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Alternate View: The Podcast Guide for Alternative Investments
Why add alternative investments to your portfolio? How do private equity or private debt risks compare to stocks? "Alternate View" answers your key questions about alternative investing. Host Matt Andrulot and experienced fund managers break down alts, covering real estate, infrastructure, hedge funds, and more private investing categories. Gain clarity on this often misunderstood asset class, learn how they differ from public markets, explore the functions and risks of alternative assets, and explore their power for diversification. This is your essential resource for understanding alts.
Alternate View: The Podcast Guide for Alternative Investments
Public vs Private Equity with Derrek Ransford from Pathway Capital | Episode 003 | 11-14-2024
An educational conversation with Derrek Ransford from Pathway Capital sheds light on the intricacies of venture capital, growth equity, global private equity, and buyouts. As a primer, he explains the difference between public and private equity markets.
Derrek breaks down the primary motivations for investors who chase private equity's superior returns, and he provides a comprehensive understanding of what that entails.
He explains the strategic flexibility in private markets, which he believes allows for longer-term strategies and better alignment among stakeholders. Learn about the importance of selecting top-tier managers and how a diversified portfolio can effectively incorporate private equity investments.
Private equity isn't for everyone. There are illiquidity premiums and capital deployment to mitigate risks.
Finally, we explore the timing and fees associated with private equity investments, including the "J-curve" phenomenon and the benefits of co-investments.
https://youtu.be/GAcKTwiQQZQ
Derrek, welcome to the Alternate View. Appreciate you taking the time. Today. We have Derrek Ransford here from Pathway Capital. We'll be talking about private equity co-investments, but we're going to talk about private equity in general. But first let me introduce Derrek here and have him tell us a little bit about himself and his firm and then we'll jump into it and hopefully learn a little bit about private equity.
Derrek Ransford:Yeah, fantastic. Thanks, matt, for having me. My name is Derrek Ransford. I work at a firm called Pathway Capital. Pathway Capital has been one of the private market pioneers, been in business since 1991. I've been at Pathway since 2002, so 22 and a bit years and I focus. I'm one of the partners managing director and I focus on our co-investment business.
Matt Andrulot:Fantastic. Well, thank you for coming here, and it's a long trek from California to Baltimore, Maryland, so we appreciate you taking the time and showing up in person here.
Derrek Ransford:Yeah, absolutely.
Matt Andrulot:Talking a little bit about private equity, which is fantastic, and specifically, we'll talk a little bit more about co-investment at the end of it, but I feel like that we should talk about just private equity in general, given our audience. So I'm going to have, I'm going to ask you some questions about private equity and hopefully we can kind of move on from there. But you know, as we define what private equity is, how do you generally define private equity? What is it and why should we be looking at private equity?
Derrek Ransford:Yeah, no, it's a great place to start. I mean, private equity has got a great name because it's basically equity investments in private companies and obviously the corollary or the opposite of that is public companies, right, and so these are privately held businesses, that you have some sort of equity ownership in it, and why would you be interested in it? It's really about the returns. Yeah, I mean it's not a lot of diversification benefits to invest in private equity versus public equities, but you can have much better returns. You know higher alpha, that's why you do it.
Matt Andrulot:Yeah, it's fantastic. I mean obviously it's a big buzzword, it's in the media quite a lot nowadays. Public markets versus private markets Obviously private equity kind of comes to the top of that list From a media perspective. As you mentioned, it's basically equity in a privately held business. Why would private businesses want to sell to private equity? What's the motivation for them? I understand the motivation for investors, right. Obviously you mentioned the returns. But why would an actual entrepreneur who had grown a business for a period of time all of a sudden look to have a financial buyer coming in and buy a piece of their business or all of their business?
Derrek Ransford:Yeah, absolutely. I think maybe a good place to start is to think about the different categories of what we would consider private equity. And so I would start on. The earliest stage of a business is venture capital. Those are businesses that are just getting going with their some ideas. They don't have revenue, they may not even have product, and they need some capital to grow and so the needs therefore I would put that under the private equity umbrella still venture capital, and those businesses clearly need that capital to grow right, and so they're taking some money in and giving up some of their ownership in order to kind of continue to prove out their product or build revenues or whatever stage of growth they're in.
