NED ROSENMAN: Welcome, everyone to BlackRock's 2023 Trustee Summit. We appreciate you joining us. I'm your host, Ned Rosenman, head of BlackRock's client business, providing custom solutions to foundations and endowments. And at BlackRock, we are really privileged to work with virtually every kind of nonprofit investor, from large hospital systems and universities to small family foundations. And we love getting to convene this group in forums like this one. We hope this event provides valuable insights for your organization.
The goal of today's conversation is to share practical strategies for managing through volatility. And we approach the discussion from three angles. First is the macroeconomic view. I'm thrilled to be joined by two of BlackRock's leading portfolio managers for this discussion. Then, in our second section, we will hear directly from nonprofit leaders on how they set up their organizations for success in these turbulent markets. And last, we do a deep dive on private equity-- which, of course, plays a starring role in many nonprofit portfolios and is an area that we are consistently receiving questions and interest from our clients.
But before we jump in, one housekeeping item. If you have any questions throughout our time, please submit via the Q&A feature, and your dedicated relationship manager will get back to you after the event. But with that, I'd like to introduce our first speakers, Gargi Chaudhuri, head of Americas iShares Investment Strategy, and Pam Chan, chief investment officer and global head of our alternative solutions business. Thank you both for being here today.
But let's start with some of the key market events that led to this regime of high volatility, and what do long-term investors like foundations and endowments do in response? And maybe, Gargi, I'll start with you because, as we know, traditional diversification did not work in 2022. Stocks and bonds both sold off to a historic degree. But what do we see as we look forward from here?
GARGI CHAUDHURI: Sure. Thank you, Ned, and thank you so much for having me. It's great to be here. As you pointed out, 2022 was obviously a year where, unless you were in cash or some very specific parts of the public equity markets, it was tough. And then, when we look at the first quarter of 2023, you have these periods of risk on, duration on, risk off, duration off. And then, of course, we had the banking crisis in March. So I think that leads us to a really interesting juncture where I would love to spend the next few minutes talking to you a little bit about how that ties out our view into what the Fed is going to do, especially with the news of some banking stresses, or broader stresses, emanating in the market, and the lagged effects of monetary policy.
We always talk about monetary policy works with a lag. The lagged effects of monetary policy are here. So what does that mean for the Fed? And then, of course, what does that mean for growth? Because, obviously, there's going to be some impact on that.
So let's first talk about the lagged effect of monetary policy and what that means for monetary policy. Before the regional banking crisis that took hold exactly about a month or so ago, what we saw was that it was inflation that was continuing to move up, especially in some of the sectors that the Fed pays a lot of focus on like services. And they acknowledged that they were on a path to take the Fed funds Rate to 5 and 1/2% or even higher than that. At the same time, the unemployment rate was at all-time lows, which allowed them to do so.
And then. Of course, in the beginning of March we saw the banking crisis unfold. And now, what the Fed has done very well is I think they've separated out, they've compartmentalized this view around there's monetary policy for inflation, and then there's liquidity provisions for our banking system. That's fine for the moment. Obviously, the market, or at least some parts of the public equity markets have believed that-- not all sectors, certainly not banks. But we think that there are-- it's still too early to call victory on that because small banks now will certainly have a tougher time, especially given higher regulations coming their way, but making loans to the broader economy. And that is going to have an impact on growth.
What this means for the Fed, I think that they can probably still raise rates maybe one more time. We certainly expect to see them raise rates to maybe a little bit above 5% and, very importantly, keep rates there. I think what the market often gets ahead in itself doing is pricing in cuts immediately, and I think what we have to all, as investors, take into effect is this world in which rates stay higher for longer.
So they may not be as high as we had thought in February and March. They may just be only about 5 and 1/8%. But they'll stay there for the remainder of this year. So that's number one.
Number two is the impact of the credit crunch, I'll call it, on growth. And, obviously, depending on who you listen to, there were some concerns about growth just coming into this year anyway. And now, I think, any concerns that you had about a slowdown in growth have moved forward.
So there will probably be, by the second half of this year, some impact on growth, and we'll probably even see us going down to a negative, at least two quarters, especially given the very strong first quarter growth that we have seen so far. And then, the last thing that I'll quickly mention before I hand it back over to you, Ned, is that this is an environment still-- and this is what makes it a little bit tricky-- of higher inflation.
So while, on one hand, we are talking about growth maybe decelerating pretty meaningfully in the second and third quarter, we also believe that earnings growth will decelerate pretty meaningfully in the second and third quarter. Inflation probably will still remain at about 3% to 3 and 1/2% by the end of the year, which means that the Fed again said higher for longer. So I'll stop right there and turn it back to you.
NED ROSENMAN: Great, Thank you so much, Gargi. And I think particularly helpful notes as we think about how we manage portfolios dynamically on the liquid side to be more resilient in the face of volatility like this. And I think there's a lot we'll want to pick up on as we now turn to Pam. Pam, your focus is, obviously, on private markets, a big area of focus for endowments and foundations. They're long time investors in the space. Others are just beginning their journey.
