way. It's an asset that's been sitting within a GP's fund, maybe it's 2, 3, 4, 5 years old. What managers are doing now is instead of selling those assets, they are basically pulling those assets out, creating a SPV, A single purpose vehicle to hold this asset. That process really does a couple things. One, it enables the manager to give some liquidity to their investors by basically giving the investors or their current LPs an option to either participate in the continuation vehicle by rolling their position or by selling it and getting some liquidity. It really is a tool for the LPs to get some liquidity, but it also enables the GP to hold onto their trophy assets and continue where they may have a really strong growth trajectory with those businesses. They have been very successful and identifying a great asset, a great management team, and they don't want to sell it because they know that there's a lot more opportunity and to create more value with that specific asset. Why is it you're getting so much attention and you're seeing so many people talking about it. By the way, we've been on this trend for a number of years already. It goes back to the first thing we talked about, which is the denominator effect. LPs are really hungry for some distributions and getting some capital back. This is a good way, it's a good way for LPs to get some distribution back, but also for the GPs to continue to hold onto some of their winners. I always say not all CVs are created equal. There's always different situations. There may be different alignment. Is it really the trophy asset? Some LPs think it's an asset gathering exercise and GPs getting more aggressive and charging more fees. Yes, the answer is yes, that happens. That's why I always say I love them and I hate them. Within all that confusion and within all of that is an opportunity because it's so misunderstood. I always talk about my job is to exploit inefficiencies in the market, and it continues to be an inefficient segment, and our investments in that area is really taking advantage of inefficiencies. Frankly, the fact that a lot of LPs just don't know and really understand the value of those assets.

Greg Campion: Yes. I like the way you put that in terms of exploiting inefficiencies in the market because I think that's very much true when you talk about areas of the market like emerging managers and women and diverse managers, that seems to be quite the inefficient part of the market and this area as well. I think to your point, it takes a certain skillset to be able to really understand, okay, what are the real risks and what are the opportunities here when it comes to these vehicles? My guess would be that not all LPs are necessarily equipped or properly resourced to handle that type of thing. I guess, what are some of the big things to look out for and how do you recommend navigating this landscape?

Mina Nazemi: Yeah, yeah, you're hitting on something which is really the biggest pain point for the average limited partner, which they're under- resourced, and they are getting these amendments from their limited partners about supporting the continuation vehicle of a specific asset or a couple different assets, and they just don't know how to react to it. They don't know whether the price that's being set is fair. They don't know if there's additional growth. That's where we come in. We can come in and we work with clients in helping them frankly have someone who can spend the time to understand the asset, who's also been probably tracking the asset and guide them in making a decision on whether they should continue to hold or sell their position. The reality is the average limited partner has just a blind policy. They're either selling all of them that come through their door or they're holding on and rolling. While that is a policy to alleviate some of the challenges for staff, it's not really maximizing value. In fact, you may be leaving money on the table by taking that blind approach. That's where we can come in and support investors. Also, the other thing that I always talk about is continuation vehicles can be a great way to really build a secondary portfolio of single asset deals. If you were underexposed to industrials or you were overexposed to a certain sector where we can curate a portfolio by vintage year, by strategy, it could be with managers that you don't have exposure to. It could be a great way to compliment what is a traditional primary approach to and building out your private equity or your real asset portfolio.

Greg Campion: Makes a ton of sense. I like that idea too of complimenting, because I think a lot of what we're talking about here today is you're talking about emerging managers, for instance. It's not like you're recommending, okay, put your entire private equity program into emerging managers. It's a really nice potential compliment probably to an existing private equity program. Similar here, I like the way you just described the continuation vehicles. It makes a ton of sense in terms of rounding out exposure to different parts of the market that maybe you're underexposed to.

Mina Nazemi: Absolutely. You may be tapped out from a portfolio perspective on how many manager relationships that you have and you can handle. This could be a great way to have one portfolio where you get exposure to other managers and also just building relationships with some of those other managers who could potentially be in your direct portfolio as well. There's a lot of great ways to really leverage what's going on in the market to really round out your portfolio as you referenced, but also in our view, to take advantage of some really great assets, trophy assets where there's a strong alignment with the general partner and you as a limited partner in any ESPV or any CV.

Greg Campion: All right. Well, that brings us to the third and final opportunity, which is Real Assets 2.0. It's a kind of catchy name, but let's talk about what it actually means and why you and the team see an opportunity in this space today.