Derrek Ransford:If you get kind of more on the mature side of things, they're exactly as you talked about. They're privately held businesses, usually majority owned by somebody, and when you think about what I think is probably most in the media is private equity, we would think of as acquisitions or a buyout strategy, and that is coming in and buying control of the business, majority of the business, so that the person buying it, the private equity firm, can really control the board, implement their strategy. They're not usually operators in the sense that they're going to come in and take CEO roles or CFO roles. They're going to try to supplement and maybe augment the management team but to help them in order to grow. And then somewhere in the middle is broadly defined as growth equity, growth capital. There are a little bit more mature businesses. They may be businesses that frankly need a recapitalization of some level, where it's, you know, taking some founder out or taking some founder down to a mountain, maybe a minority investor, and often those need capital to go to the next level. So if you kind of think about all those different areas, I mean there's different reasons why they would need capital. We talked about some of them.
Derrek Ransford:But if you're the more control-oriented buyer, if you're a business owner, why would you sell? You may not have an obvious heir to give it to or an obvious business partner to take over the business. You may be at a time where you want to give up day-to-day control but still have maybe roll some money into the next transaction. You may need to do something that's more strategic. You may want to go out and be acquisitive and buy a competitor or start a new business line, and you need some capital for that new business line and you need some capital for that and you know it's an alternative, I think, to being selling to some strategic investor, which you haven't asked yet.
Derrek Ransford:But you know we can talk a little bit about that. And you know the strategics have benefits and negatives positives and negatives, as there is with everything. You know a strategic may, you know, want to do something completely different with your business. It could be your baby, they could want to change headcount or take it in a different direction. You know there's a lot of pluses and minuses about thinking through selling to a strategic.
Matt Andrulot:Yeah, so as you kind of mentioned that right obviously venture is kind of like pre-revenue Private equity is typically solid businesses generating some sort of revenue that is looking to do something different, whether acquisition or growth equity, to kind of grow those businesses. So around those kind of scenarios, as we look at the market, environment and these type of companies, you have small mom and pop type of businesses and then you have massive, you know companies where you know they're looking at some billion dollar checks right, like huge. Can we talk a little bit about sizing amongst that and the difference between, I mean, obviously the mom and pop that's looking to transition, that has no heir, that wants to take over the business and sell. I get that right.
Matt Andrulot:But there's bigger businesses than that too, like generating significant amount of revenue in the hundreds of millions of dollars and even into the billions of dollars right in amount of revenue, you know, in the hundreds and of millions of dollars and even into the billions of dollars right in terms of revenue. That's not really like a transition over and that's where kind of that private equity market environment takes place. But talk about the difference between let's call it, the small business.
Matt Andrulot:And I'm not really talking about like really small businesses. I'm talking about reasonable size businesses relative to the behemoth type of business. And then there's market environments and I have plenty of questions that go around those.
Derrek Ransford:Yeah, absolutely. I mean, look, you know, there's a wide swath of deals that happen across all those market sizes, all those transaction sizes. You know at the largest end. You know things that your listeners or followers may know, things like Dunkin' Donuts and Subway sandwich shops. Those are owned by private equity firms, right, yep, a lot there.
Derrek Ransford:You're probably thinking of the alternative as to being a public company. You know some of those businesses can be public. Public company, you know, has again its pluses and minuses. But one of the certain things that it's hard to do as a public company is to make more strategic changes. Right, you're more focused on quarter-to-quarter earnings, and so they're going to be able to, in the private market, do some of the things that they want to do, maybe to, whether it's a turnaround or just kind of an augmentation of strategy to put it in place so they can kind of get it in a more smooth glide path that the public markets may may want.
Derrek Ransford:Um, you know the smaller mom and pop things. Obviously you're farther away me, even if we're not talking mom and pop up up a little bit, but right here you're farther away from ever being public. They're going to have completely different strategies, completely different um focuses and and and probably more variability. You know if you, if you a lot of people like the small and mid-market for private equity, they think that maybe there's better returns that are available there and I think broadly I'd agree. But I'd also say there's a wide variability of outcomes because those businesses are just a little bit more fragile. Right, things can go wrong, they can go wildly right. The larger end things tend to be a little bit more stable, I think, from a return perspective, a little bit more banded return, but also that comes with a little bit less risk.
Matt Andrulot:Yeah, so there's been a huge amount of statistics related to the public versus private, and the majority of companies are private, globally, right, and we've seen a shrinking amount of public companies or private companies going public over the years. I mean, the stock market continues, in terms of listed companies, has continued to shrink. What do you think that is why of that? I mean, I have my own assumptions, but I'm curious to what your thoughts are around it.