But particularly in light of Gargii's comments, what does that imply about building an alternatives book at a moment like this?
PAM CHAN: Yeah, no, absolutely, Ned. And first of all, thank you for inviting me into this conversation, to my favorite people at BlackRock, you and Gargi. And a wonderful topic, lots to discuss. And I want to be a fly on the wall for your next panel when you have all our client experts talking about what they are doing in their portfolio. A couple of things from my end. One, I just say upfront, the private markets are obviously not immune to all the volatility that Gargi just described, as she looked at the macro environment.
That being said, we all know on the line here, as investors in alts, that the pass through is much more muted. Right? So I don't have the same day-to-day volatility from a market-to-market perspective that Gargi does, which I actually think gives us more flexibility insofar as how we think about building our portfolios and maintaining those portfolios on a go-forward basis. I do think it means a higher focus on risk, right?
So really understanding what it is you own and thinking through both direction and order of magnitude. Insofar as, if you actually instantaneously securitize that private market asset, what would that entail and what market risks are you exposed to? How much equity beta do you have in the portfolio? How much duration risk, as Gargi was noting, risk on, risk off et cetera?
How much spread risk do you have? And how much do you have in the private market portfolio that is orthogonal or less correlated to broader markets? Which frankly, should be one of the main reasons why you have the private assets in the portfolio in the first place, right? Because you are looking for that value add, whether it is something you directly manage or from the manager who manages those assets for you.
Poll #1:
Where do you see the greatest investment opportunity within your portfolio?
Real estate Private credit Public fixed income Hedge funds Private equity ex VC Venture Capital Public equity
I think the other thing that I would say is that, that muted market volatility, we are waiting for it. Right? So I think pricing, the public private premium has not yet widened. That is actually, for me, an exciting time to be an investor in the private markets, right? So if you have a three year investment horizon coming up for a given fund, I think what we'll see is some of the most interesting risk adjusted returns.
] Because frankly, historically, we've always seen post-market dislocation that lagged effect and then that vintage being exceptionally strong. And we'll hear that, I'm sure, from Edward and Arslan later in the private equity panel. But I'll focus my comments on the rest of the private markets, for which I think it's also true.
The other thing that I would say is that this ability to be prepared for the dispersion of selectivity is also going to be incredibly important, both at the manager level and at the asset level. And what that means, I think, is waiting for what we believe to be the right risk adjusted return from a pricing perspective, but also being nimble and understanding the discipline of which mega-trends or which objectives you have for your underlying portfolio and sticking to those. Because again, building a private market portfolio, Ned, as you noted, is an ongoing journey, right? It's not a one time thing. And so that's something that we have been especially focused on.
NED ROSENMAN: Great. Well, thank you. And I think that has all of us very interested to hear, what are some of the themes that you are seeing in opportunities that you're managing toward in your portfolios today?
PAM CHAN: Yeah, absolutely. Thank you, Ned. And maybe I'll start with some thematic attributes and I'll get into a few examples.
So first thematic attribute, very focused on downside protection, moving up the cap stack, in many instances, lots of structure, really trying to look for investments that are less reliant on the capital markets, that have less exposure to market risk, and frankly, where we can hopefully amplify the amount of idiosyncratic or diversifying risk that we have. So a couple of examples. One, I think private credit is something we should talk about and underscore.
The reason why I say that is because, as we think about some of the comments that Gargi made around bank retrenching and the Ides of March and everything that we saw, we will see the private markets fill that financing gap and we're already starting to see that with our credit teams working on more and more bespoke financing solutions with corporate issuers. But also, going forward on the real asset debt side as well, so infrastructure debt and real estate debt.
And so credit across the board is something that, I think, we will spend a lot of time on. The other thing that I will note here, which I think is an interesting analogy, not to say that this last kind of bout of volatility is akin to the GFC, because I don't think it is, but one thing that I think is worth noting is that out of the GFC, it catalyzed the emergence of private credit as a fundamental building block in the private market space. Coming out of this bank retrenchment, we will see new private market asset classes emerge in force, right?
And so whether that is more asset-backed lending, more specialty finance, more venture lending, those things will all come to the fore. And I think venture lending has been something we've been spending a lot of time talking about, just given, obviously, the SVB idiosyncrasy that we saw last month. So private credit is one space. The second thing that I would say is, continue to focus on those mega-trends as we think about demographics, digitization, et cetera, and inflation, frankly, which Gargi very articulately summarized in her opening remarks.
Those things are going to continue to be pervasive themes as we invest going forward. And so what does that mean? I think it means being focused on sectors like health care that are tied to these mega-trends, being focused on things like digital infrastructure, or frankly, elements of the infrastructure space that are supported by fiscal programs, like the IRA. That is not going away.
That is just beginning. And then lastly, as we think about more idiosyncratic risk, where else can we play and what are the things that we frankly would have wanted to do previously that we still want to do because those trends are still there? And inflation, I think, is the thing that's going to be most pervasive as we go. And so whether it's floating-rate debt, akin to kind of example one, or an infrastructure space, kind of take or pay where there's inflation linkage.
