Business Breakdowns
· Josh Clarkson
[00:00:00] S1: Let's get out of the way the elephant in the room, if you will, of the most notable recent regulatory step, which is President Trump's executive order mandating that ERISA look into adding private markets into 401k and DC plans and facilitating that change. That was the big bang recently that really set a lot of this off, and that countermanded a Biden executive order that said they were probably not a fit because there had been attempts at this before. But the Trump executive order, which had been long anticipated, is certainly viewed as the largest, biggest change recently that opens a whole new market. Now, beyond that, there have been other more recent regulatory changes, such as no-action letters around marketing rules and some changes about how many illiquid assets certain types of funds, like interval funds and closed-end funds, can hold. I think some of those are more around the edges. But if you go back much further, the beginning of the United States securities regulation as we know it today was really in response to the Great Depression. And in the Great Depression and the run-up that preceded it in the '20s, you did have lots of these investment trusts that were leveraged investment vehicles investing in the hot stocks that performed very poorly. And so the SEC was very focused on regulating what types of commingled investment products could be brought to market for the retail market. And they created the world of registered securities, which means both individual securities as well as mutual funds. And over time, certain exemptions to that evolved: certain private markets exemptions, certain other type of structures.
· Matt Reustle
[00:00:00] S0: Yeah, and maybe you can elaborate on some of the products that did become available to retail investors and how some of those played out. Maybe they can instruct what's going to happen in the future.
· Josh Clarkson
[00:00:00] S1: Call it in the pre-2020 era, pre-2015 era, there were private markets available for retail in a variety of structures. There were certainly non-traded REITs that have been around for a while, not necessarily brought to market by top-tier operators, not necessarily with the most shareholder-friendly structures. There have been various ETFs that tried to mimic alternative asset management returns. There had also been reinsurers set up by some big-name hedge funds where the investment portion would be handled by that big-name hedge fund, and you were supposed to be able to get that exposure. Bill Ackman certainly has a well-known closed-end fund listed in Amsterdam. But these had all been relatively niche products. Where you really saw real momentum get behind this in the private wealth channel was when BREIT and BCRED were rolled out by Blackstone about five or six years ago now. And then many other top-tier alternative asset management firms have brought out similar products that are non-traded BDCs, non-traded REITs, and interval funds are the three main categories. That's kind of what turned on the modern semi-liquid wealth channel private markets experience, if you will. And generally, it's proceeded pretty well. Investors have enjoyed really strong returns, really strong downside protection. And when there have been issues, such as BREIT in 2022, the managers have stepped in to structure transactions like what they did with UC Regents to ensure that investors were able to get access to the liquidity that they were promised, which generally speaking is about 5% of NAV a quarter, can vary a little bit by fund. Investor education is a really important part of this. The alts managers are doing a great job of being very clear about this. They're sometimes dependent on that intermediary being clear about it. But I do think it's very important that the investors in these products acknowledge that they are essentially illiquid compared to an ETF that you could sell your entire position in in a minute and should think about that appropriately in their liquidity needs and their financial portfolio.
· Matt Reustle
[00:00:00] S0: Do you have a quick summary on BREIT of how that played out? And you don't have to get into the nitty-gritty details, but how it worked through the system and as an example of what happens when you have, in theory, illiquid security dealing with some type of issue around it and how investors are treated or what their options are in that type of situation.
· Josh Clarkson
[00:00:00] S1: I'm not terribly close to that situation. I was not directly involved in it. I only know what I read. So I do want to caveat all of this. My recollection is that in 2022, when rates were going up—maybe it was early '23—BREIT received redemptions in excess of that 5% NAV that they generally distribute. My understanding is that the majority of those redemptions were from leveraged Asian private bank clients that were holding this on margin, which nobody really does with these instruments anymore. It's not done with interval funds. I have not read any story of a widow-orphan parent who suffered harm due to BREIT distributing assets as it always said it would. Some people referred to it as gating. I think that was a bit unfair because it just did what it said on the tin, and they then struck a deal with UC Regents. I'll admit I don't recall the specifics of it, but that essentially ensured they had plenty of liquidity to meet those investor redemption requests, and they've done so. Performance has been improving, net flows have been improving. So while certainly the media made a big storm of it, it really did exactly what it was supposed to do. Now, again, it's important investors realize that these are less liquid structures. I would counterpoise that to an incident that happened quite a few years before now. I think this was in the 2000-teens where a firm called Third Avenue had set up what was essentially a distressed debt fund in a mutual fund wrapper that would have daily liquidity. Even if these were liquid securities, they were generally pretty thinly traded because if you're in the middle of a bankruptcy for a midsize capital structure, those loans or bonds are not trading very frequently. They're certainly not trading in any size without moving the price. And when they got a lot of redemptions, they did have to gate the fund in a way that, if not had never been contemplated, certainly had not been as broadly advertised to potential investors as being possible. And that did lead to some really unfortunate outcomes for investors who did take quite a while to get their investments back. The products you see today largely solve for that type of risk by having limited liquidity, by maintaining liquidity sleeves in many cases so that they can be sure they always meet that liquidity.
· Josh Clarkson
It's very important that investors understand that you are trading liquidity for lower downside risk, potentially better returns, and that that is a trade-off you're making. And it needs to be viewed in the context of an entire portfolio that has plenty of liquidity for your near-term needs. But if you have some money that you can put aside and think about a little less liquidly, then it opens up an opportunity to have potentially much more attractive, consistent returns, limited volatility, and in many cases very strong income distributions. And those yield-oriented investments is where we've seen a lot of the initial interest in these alts for the private wealth channel. I predict—want to caveat that a lot here because I certainly don't have a crystal ball—you would see most of the initial interest in a defined contribution market in 401(k)s. I'll tell you right now that if I could invest in a private credit or private equity option in my daughter Emma's 529 plan, I'd do it in a heartbeat. It's tax-sheltered, it's long-term, it's really the perfect home for investment that produces very high ordinary income yields.