Derrek Ransford:Yeah, I mean the data has been what it is, like you said for a long time that the number of private companies, I mean, depending on what metric you look at, you know those over a hundred million of revenue, those over 10 million of revenue, I mean any kind of cut, and it's the same in every market. You know US, europe, kind of Asia, so that's always been the same and so that's always driven a big opportunity set. And I think what you're talking about is a more recent phenomenon, maybe over the last decade or maybe decade plus. Look, I think you know I'm not.
Derrek Ransford:I don't travel in the public equity world so I can only speculate a little bit, but I think it's very difficult to be a public company these days. You know you have to manage quarter to quarter. Obviously you get really punished if you don't make those earnings, and you know businesses in market environments like we're in today need to do things and reposition themselves and do things that are strategic and that can be challenging in a public arena. And I think you have more capital flowing to private markets, which allows some of these businesses that would have otherwise only had an IPO as their exit opportunity now to have other opportunities. They can sell to bigger private equity firms, they can realize a little bit of capital, maybe get some money to their employees and other shareholders that have part of that and refocus on another strategy for a five-year period.
Derrek Ransford:And the alignment of interest in the private markets is really powerful and I don't know if the public markets have quite that same level of alignment. Public markets have quite that same level of alignment and you know, the glass half empty person can say well, there's a lot of fees and a lot of you know leakage of money that goes to the private equity firms, it goes to the CEOs and to the. But when interests are aligned, everyone kind of rowing in the same direction, it can be quite powerful for the investor as well.
Matt Andrulot:Yeah, from an investor perspective and you're completely right, I think from my perspective. You know, quarter to quarter performance isn't the long-term objectives that most individual investors have. Right, most have a long-term goal and objective associated to their portfolios and granted quarter to quarter like if you're managing quarter to quarter, that could be very difficult to do. And then obviously the private markets and we could talk about illiquidity to that in a minute or two, but obviously the need for liquidity has shrunk. I felt like that most companies on the private side to go public was to generate liquidity to some extent.
Matt Andrulot:Yeah, I agree with that Right and I feel like the the growth of the private equity markets themselves and even the credit markets themselves have expanded that capability to stay private longer without the need to generate liquidity from an ipo and have to deal with all the things that you mentioned regarding regulation exactly so you know, with that alignment of interest and the ill, is the illiquidity component worth, you know?
Matt Andrulot:and we call it illiquidity premium right, like, yeah, you hear that term but you know it's basically, you know, your ability not to access that capital or your money back in a short time frame worth, you know, with the fees as you mentioned and all that kind of stuff, is it worth it relative to the public markets?
Derrek Ransford:Yeah, I mean you can call it whatever you want. In order to do that, you need to demand more return, right, yeah, otherwise it just doesn't make sense. Yeah, look, I think in private equity, broadly across all those categories that we talked about, there's a really high dispersion of returns, and by that I mean not all private equity is the same. There's no index, no passive index that you can invest in, the spread between the best private equity general partners and the worst, or, if you think about it, the top quartile and the third quartile, ranking very, very wide If you look at the comparable amount to a public bond manager or a public equity large cap manager, very, very narrow. Then you go back to private equity and you say, okay, let's just say the average return. Again, there's no index, but just the average return probably doesn't inspire you that much compared to what you can get in just an S&P.
Derrek Ransford:But because there's that dispersion returns, there's that opportunity to very significantly outperform and that's really what you need to demand. You know, if you're going to be in private equity, you want to be with good managers, you want to have an appropriate strategy, you want to be doing it right, because as much opportunity as there is on the upside, there's equal opportunity. On the downside, you can do it wrong and underperform public equities and then obviously you're locking your money up and underperforming. So, yes, there's that opportunity to get that and it's out there. But you got to do it smart.
Matt Andrulot:Yeah, and how do you manage that risk? I mean, I have my thoughts around it, but how do you manage that component of you know getting the right manager, right Timing to an extent like no one's timing? Private equity in general, right, it's a long-term goal and objective, relative, and you know you guys even pace right in an appropriate fashion. But what are some of the risk mitigation components that you can do with inside of private equity other than getting the manager right, which is tough in itself?
Derrek Ransford:but yeah, I mean this is a little bit of philosophy, but you know, the philosophy that I've just grown up in is to and I believe in it is to be a consistent deployer in the asset class. Exactly what you said. Not try to time it. You inevitably will get it wrong, partly because when it feels like the right time to put money to work, sometimes money just doesn't go into the ground right away. In private equity, it takes some time, if you're investing in a manager, for them to then go out over a couple year period and find investments and then invest and then hold them for five years and then exit them. It's just no one has that kind of crystal ball. Um, so we believe, uh, and preach, you know, very consistent deployment of capital.