And then the last example that I would say, and this hearkens back to my comment that there'll be new asset classes emerging, is how we look at some of these niche asset classes that really have kind of idiosyncratic risk premia that are less correlated to market risk and equity duration, spread, and all the things that Gargi eloquently talked about at the beginning. And so we will continue to see that, whether it's insurance, sports media, entertainment. You're already seeing the velocity of those deals pick up and that space is already almost a $700 billion space, when it was about only $100 billion in 2011.
So it's grown very quickly. So those are three areas that we have been focused on. But frankly, the attributes of those three areas are remarkably consistent given the volatility that we're all facing going forward.
NED ROSENMAN: Thank you, Pam. And I think just rounding out that session, three of the things that stuck out to me, one from Gargi, that inflation and volatility are here to stay. Two, that private markets, as you illuminated Pam, are not immune.
But three, that there are unique opportunities, particularly in private markets, that this environment creates. And so thank you for bringing us through that, Pam and Gargi. Really appreciate it. You're two of my favorite people of BlackRock and I look forward to speaking with you soon. And now I'd like to hand it over to one of my closest partners, Olaolu Aganga, as she leads our session with trustees, CFOs, and CIOs.
OLAOLU AGANGA: Welcome everyone. Thank you so much for joining us as we talk about managing through volatility. We are going to discuss the role of investment committees and times of uncertainty as we continue to navigate higher interest rates declining, but not fast enough, inflation, and how do you juxtapose that with your organization's operations and business needs? These times pose new challenges for trustees and investment committee members, but we have a great panel today to help unpack some of these critical questions. My name is Olaolu Aganga and I'm a managing director in our Endowment Foundation and Health Care OCIO business, and I'm joined today by three distinguished speakers.
Amy Diamond, CIO of the University of Southern California, Ann Beck, CFO of Renown Health, and Keith Wirtz, Chair of the Investment Committee for Arizona State University. Now, to kick us off, I will ask a tough question, but it will help the audience get to know all of us better. Now, the three of you represent different roles within your institutions. So can you share a little bit about your role to help us get to know you better and then describe what your organization's risk tolerance is defined by. So as I look across the screen, I will start with Amy.
AMY DIAMOND: Great. Thank you. So I'm Amy Diamond. I'm the CIO of USC's Endowment, $7.5 billion endowment, and we have a dual mandate. It is to compound capital over the long term to support future students and the University in perpetuity, which is a largely equity-centric portfolio, but we also want to have a stable and growing income stream in the near term, and that requires diversified assets.
OLAOLU AGANGA: Thanks so much, Amy. Keith, I will go to you next.
KEITH WIRTZ: Great. Thank you. My name is Keith Wirtz. I'm a Representative at ASU Foundation. I serve as a trustee for the foundation as well as I chair the Investment Committee, as you've mentioned.
And I think predominantly my role involves working with the committee itself as well as working with the two investment groups that support the program. We work with our OCIO that's external. We also work with the Internal Investment Office that's involved on elements of the operating program likewise. And so that's generally my role, is to coordinate and be involved with those two operating groups.
OLAOLU AGANGA: Thank you so much, Keith. Ann.
ANN BECK: Hi. My name is Ann Beck and I'm the Chief Financial Officer for Renown Health. And in the work that I do, we help manage the $700 million that we have in our assets under management.
OLAOLU AGANGA: Really, really insightful. Ann, I ended with you, so I will start with you on this next question. And you did a lot of work around setting Renown's investment program up for success even before a crisis comes. So two parts, what inspired that and how did that upfront work play out in 2022?
ANN BECK: That's a great question. And the inspiration really comes from being in health care my entire career. In health care, we're always planning for the worst and hoping for the best. We have plans around fire, hazard waste, community crisis, bomb threats, everything.
We don't have any playbooks on pandemics, so we were very happy that we had a playbook around our finances as we entered into the pandemic, through the work that we did with BlackRock. So that inspiration comes from health care. It has helped us because we have that playbook.
Poll #2:
Where could you use support when preparing your investment program for a downturn?
Answer options:
Analyzing current risk and expected return Assessing liquidity needs Enhancing governance and portfolio oversight Strategic investment planning for long-term growth ….. …. Other – Not mentioned
The playbook was basically for us to respond to any changes in the environment, whether they were internal or external, and to not react. Because we see them as being two very different ways of dealing with internal and external changes. So the work that we did was to have a playbook on how to respond and we've used that playbook here in the recent past, both with what's happened in the macro investment environment and certainly what's happened within our own institution and the challenges that we've had to our liquidity and how best to manage our portfolio to meet our liquidity needs.
OLAOLU AGANGA: Right, precisely. Thanks so much, Ann. Now, just to do a little bit of compare and contrast, Keith, from an endowment standpoint, as chair of your Investment Committee, can you tell us about how you all at ASU set up a governance framework that worked? And if you can give you some words of wisdom to others that could find themselves in a similar position, what would that be?
KEITH WIRTZ: Great. Thank you. I think I'd start with a description of our historic, looking backwards. About 12 years ago, there was a decision made that we wanted to evolve the investment program itself and side by side, there was an evolution that was taking place within the structure of the foundation and other elements of what we today refer to as enterprise partners. We were in a investment program that was supported by an outside non-discretionary advisor and we made a decision to explore the modeling using an OCIO arrangement.