Mina Nazemi: I alluded to this earlier in our conversation, which is we've historically invested in real assets as an area where, one, we could diversify away from your traditional private equity, so on the corporate, but also as a way to get access to a different part of our economy. If you think about infrastructure and energy and so forth, those are all very essential components of our day- to- day lives and an opportunity set. When we define real assets and real asset 2.0, we really think about it in three different categories. We think about it as really in the areas of growth. One is in the renewable space, and this is beyond solar and wind, but renewable. Two is what we call the circular economy. Then three is digital infrastructure. If you think about what is going on in the world, there's more of a movement to sustainability, but there's also, especially as you think about what's going on with the energy transition, a lot behind the energy transition is really about energy security. We are clearly seeing that in the macro environment and what you're seeing that's going on in Europe. We've seen that as an opportunity for a very long time. Very similar to our approach on the private equity, we tend to focus on the small end of the market, smaller niche strategies. Frankly, given the dynamics of what's going on in our industry, and especially with the Inflation Reduction Act, we are making investments and we're building platforms, and we're investing in projects that has that supporting them. It's like a tailwind to help and continue to fuel the growth and the success of those specific projects. What I describe is we're building to core. We're building these platforms or these assets and really selling it off to these much larger infrastructure managers. Many of them also listed infrastructure managers. Again, it's capturing inefficiencies in the market. Not a lot of capital is in that smaller end. It's much difficult to understand that smaller end of the market. That's where we invest, and then we're growing those platforms and selling them off to the much larger platforms who've raised a lot of money and need investments and need opportunities to invest in, especially with this kind of lens.

Greg Campion: Yeah. Okay. If you think about this transition, so to speak, from real assets 1.0 to 2.0, so the themes that you mentioned clear that it seems that there there'll be tons of growth there for many years to come, whether it's energy transition or digital infrastructure. We all are very familiar with the exponential growth that we're seeing in data, and that's only going... And needs for transmission and storage and everything else. That's only accelerating with all the developments and innovations we're seeing, AI and VR, et cetera, et cetera.

Mina Nazemi: Even think about it too, how much data you're just using for your day- to- day or schools. Schools now, we've worked on investments which lays down fiber to service some of the school districts. If you think about the energy transition, what is the biggest challenge with the renewable space is actually battery storage where you have the sun shining all day. Where are you storing that energy, so that energy is really accessible at night when the sun isn't shining? That's the niche kind of modular place that we're investing in. By the way, we're not taking any technology risk. This isn't us doing this hydrogen or these far out there investments. It's very consistent with our strategy and very steady at investments, not taking on a lot of risk, very little to no leverage, again, taking advantage of just the market dynamics and just the secular tailwinds around the energy transition, working from home, consumerism, et cetera.

Greg Campion: Well, if our listeners want to learn more about this one, this is the one where we don't have a white paper out on it.

Mina Nazemi: Not yet. It's coming out. It's coming out.

Greg Campion: I heard. There'll be something to on barings. com very soon on that one. Okay. Well, we've come to the end of our conversation. We covered a lot of ground in a short amount of time. Hopefully our listeners found it valuable. Any parting words of wisdom for listeners if they're managing a private and equity, real asset exposure? Obviously, there's no one size fits all solution for everybody, but any kind of broad parting words of wisdom?

Mina Nazemi: Yeah, I would say in this asset class, manager selection is more important than ever. It's only in really distressed markets do you actually start to see who are really good managers, who knows how to roll up their sleeves, solve problems, and create value. Versus those who've taken advantage of the last 10 years or post GFC of just low interest rates. Manager selection is even more important now than ever in as you continue to build and invest in your private equity and alignment is even more critical because any manager can come or anyone can come and tell you, " Look, I have this great investment opportunity." But if someone is putting their money where their mouth is, and in our emerging managers, we've talked about it before, there's a much, much higher alignment. We think that's much better. Right? It's sending you a signal that they have that much conviction and they are putting their own money where their mouth is in those same investments. I would say those are two big parting comments as people are building out their portfolio, but also just don't get stuck in the re- up trap, I would say. There's a huge re- up trap where people say, " Well, I just have money to reinvest in my existing manager base." This is a time to take a really hard look and say, " Who's delivered?" " Who's executed?" " Who hasn't generated returns?" " Who has gone and had a strategy shift?" Also say, " Who are new managers that we can build relationships with?" Those are managers who will be really grateful to you as a limited partner for giving them capital in this very challenging fundraising environment.

Greg Campion: That's great advice from somebody who knows this market well and has been operating in it for a long time. I appreciate that, Mina. For our listeners, as I mentioned multiple times in the conversation, there's multiple written pieces that you can go check out to dive in further on some of these opportunities that we talked about to look at some of the stats in Mina and team's analysis yourself, and of course, reach out to your Barings representative to get in touch with Mina and others for more detailed conversations about everything we have discussed today. Mina, this has been awesome. Thank you so much.

Mina Nazemi: Thank you. Thank you for having me.

Greg Campion: Thanks for listening to episode number eight of season eight of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. If you have specific feedback, you can email us at podcast @ barings. com. That's podcast at B- A- R- I- N- G- S- dot- com. Thanks again for listening and see you next time.