Derrek Ransford:Um, why would you do it? Obviously the returns you know you take. That's why you want to do it. Um, you probably don't want to put all your eggs in one basket at the same time. So you, I think at the portfolio and this is where your expertise is with your clients is building diversified portfolios and considering what other needs investors have and what are the right levels for each individual investor to be investing in the private equity. But it's getting the manager right. It's time. Diversification and then, I think, other levels of diversification. So, while small, small and middle market are interesting, um, there are interesting things in larger ends of the market. So you want to be open to a variety of things. Um, geographic, you know we're big believers in the us, really, and and western europe, but um yeah, talk a little bit about those differences in markets geographically, because it's it is interesting.
Matt Andrulot:And then we we also throw in the currency component to things like right. So you have different geopolitical, you have currency. You know it's I don't want to say it's easier in the U S market, in the domestic markets, but you very much understand laws, you understand business to some extent and everyone's kind of playing from the same playing field with regards to currency, where, when you start stepping away from the domestic markets and heading into the international markets, you're throwing a whole bunch of different things into that mix as it relates to, you know, identifying managers and buying companies in those markets.
Derrek Ransford:Yeah, absolutely. I mean, you know, I think anyone that invests in private markets needs to have a global perspective and be global aware. But I think all the things you've just mentioned are accurate. You go to some markets and you look at the number of private equity firms that are there and the amount of dollars they have to invest, and you look at the number of companies that trade in the private markets and you start to realize that you know one or two of these private equity firms make up a lot of the market. Right, you don't want to be in that kind of position where you're effectively buying the market because, again, that kind of drives you back towards the mean returns.
Derrek Ransford:But you're also incredibly accurate about currency. It's because of how we talked about the money goes out, the money comes back. It's incredibly hard to hedge, yeah, so you are in, in effect, taking on currency risk. So, as a result, we've tended to focus more on the US and Western Europe. There's our active markets more into Central Europe and parts of Israel. Latin America has some players. Most of them are more across countries, not country specific, and Asia has developed in different ways, where China has a slightly different market that's more minority focused than, like, say, japan is, and you know Australia and some of those other areas. But, yeah, the rule of law. You know tax we didn't talk about tax, but tax is also an important factor and so that's driven a lot of investors to the US market.
Matt Andrulot:And when you guys look at managers that are participating in that, I mean you're looking for non-tourist type of managers, meaning like ones that just aren't dipping their toes in there, ones that are really participating in that market environment, understanding the rules of engagement, as I call it, with all the different kind of components that we've already identified.
Derrek Ransford:Yeah, I mean there are different schools of thought. You know, our school of thought is a little bit to be more with people that are proven, that have not just been in a market but have invested capital in a market, have the right relationships in a market. There are schools of thought that some of these emerging managers is a big buzzword in the space, that, hey, let's find the next great fill in the blank. And to find them we've got to take a little bit more risk because you're kind of backing somebody that's coming from some area where they don't have a lot of that experience. And you know, I think that's that's just riskier, right, that could, that can work out and it can not work out.
Derrek Ransford:But things that I would say most investors probably look for in private markets when you're looking at a manager is, first of all, these are usually 10 year plus vehicles. So people that have been together for a long period of time, that have worked together for a long period of time, have great relationships with each other, interpersonal relationships as well as the governance of the firm to make sure that that is good for the long term right. Then those that have expertise in particular industries where they're focused. We can talk a little bit about kind of how the transition from more journalist to more industry-focused, if you'd like in a bit. But you know, those that have industry expertise, those that have great contacts, like you know something that feels more repeatable.
Matt Andrulot:Yeah, you always want more repeatable and be able to, you know, execute what their strategy and philosophy might necessarily be in that environment per se. I'm going to move on just a little bit more on the educational side of things, because we're big educators here. I know you guys are as well. We want to make sure that our clients and folks that are investing in private markets understand the differences associated between private market environments and public market environments as best as they necessarily could. You pointed out a couple of things with regards to duration or how the length of some of these investments are in 10 years.
Matt Andrulot:But I want to start at the beginning a little bit, and you know we throw out the term J curve. Can you explain that a little bit for folks? And then you know 10 years is the, the full length. It's 10 years usually with two one-year extensions, right, so it's almost 12 years in most situations on an average basis. But people see 12 years or 10 years and they kind of freak out over it, being like, oh my god, that's an enormous amount of time. But the cycle is very different. So can you explain a little bit about the front end of it, which the j curve, which I think is very important for people. Yeah, and then that middle portion of it, uh, you know, of what really takes place in terms of investment period and harvest and like where that timing comes into play, because I think that's a misconception amongst people is like, oh my god, 10 years with two one year extension, that's 12 years. I'm gonna be dead, like yeah, yeah that's not.