And we went through a process about 10 years ago of doing a search and ultimately selected a boutique OCIO. As we went through some change internal, and as we grew more accustomed within the investment committee of a redefinition of roles, we came to a conclusion that we wanted to make another change, going from an OCIO scenario that was more of a boutique firm to our solution today, which is BlackRock. And we're using today BlackRock as our primary investment arm, the OCIO service, and we, at the same time, brought in some internal expertise and set up an investment office internal. And in doing so, that allowed the investment committee to truly take on what I would refer to as the governance role and the operating roles has since been delegated to these two investment offices, the internal and the external BlackRock circumstance.
I think that's really fit the nature of our program quite well. And I think advice I'd give to other programs, other endowments, strive to discern what kind of structural arrangement, what kind of governance arrangement fits your program best. And once you make those decisions, the stability and the longevity of that structure really serves in the interest of your program. We feel really good today that we've got things set up for our program and we're hoping to let this structure work on our behalf for the next 10, 15, 20 years. And so we're looking for long strategies and a lot of stability within the way we approach our investment program.
OLAOLU AGANGA: Yeah. That's really, really good. Amy, I would like to get you in on this conversation. Now, in times of uncertainty, many investors may start to question their strategic asset allocation.
And in our-- as I look across the screen, our collective years in this business, I think it's fair to say that tends to happen at the worst time, the absolute worst time when you have the biggest draw-downs. Now, I have a complicated question for you here, but, how did you navigate these conversations with your investment committee at such a critical time in 2020? That's when you joined the organization.
And what investment decisions did you make? And can you comment on whether you had those conversations around whether to pause private market capital deployment or not? Those tend to happen around the same time.
AMY DIAMOND: So, thank you. Yeah, so I actually joined USC in October of 2020. And so we had already started to see significant recovery in the markets, but one of the reasons I was hired was to rethink and re-imagine the asset allocation for USC. It was a program that was perhaps a little more liquid, a little more passive than what the vision was for the future.
And so in the beginning of '21, we adopted a new asset allocation that really did emphasize the need to be more active, more concentrated, and really explore inefficient parts of the market, both in public and private markets. So that was happening at a period of time when there was quite elevated valuations, when our venture capital portfolios were quite strong. And so we began to implement what I talked about this, diversifying assets, the total return part of our portfolio, at a time when a lot of investors were really pushing much more into the equity market. And I think the goal is that we can't predict where markets are going to go.
We have to believe that we have an asset allocation that can manage through volatility in the markets. And if we're going to have a more active program and invest heavily into the illiquid markets, we need to have constant liquidity planning and keep stress testing that. So that was the ethos and the philosophy behind a new asset allocation in 2021. So when 2022 happened and the markets were much more volatile and there was significant draw-downs, we had a plan.
And so for us, having a plan, a liquidity plan, where to hit to get cash when we needed to meet our obligations, which are both payout and the capital calls on the private portfolio, know where we're going to go takes the stress off the team from having to manage through that. So I would say where we sit today is still believing in our asset allocation. We are seeing unique opportunities in the public markets, but that's part of just the normal course of business. But we still are strong believers that there's a lot of attractive opportunities to compound capital over the long term in private and illiquid markets.
OLAOLU AGANGA: Thanks so much, Amy. Now Keith, you mentioned using the outsource model. You gave a good description about how you all work together, both internal teams, external providers, and then the investment committee. Can you comment around the conversations that you had, maybe you had to drive some of those, to successfully achieve that arrangement with your investment committee? How did that conversation go?
KEITH WIRTZ: Well, and I was part of the committee and have been chairing the committee for most of the evolutionary phase. I think the first thing I'd point out is that going from an advisor model to an OCIO model did require a real redefinition of roles. And I think part of the learning process we experienced was that we had certain committee members who had difficulty with that evolution of role, taking on more of a governance perspective or responsibility at the committee level and allowing the investment team to do more of the portfolio day-to-day decision making. And there was a point in time where we went through some changes of membership on our committee to make this work more properly, for our needs at least.
Poll #3:
Have you considered utilizing an Outsourced Chief Investment Officer (“OCIO”) for all or a portion of your investment portfolio?
Answer options:
We currently partner with an OCIO provider Yes, we are considering or intend to within the next 12 months Yes, we are currently evaluating No, but interested in learning more No, and no plans to
And so we went through some adjustments. And as we changed the OCIO service providers to BlackRock, as well as we had to do some changes on our side with the committee structure. And I think today, we feel really good about the description and definition of the roles from the committee down to the two investment groups that we work with. And I think that's leading to better success.
One other advice I'd give to those listening to this, the endowment's a long horizon investment program. Some of the decisions we're making are long term decisions within the portfolio. It's my view that investment committee membership is really, really important and I have found that it's worked well, for me at least, to have a mix of business practitioners or people with business acumen with investment practitioners. Having that mix I think leads to a good group chemistry within the investment committee. And I have a bias towards having membership, that specialized committee membership that has tenure. I'd prefer to see members stay on the committee for some time to see the effects of the decisions we're making.
OLAOLU AGANGA: Thanks so much, Keith. I'm going to pivot my questions a little bit just to touch on some of the day-to-day realities of being in the weeds while at the same time really managing key stakeholders. And this one is Ann. What strategy did you use to communicate with your investment committee, especially around the operations, what frequency? We know Keith just talked about that close dialogue. Again, if you're in the weeds, how did you navigate those conversations?
ANN BECK: Well, fortunately for us, we have a very mature investment subcommittee. It's comprised of people who are very active in the investment environment, and so that's extremely helpful, that they're knowledgeable and also they have a strong connection to the organization and a commitment to want to help. The challenge becomes, how do you communicate the connection of operation to the asset management? And as I've indicated before, the asset that we're relying on right now needs to be more liquid than maybe we had originally intended when we developed our investment policy.
So the challenge becomes communicating the need to remain steadfast to the investment policy in a rational way and not react to what's happening in the market or internally, but to, again, respond and look at what's happening within the organization short term, what do we expect to happen from our operations near term, and what do we see as our longer term recovery, and where does that intersect with the investment policy to be thoughtful about any changes or revisions that we might make? So the communication that we've had most recently with our investment committee is around liquidity. That is really the phrase of the day for us.
And having our committee understand the liquidity needs that the organization has, again, in the near and the short term, and then the operational improvement plans that will allow us to maintain the integrity of the investment policy, which as Keith said, is a long lived document with longer term goals of compounding capital. So it's difficult for a committee who drops in periodically, to that has day-to-day exposure to what's happening in the market and trying to understand, how does that fit in with our operations, and where do our operations intersect, and where is their disconnect, and what's the work that we're doing to remediate the disconnection about the liquidity needs that need to be generated from the portfolio and the liquidity stresses that we have as part of our near term operation? So again, for us, and for me personally, having the committee that we do with the knowledge base that they have, makes it a lot easier to have what might otherwise be difficult conversations. That and coupled with the amount of work that we've put in, in front to make sure that we had a plan, and as Amy said, that we were able to address our liquidity needs with a plan that we developed when we didn't have liquidity needs. So those are the type of things that I think make it so that our committee is successful in providing what the organization needs from that committee and the direction and oversight that they provide.
KEITH WIRTZ: If I could add, I was going to mention that. I can only imagine as a result of the pandemic and then the post-pandemic environment, that your operating team, as well as the committee and the investment group, you must be working at a much higher level and much closer level of communication than previously, just because of all the circumstances that you're contending with. And that has always underscored, to me at least, that these structural arrangements between committee, the operating group, and the investment team, that having good communication lines, it's almost like a partnership. You really want to have the best, highest level of communication between the different parties to make it work right.
OLAOLU AGANGA: And that's really an important point, Keith, I have to say. It's good hearing from your respective institutions how you navigated the communication. And now that actually draws a spotlight on Amy.
Saved the best question for last. So Amy, as we've heard from both Ann and Keith, you came into your role at a very interesting time for markets. Now, how did you manage that relationship with your investment committee, the communication, and what was the importance of doing so at such a critical time?
AMY DIAMOND: Yes. Thank you. I think the topic around communication is incredibly important because we want to make sure everybody's level set in what we're doing, understand how we're thinking about things, understand how we're thinking about portfolio construction and the investment philosophy. And because everything was new and it was new for my relationships with the trustees and the administration of the University, we intentionally used each meeting.
So we have four investment committee meetings a year, formal investment committee meetings a year. Use each one of them as almost a deep dive or tutorial in things that not only are helpful for us as a team to sort make sure that we are incredibly thoughtful and understand all of the nuances of what we're trying to do. So for instance, portfolio construction, how we think about optimal number of managers in different parts of the portfolio, how we think about how managers are diversified with each other, and walk everybody through it as if they knew nothing before. And by doing that, it's almost like we have these endowment 101 manuals at each one of our investment committee meetings. And so then now we're on the cycle of the next year of that sort of same topic and we're able to update them and show them where the refinement is.
And so I think, for us, being able to capture all of these changes in PowerPoint presentations that are really easy to digest and understand, means if we get new investment committee members, they can easily step in and pick up and understand. And really, it's about the repetition and about that communication. And another helpful tip that I think has worked is that I put a cover letter before every one of the investment committee meetings and basically summarizing what I hope they take away from it and there's a little bit more stream of consciousness about what's on top of my mind.
And it helps do it at the beginning of the meeting so they get the punchline. And it just, in particularly times of volatility now, it lets them understand that we are aware of the risks, that we have a plan, that we really understand there's a lot we don't know, and that together we will navigate and work through it. And it's been a really helpful period of time.
OLAOLU AGANGA: Thank you so much, Amy. We could definitely continue to have this conversation. There's so much to unpack there.
We have a short window of time, but I want to thank you all, really, for making the time and participating in the summit, managing through volatility, the role of the investment committee in times of uncertainty. Really appreciate you joining us. And now we're going to go off to our next session, private equity landscape.