Matt Andrulot:That's not the case. It's a very different experience that you receive throughout that. So I think it's important to kind of educate around that to make sure you understand. And now it's all different, right, Like people have different ways of doing things, but on average, like from an educational perspective, what? What should people think about?
Derrek Ransford:Yeah, and I'll add in there to try to talk about a little bit of a slight misnomer, is that you know, let's use a round number of $100 million, right? Sure, if you commit $100 million to a private equity strategy, you are never going to have $100 million fully invested. Good point, you know, or never going to have $100 million of exposure. And so that we'll talk, yeah.
Matt Andrulot:I think that's super important as well. I don't think people understand that as well, but once in a while people draw all of it in some situations, in some types of investments. But regarding private equity, for the most part I fully agree with you.
Derrek Ransford:Correct, correct. So typical private equity fund has a five-year commitment period. Let's use the $100 million. So $100 million, the general partner will say we're going to go out and try to find investments over this next five-year period. Let's say they're going to find 10 investments and do it equally over the five years. Each of those individual investments is typically underwritten to a five-year hold Venture capital, with early stage being slightly different because that will have longer expected hold periods.
Derrek Ransford:But we're talking about buyout acquisition strategies, five-year holds. So the company that's invested on day one or year one hold periods. But we're talking about buyout acquisition strategies, five-year holds. So you know, the the company that's invested on on day one or year one should be realized in year five, right, and some of that cash start come back to you and so on down down the line.
Derrek Ransford:Now for each of those five-year expected holds, there's some bell curve around that of what actually happens, right, some of them do very well and and are early. You know, maybe in as early as two and a half or three years, some of them take a little bit longer maybe, or seven years, and so you're right, when you get to year 10, you're likely going to have at least one or two companies that has had something that's going to need a little bit more time. So there's usually the extensions, but also a lot of capital is also going to have been realized and returned back to investors, and so you have a lot of your money off the table. Usually, at least, you know a hundred percent of your money back at that point in time. So that's kind of how the flow works, and because of the money going out over that five-year period and some of the early realizations coming back is why you can never get to that full amount that you've committed in terms of underlying value. Now the J curve is an important part too, yeah.
Derrek Ransford:Right and it scares a lot of people Well.
Matt Andrulot:I think they're surprised, like I, cause usually you buy a stock one day, like on the public markets, and you look at it and you're like I paid 50 bucks for the stock and hopefully tomorrow it's $51. Right, and you can see that move like every single day. So I think it's more of a surprise than anything when they get their first capital statement.
Derrek Ransford:Yes.
Derrek Ransford:So, sorry, no, no no, it's a great topic, so let's stick with that $100 million commitment. Most private equity funds charge fees on committed capital, not on invested capital. Yep, some invest capital, but most on committed capital. So if you invest 100 million, you, let's say, you're paying a one and a half percent fee. You're paying down on day one even though not many dollars have been invested Yep, right. And then your 100 million dollars is going in, let's just say, evenly over five year period. That fee has a disproportionate impact on the actual dollars you have invested in the early years, right. So it it's 1.5%, but it looks a lot bigger than 1.5% because it's off of a fairly small capital base. So it's also important for listeners and followers to know that, yes, you do have a J curve and some of those IRRs or return look a little bit scary because they've gone down quite a bit, but it's usually off of a fairly small capital base, usually not that much has gone in.
Matt Andrulot:Yep.
Derrek Ransford:And then there are other strategies within private equity and other mitigations to help mitigate the J curve, and so if that's important to people which it is, it can be you can have a multi-pronged strategy to help alleviate that a little bit.
Matt Andrulot:That is a fantastic transition to talk about co-investments as well. So I want to talk a little bit about co-investments. I think it's by far one of the best ways to access private equity in my mind, if you can find the right manager and have the right access. But we target like co-investment as part of another strategy with inside of of, uh, private equity right, like relative to secondaries or something like that. So can you explain a little bit what a co-investment is? Um, in a particular co-investment fund too? I guess that goes along with that because they kind of run parallel to each other. But you know, talking about all those things that we've already talked about around private equity, I think it's a good transition into co-investments.