EDWARD NG: Thank you Ann, Amy, and Keith for sharing your insights and experiences on managing through volatility and Olaolu for moderating an engaging session. It's clear that navigating uncertainty is essential for any investor. We're now going to shift our focus to the private equity landscape, something that endowments and foundations have been leading the charge in for quite some time. I'm Edward Ng, head of our investment team serving endowments foundations and health care clients.
Joining me today are Arslan Mian, Lead Portfolio Manager in Venture Capital within our BlackRock Private Equity Partners and David Rowe, Managing Partner of AE Industrial. Thank you both for being here. In this session, we're going to explore the current state of private equity, where opportunities lie, and how investors can maximize each dollar that they spend in these illiquid markets.
Without further ado, let's dive in. Arslan, would you start by providing us a forward looking view of the private equity markets? Very curious on your views on venture capital versus buyout, growth, secondaries. And particularly, given what central banks have been doing in terms of fighting inflation and the recent stresses we've seen in the banking system.
ARSLAN MIAN: Great. Well, thanks for having us, Edward. And from a high-level point of view, just to set the stage, I mean, private equity has become mainstream. And one of the numbers we from a high level talk about often is it used to be a couple of trillion industry not long ago, call it 10, 15 years ago. And today, it's over $10 trillion in assets.
So when an industry becomes a $10 trillion industry, I think it's fair to say it's mainstream now and it's very much part of every sophisticated institutional investors' portfolios. Within the three or four broad categories that you mentioned, I'd say buyouts is predominantly the majority of that and you had mentioned, it's call it about half. And the other half is roughly divided amongst venture capital, growth, and distressed and other forms of private equity. And then secondaries, I'd say, it covers the whole gamut. So I would not put them in a separate category, but within buyout venture and growth, think of buyouts being majority of this industry. And this industry from a fundraising point of view raises about $600, $800 billion a year.
Poll #4:
Do you plan to change your private equity allocation (including VC) within the next 12 months?
Answer options:
Yes, increasing significantly (5%+) Yes, increasing marginally (1-5%) Decreasing significantly (5%+) Decreasing marginally (1-5%) No anticipated changes
And again, from a backdrop point of view, I will pivot to where we are today. And in good days, the industry has also raised up to $1 trillion in assets. So in terms of look forward and how we think about the three big areas, Edward, that you mentioned, I'd say we are pretty excited from an opportunity side point of view in what we see ahead of us, and in all the areas that we mentioned. So let's just take buyouts as an example.
And we've looked at data going back 30 years. The best returns the buyout industry has generated have generally come after some sort of a recession, a downturn, or a correction. Be it the dotcom, be it the GFC, or going back to the late '80s, early '90s. So you think about all the different financial crises or market corrections that the industry has gone through, the best returns have generally come after some sort of a correction or a recession.
On the venture capital side, I'd say we've seen valuations come down to a level where we haven't seen in a long time. There are companies out there that raised money not long ago, 12 or 18 months ago, at very hefty valuations. And many of those deals we didn't go into, but now we're able to go after some of these businesses at 30%, 40%, 50% discount. So from a look forward, Edward, going to your question, we feel the valuations in the venture capital industry are coming down at a level we haven't seen in a long time and we're getting structural liquidation preference and terms that even 18 months ago many of these companies would not entertain.
And growth, I'd say in the same category, has also been, from a valuation point of view, very hard to invest in sector because these high growth companies were demanding really, really high prices and premiums, and oftentimes, revenue multiples with no cash flow. What I would say is cash flow is very much the theme of the day. Many of these growth companies, and we see that in some of the public tech companies as well, are now having to convert their revenue into profitable cash flow. And they are having to have the discipline of, I need to show profitable growth and it's not grow at all cost.
And if I can show profitable growth, that's how I'm going to command higher value. It's not just burning cash into infinity and not having a profitable business model. The fourth area I would say, which actually becomes very topical in an environment that we're going through right now, is distressed. And on the distressed side I would say it's not just a large company that borrowed a lot of money and now the rates are going up, so that company may face more interest payments than they planned for, so they may file for bankruptcy.
Distress comes in all shapes and sizes. It actually could be a distressed parent that's having to sell some of its non-core divisions or orphan divisions, again, at prices we haven't seen in a long time. And that we, again, see as a very, very exciting time to be looking at stressed or distressed payments and carve outs and businesses we can buy from these large companies at pretty attractive prices. One last point I would make, Edward, and I'll turn it back to you is, all of this comes with the backdrop of, there is less leverage today than there was a year and a half, two years ago to these private equity firms.
And what that means is, from a valuation point of view, we need to adjust the valuations to come to a level where with low leverage we can still create private equity returns. And that price discovery period is what we're going through right now, where sellers probably had higher expectations last year and this year we're starting to see their expectations come down. And the market clearing price, hopefully over the next 6-9 months, will make these investments viable, even with low leverage. So I'll take a pause there. Back to you, Edward.
EDWARD NG: Arslan, thanks for those comments. I just wanted to pick up. Could you elaborate a little bit more on the secondaries, in terms of what you meant as opportunity set, what's creating that?
ARSLAN MIAN: On the secondary side, what I would say is some investors do face, in an environment we're going through, do face the denominator effect. And what I mean by that is, their public portfolios decline faster in value than the private portfolios. And if they have a set target and allocations, they have to shed some of their private equity assets.
So from a secondary buyer point of view, we're able to move in and buy some of these private equity portfolios that are in year three, four, five of investing and at a very exciting phase in their investment period, at pretty attractive prices. So a few years ago, we had to pay premiums for some of these private equity portfolios in the secondary market. Today, we feel we can get these portfolios at discounts that we have not seen in a long time.
EDWARD NG: Great. Thank you, Arslan. And I appreciate those kind of broad comments. Over to you, David, with a question kind of building on Arslan's comment about a while back, we have a market very rich with liquidity, lots of dry powder. Kind of what's your market perspective at the individual company level, and what kinds of opportunities are you seeing, and how do you think the environment kind of evolves from this point forward?
DAVID ROWE: Well, I think everything that Arslan brought up made a lot of sense and rings true for the various businesses in the market segments that we focus on. Clearly, we're a very specialized firm. We invest in aerospace businesses, which includes everything from government services to related engineering companies, to space companies, to commercial aero, to jet propulsion, to power generation, businesses like that, as well as business aviation. And all those markets have different dynamics and have benefited or have been impacted by the various things that have gone on in the market over the course of the last 24, 36 months.
I would say that, again, our focus has always been primarily to live one level below the original equipment manufacturers in all of these industries where we play in the supply chains. And obviously, the pandemic and the 737 Max issues impacted the commercial aero market tremendously. You throw on top of that the constraints on liquidity relative to the capital markets and there are some difficulties that these supply chain companies are experiencing. Luckily for us, our businesses were not overly levered. We're very conservative when it comes to that. We're typically a one-to-one debt-to-equity player in our markets because of how capital intensive our businesses are.
But for the most part, the competitive landscape that we play in, a lot of the businesses that were at peak production in the cycle of their business to support the growth that the major OEMs had been experiencing, are really in a difficult state right now. They blew through their buffer stock during the pandemic. There was a lot of confusion as it related to production requirements and that's all kind of leveled out now. And you're seeing companies that were over levered being put under tremendous pressure by their capital markets players and we're taking advantage of that.
I think if you look at the history of our firm, we've done extremely well coming out of down cycles. And you could argue this is one of the most painful down cycles in our industry's history. So we're primed. We've got plenty of capital to go to take these companies to the next level and we're very much in a consolidation phase for different market sets in different market segments in our group. But I think our activities in the space sector are exciting, and clearly, the opportunities that we have in the commercial aero and the business aircraft markets are really exciting for us, given the dynamics of the market today.
ARSLAN MIAN: That's great, David. If I were to jump in there and ask you a question from an economy point of view, how big is this space economy and where do you feel it's going to grow into over the next 10-15 years? And what's really driving that growth in the space economy?
DAVID ROWE: Well, when you look at the existing market, it's around $0.5 a trillion in the space market and it's growing to around $3 trillion. And the reason behind that is really the geopolitical tensions and the impact on replacing and putting new satellites into orbit for defense systems, as well as replacing all of the existing communication systems that are basically outdated and becoming obsolete with new satellites that have all different types of new technologies built into them.
EDWARD NG: Well, thank you, David. That was super helpful to kind get your perspective. I think one of the things I wanted to follow up on was something that Amy mentioned in the last session, around the importance of having a strategic plan and focusing on executing it. When we think about working with our clients and their private equity program in partnership with Arslan and managers like David, is the ability to allocate over a cycle.
And as we kind of heard or what I heard was there are opportunities, whether the markets are on their way up or perhaps nearing a bottom, as David suggested today. But really kind of managing through our volatility is that kind of consistency of that allocation process. A question for you, Arslan. As you think about the importance of manager research and selection in these environments, what advice would you give trustees or other peers as you think about your own due diligence processes?
ARSLAN MIAN: Yeah. Thanks, Edward, for that. And I totally agree with you. I think private equity, from a portfolio construction as you mentioned, it's a long term asset class.
And during the course of one of these programs, If it's a 3-4 year investment period followed by another 4-5 years of harvesting and exiting, you are going to be in one of these funds for 8-10 years. So that partner selection and who you work with becomes extremely critical to developing a successful private equity program. And one of the things we look for when we're picking a private equity fund that we're going to go with is a team that has been battle tested, a team that has gone through cycles. I think that, I would say, in an environment like this, becomes even so important.
It's always important, but when you are going through cycles, you better be with a partner that has seen a few cycles. In our own history, as the Private Equity Team within BlackRock, we've been investing for over 23 years. We have relationships with 400 different private equity firms around the world. And I can tell you, we're not putting capital with all 400 of them around the year, right?
Within that, we have a very core strategic group of partners that we invest with, and oftentimes, we invest directly in their companies as co-investors. And generally I'd say there are four P's that we look for in all the partners we select. First and foremost comes with people. Again, going to my earlier point, right?