Derrek Ransford:Yeah. So let's go back to that private equity fund that I talked about $100 million investing over a five-year period, charging 1.5% management fee also charges typically 20% carried interest, right. So 20% is a net profits performance. Um goes back to the general partner um, as they're building out that portfolio again, and kind of one of the transitions that's happened in the marketplace is from generalists yep, that just invest across everything, to industry expertise, partly because the need to really, you know, do something with these businesses. You can't just buy them and lever them anymore. That's an 80s strategy, you know. You have to be active, you have to have operating, you know, people, you have to have networks and so, as as gps have become more and more focused on their industries, um, they want to be able to pursue a wide variety of size really of transactions, and so a co-investment is when that same manager goes out and finds an opportunity one one of those 10 deals I talked about and puts it in the fund.
Derrek Ransford:They have some fund constraints in terms of portfolio construction. No more than a certain size can be in one individual investment and for them it's not worth the risk to put too much in one investment. It's not prudent, right. So they usually will go back to their limited partners, their existing investors, and say, hey, we need a little bit more money for this deal. Um, we think it's a good deal. Um, we will let you take a piece of it and we're not going to charge you that management fee, that one and a half percent management fee, and we're not going to charge you that 20% carried interest, so you can get access to the same deal same same same security Invest at the same time with minority protections to allow you to exit alongside them at no fee and no carry. And so that's really what a co-investment is. It's investing alongside someone else that's really leading the transaction, and they typically come at discounted economics and almost always no fee and no carry.
Matt Andrulot:So why would they do that? I mean, it seems good deal like opportunity to raise capital. Why are they giving it away for free?
Derrek Ransford:Yeah.
Matt Andrulot:Right, it's always the. You always have to look at the other side of the coin. Yeah, why are these guys giving the good deals away for free where they could actually generate additional revenue?
Derrek Ransford:Yeah, I mean we kind of joke at my firm that you know, know, general partners are usually focused on two things it's money and it's money, you know, and, and so they want to. They want to make the most money, um, so why would they give something away for free? A good, great question. Um, typically they have some fun constraints, like I talked about, so they can't put more than than so much in a fund and, and remember most of these, uh, they make their money mainly off of that carried interest or that performance fee, that 20 percent gains, and so you know it's prudent for them not to put all their eggs in one basket, so to speak, and to have a diversified portfolio, um, so that they can ensure that they're going to make, you know, that 20 carry on everything. They're not usually trying to swing for the fences. Now, the other thing is, if you put your biggest, if you put, let's say, 30, 40 of a in one deal, you have the risk of not making money on that fund. But if that deal doesn't do well, it's a double whammy that people are probably not going to want to invest in the next fund. If you've got this massive deal, that's done really bad, correct, and so we generally find I think the market generally finds call investments are those types of situations where they just need a little bit more money. They've got some expertise in an industry, they've been able to secure an interesting opportunity.
Derrek Ransford:The larger deals typically are a little bit skewed in terms of the return profile because they don't want to put their riskiest deals there. So they have a more positive return skewed outcome, a little bit more downside protection, and that's the typical reason. There are other reasons, though, too. It could be the last deal on a fund and they just don't have the capital. It could be an existing company that they've done and they want to do a massive add-on acquisition. We're actually I shouldn't talk too much about us, but there are situations out there where, for regulatory reasons, that a private equity firm may not be able to own more than a certain percentage Accounting firms. As an example, you can't own more than 50% right, so you may need to bring in some strategic partners or co-investors to help kind of bridge that gap. So there are multiple reasons, but that's the main one is they just can't put it in the fund.
Matt Andrulot:So more diversification. I always say control right. They want to control the transaction and don't want other parties involved.
Derrek Ransford:Yeah, yeah, that's better said Right.
Matt Andrulot:Yeah, but there's a lot of benefits to co-investments. I mean, doing a single co-investment is a lot of risk. It's a single company, right? You're basically investing in one single company. So, as a co-investment fund, you know what are some of those benefits that you get from investing in. You know, obviously, the fee component which you described no fee, no management fee, no carry is fantastic, right. So you mitigate some of the J curve that we were talking about before, correct. But also the return component is pretty interesting. But then, you know, talk a little bit more about, like, the difference between you know one single co-investment because once in a while you'll see that but relative to having a diversified portfolio, yeah, I mean you know if you're ultimately going to be able to find these investments just like one of the general partners.
Derrek Ransford:You want to build some level of diversification and you know there's a there's there's variety of ways to think about what's the appropriate number of investments to put into fund to make sure it's appropriately diversified.