Teams that have seen cycles. The second point is around philosophy. And David here, as he summarized, their philosophy in how they cover government services, and how they cover space, how they cover aero and aviation. That's what they've been doing for 30 years, right? That's what excites us, is a GP that's got that knowledge, that has how that know how, that expertise.
And the third P is around process, right? When David and David's team invest in the company, there's a process around diligence, but then the process of value creation and what they do with that business, you heard consolidation, that is one of the ways they're going to create value. But there are 20 other things they're going to do with these businesses to make them better by the time they exit. Right?
So we spend a lot of time in manager selection, understanding that process of value creation, of how the GP is going to create value. And we feel-- And I didn't start off with performance, right Edward, for a reason. If you get the first three P's, right, you get the right people that have the right philosophy and they have a process of value creation, you should get top quartile performance out of it.
Oftentimes, the pitfall are our industry falls in is they go right to the performance without forgetting what actually created that performance. And we have, again, the history of investing with several of these private equity firms over the last 24 years that gives us the ability to use a lot of data. When we get to performance, we actually do a lot of slicing and dicing. We do a lot of data analytics.
But it should an output of the other three pillars that make the performance happen. So manager selection, and I guess the two words people often use, private equity is about access and it's about selection. Right? Access comes from developing relationships over a long period of time so you are with the right manager. So take a pause there. Back to you, Edwards.
EDWARD NG: No, super helpful and I like the four P's moniker. Easy for me to remember and you're right, we all strive for performance. But I think as you've highlighted, the importance of both people, philosophy, and process really become that foundation.
I guess over to you, David, with regards to, obviously, having a partner like you and AE. Where do you kind of see opportunities? You touched on the 737 Max and defense, but Arslan mentioned the concept of space. What's he talking about? What are you seeing in the version of space for private equity?
DAVID ROWE: Well, again, we love focusing on businesses that are in the supply chain or that are on the leading edge of delivering new technologies to a market. We also predictable earnings and predictable revenue, right? And to juggle those three things, you really have to find opportunities where you're investing in companies that are critical toll gates to their markets. We do not like commodity-oriented businesses.
We like businesses where the end product has to go through our companies to get to market. And for instance, we created a company called Red Wire, which we consolidated a number of different component manufacturing companies. You cannot launch a satellite today without having eight of our products on that satellite. You just can't.
We invested in a rocket and a rocket propulsion company that's feeding satellites into the low orbiting satellite market. There's going to be 40,000 low orbiting satellites that are going to be put into orbit over the course of the next 10 years. Having a vehicle and a facility and a capability to help facilitate that market is a phenomenal opportunity and that's why we invested in that asset.
We also invested in Sierra Space, which is again, another well established company that has a tremendous launch history and that will be feeding satellites into the low orbit and middle orbit market space. And then we invested in a company called York Aerospace and York Space Systems, which builds these satellites. And has a tremendous amount of backlog. So we love businesses that are critical toll gates, that have great, predictable revenue. And predictable revenue comes in the form of backlog and long term contracts. Now, when you think about, again, investing in the commercial aerospace market in the downturn that we had relative to the cycle, the comfort, we still went to bed and we slept well, because essentially, these backlogs were pushed out 18 months, but they were pushed out.
There are 40,000 airplanes that are going to be built to serve that market to offset 20,000 airplanes of attrition that have just gotten older and they need to come out of service. And so our businesses may have suffered from a revenue and an earnings profile standpoint because of the market dynamics, but the market didn't go away, it just got pushed to the right. And that's really what the effect of any market downturn has on these types of businesses.
So we've invested in 145 companies. We're very proud of the fact that we've lost money once, which I think is a phenomenal record for any private equity company. And we sleep well at night because we believe in the assets that we invest in and we have a great team of people that, essentially, can help manage and create value in each one of the investments that we make.
EDWARD NG: That's super helpful and I really like the toll gate concept in terms of being kind of a critical path provider, where people have to come through you to go to market and be successful. Well, I think we're almost nearly at time. I wanted to Thank You both for taking the time to discuss the ever-changing landscape here in private equity. I think you've shed some really interesting light in terms of where the industry stands today, where there are some opportunities.
It sounds like they're very rich. I would not have put space as part of my bucket list, but certainly seems like a good opportunity. I think as Arslan reminded us, the importance of maintaining that strategic focus, that long term-ism.
These are really challenging times, but I think you have to kind of stay adept at your pacing model to really participate in these opportunities over time. Again, thank you both for your time. I'm going to turn it back over to our emcee, Ned Rosenman to close us out.
Poll #5:
Would you like BlackRock to follow up with you about any of the topics discussed today?
Answer options:
Yes No
NED ROSENMAN: Well, thank you Edward and team for that unique window into the PE landscape. And thank you to all of you for attending the 2023 Trustees Summit. I think if there's one message to take away from today's conversation, it's that during times of uncertainty, we're really here to help.
Whether it's with insights on your portfolio, the design of a custom solution, or connecting you to anyone from our network of nonprofit investors or experts internally here at BlackRock. So with that, I will sign off. Thank you again for joining us.