Derrek Ransford:Certainly you don't want a hundred, because that any individual deal is not going to really impact things, and certainly you don't want two or three, right, so it's somewhere in the middle and it's diversification.
Derrek Ransford:I mean, I think a lot of people will think about it.
Derrek Ransford:As you know, if you can get a variety of these direct investment, these co-investments with no fee and no carry, and build it up over the same kind of time period maybe a little bit shorter three to five year type of time period and the same kind of number of companies as a buyout fund would normally do, you start to replicate the same kind of exposure that you would get by investing in a private equity fund. You start, you take away a little bit of the risk because you're not investing in one manager. So if you know a senior person leaves or something like that, you don't have that same idiosyncratic risk of a firm. But if everything's at no fee and no carry, your expected return is significantly higher. And there are very few parts I think certainly in private markets, but I think in almost any market where you can say look, if I do this the right way and build the right kind of diversification, I'm not really taking that much incremental risk. But by cutting out all the fees and carried interest I have a widely higher expected return.
Matt Andrulot:Yeah, a hurdle so much lower. Right Like to overcome that. Where you're taking that J curve component, you're eliminating a lot of that and that's why I always point out that you know investing in co-investments alongside of great managers, you know sets the bar much lower from a fee perspective but your outcomes can be like so much better relative to what your traditional drawdown primary fund component is.
Derrek Ransford:That's absolutely right. And the other thing is most co-investment funds charge fees on invested capital versus committed capital. So that has a huge impact on just the total fees you're paying, but certainly on the J curve.
Matt Andrulot:Yeah. So one thing you pointed out as well is that most of the time that you're getting those general partners offering co-investments to their limited partners, how important is it to be an investor in their primary fund? Because we see co-investment opportunities all over the place. But to you guys, I mean it's I know, I know what the answer is a little bit, but I want you to kind of talk about it. But what do you think the importance is of being a primary provider of capital relative to being a co-investor?
Derrek Ransford:Yeah, I mean, I personally think it's very high. It's very, very important. But I'll try to talk from a market perspective. There's a concept called selection bias, which is maybe known to your followers and listeners. That's essentially I'm getting the least attractive deals.
Matt Andrulot:Yes.
Derrek Ransford:And I think that it exists in the market, right, and that's how do you mitigate that? Right, you want to be the person that gets the first call or the second call. You know. Obviously, you don't want to be the person that gets the 10th call or the 100th call after everyone else has passed right. And so you know, I generally think finding the right alignment of interest with that person, that's providing you.
Derrek Ransford:What is the reason that they're providing you that opportunity? Yes, and so if you are an investor in their fund coming back to full circle where we talked about before why does a GP do it? It's because they also want to curry some favor, right? They want you to invest in their next fund. And so by being an investor, being aligned to them already and being a provider of capital to funds is, I think, critically important to eliminating or at least greatly reducing that selection bias. Not to say that you can't find deals that you're the 10th call or 100th call that are interesting or good, but it's a lot harder. And then I think the other thing too is these are minority investments as a co-investor, so you are relying on that general partner to execute the strategy and, frankly, run the company from a governance board level and dictate the outcome. And if you don't believe in the person that's ultimately in control of that and one way to say that is you haven't invested in that firm or behind those people then you know you're kind of leaving it up to somebody that you may not believe in as much and that's obviously a riskier strategy.
Matt Andrulot:Yeah, I think you said it best before when managers think of two things money and money, and that they get full fees coming into their primary funds, that they do not want to jeopardize that and they actually want to make you happier relative to you know, providing you that no feed, no carry, co-investment to be a next participant in fund 10 or whatever number it might necessarily be.
Derrek Ransford:Absolutely. And and I mean we talked about just investing in a fund it's obviously better if you invest more dollars in that fund, correct, and you're a bigger, more important investor for them. Obviously that it's gonna gonna help things.
Matt Andrulot:Yeah, that goes that goes a long way for folks like that. So, um, so, co-investment is obviously a fantastic opportunity if you have the right relationships with the right general partners and you're a primary fund provider of capital to them. So I'm going to stray a little bit farther and say let's talk a little bit about just market opportunities in that space. Amongst that, what are you seeing from an opportunity set in private equity, given the market environment we are in today? I mean unique market environment. I mean not that we don't have a unique market environment all the time, but just in general.
Matt Andrulot:We've seen an expansion in the private side of the world, both on the credit side and potentially on the equity side. We've seen valuations move. We're starting to get some volatility in the equity markets as well on the public side. So curious, you know you guys talk to a lot of different private equity fund managers and are evaluating a lot of co-investment opportunities. What do you guys see as like opportunity set amongst you know, the globe, the world, geographically, sector wise, like what? What is seems to be compelling to you guys and some of the private equity firms that you guys are dealing?
Derrek Ransford:with um, I'll talk a little bit about market, maybe in general first, yeah, trying to talk about the co-investment market and the environment environment there. Um, there's a couple of slides that we provided. Maybe I can show um the second one in in uh, the group which talks about really private market valuations compared to public market valuations and also private market performance compared to public market performance in terms of EBITDA and revenue growth, right Fundamental performance. And so look, we'll start again. We don't believe in market timing. You know, I think as an investor, I think most pundits will say like it's good to continually invest in the market. But if you look at where we sit today, the difference and this is a little bit dated, this is the end of the first quarter but on the left-hand side, you can see a chart that shows public market valuations in terms of enterprise value to EBITDA, at about 15 times and a trend that has been moving higher over the last three or four years, and private market valuations at just above 10 times, 10 and a half times and a trend that's been moving down over the last couple of years. And you contrast that with the right-hand side of the operating performance of businesses. Typically private market companies are growing faster in this data set almost twice as much as the S&P. And look, that kind of always exists. That kind of helps to compensate for the illiquidity premium, like you'd expect that. But that does ebb and flow over time and this is never a flow, but this is a good time from that perspective.
Derrek Ransford:And then I think you think about of um, investing in vintage years is a common thing in private equity and you try to think about everything in the same kind of it's usually calendar year of when something started right, because they're all investing over the same market environment, even if it's a couple year period. And the data shows and this is on our third slide that that in times of turbulence, in times you know a recession or just after a recession, that the absolute return, as well as the relative return of private equity to public equity is greater for those vintage years that are during a recession and right after recession. So it's not another way and it kind of makes sense intuitively that like, if there's turbulence in the market if there's, you know debt markets are tricky, you know maybe there's some forced sellers for some reason or another there's pretty good opportunities to be had. There may not be as much volume as transacting, but there's good opportunities to be had and so we think we're in that kind of market environment right where no one really knows exactly where we're going Looks like interest rates are going to be coming down. That's going to be generally beneficial for private equity investors, you know. But they're also working through some operational noise. As you know, it's been difficult quarters to go through. So that's kind of what we see. I think macro, you know, within particular industries I think it varies and we can talk an hour about that, so I'll kind of maybe leave it at that.
Derrek Ransford:From the co-investment perspective, it's a difficult fundraising market for general partners because a lot of the you know what we've talked about it's a little bit of turbulent market. As a result of some of that turbulence, there has not been a lot of exits, yep. So gps haven't been able to exit the deals from their older funds, which they frankly need to show performance on those older funds to help them raise their current fund right. And and you have this, this concept of a denominator effect that you've invested a lot of investors have invested in private equity, expecting for there to be those distributions and if they they haven't come, their market value of their private equity portfolio relative to other things has swelled, and so they look overweight private equity, right.
Derrek Ransford:And so that has this compounding effect of then not wanting to invest in these private equity funds that are currently raising money. That's a normal cycle dynamic. That happens all the time through cycles. But what it means from a co-investment perspective is that these GPs and their funds are having to elongate their investment periods. Right, they can't just invest really quickly because they can't just raise their next fund. That's not a guarantee. So they're investing, usually smaller amounts, invested over time, but they still want to do the deals that they are interested in, and so that means needing to find partners to bring in for co-investment to help kind of make up that equity gap.
Matt Andrulot:So it looks like a great opportunity for co-investment opportunities, since the capital is not there, the demand for dollars is there and the opportunity set seems to be there, but the dollars open up opportunity for folks like yourselves who have co-investment opportunities and can supply those dollars.
Derrek Ransford:It absolutely is, and I but I would say in a market drop where or backdrop where there is less deal activity right. So we found and I think this is a market dynamic, not just a pathway dynamic that you know, certainly over the broader part of this year, you know, from kind of March on, deal activity has picked up quite a bit. Co-investment activity has picked up and the deals that have been done over the more turbulent times of the last year or two are starting to look pretty interesting and we think that's going to continue. So you kind of have to find your spots, you have to work hard to get access to some of these co-investments, but we think they're a pretty interesting time to be doing deals.
Matt Andrulot:Great Well, thank you for coming on the Alternate View. We appreciate your time traveling all this way and talking a little bit about private equity and co-investment in general.
Derrek Ransford:Thank you.
