Private Markets Investing:
An Alternative Model

Over the past 25 years, average private equity returns in the United States have exceeded public markets returns by approximately 3% per year.¹ Much of the outperformance occurred 10–25 years ago, when private equity was less competitive and opportunities more plentiful. During this period, private equity investors—which we’ll call “sponsors” in this paper—even the average ones, were rewarded for accepting illiquidity.

Over the past 10 years, the average U.S. private equity fund outperformed the S&P 500 by only a small amount.¹ But dispersion between the top and bottom quartile performers has remained wide. Strong performance among the top quartile indicates that attractive opportunities still remain in private markets even as competition rises.

In this paper, we argue that improvements to the traditional approach to private markets can substantially increase access to better opportunities and the probability of outperformance. The model we propose is one we’ve been executing for over 10 years. We believe there are clear and tangible reasons the model can produce investments with better and safer returns that merit a relatively large allocation of family assets.

1. Diversification. Portfolios tend to be safer to the extent that they are comprised of a relatively high number of investments, the performance of which is non-correlated to each other. Investments that offer a high level of non-correlation to economically sensitive investments include those in the areas of government contracting, insurance, healthcare, infrastructure, and real estate with long-term leases.
2. Structural Downside Protection. The best sponsors we know are consistently able to build downside protections into the securities they negotiate to acquire. Standard protections include structural seniority to common equity. Niche protections include earnouts and seller notes that are forgivable upon the occurrence of certain events.
3. Mispriced Opportunities Where the Buyer has “Edge”. Good sponsors find opportunities that are easily understood to be advantageous, but even the best only find a few. There is a tension between seeking concentrated exposure to these types of investments versus maintaining diversification.

Our model addresses the tension between diversification and concentration in the best opportunities by seeking to create exposure to a large number of exceptional sponsors but a relatively small number of investments per external sponsor.

Talent Drives Returns

A recent academic paper in explaining differences in private equity performance found that the individual sponsor is about four times as important as the private equity firm where they work.

The key to our model is building a substantial network of high-quality external sponsors, which in turn generates a substantial volume of curated deal flow.

There are three primary types of external sponsors we work with:

1. Contractual. Sponsors who are closely tied to our firm through contractual arrangements that create a foundation for repeat deal partnerships. We typically get to know a sponsor in the context of a first deal together. Subsequent to that, we begin to support the sponsor’s platform by helping with overhead costs and providing some amount of discretionary or semi-discretionary capital.
2. Repeat Relationships. Sponsors who we work with on a consistent basis without a contractual relationship. Our network and reputation in the market allow us to see a wide variety of opportunities from a wide variety of sponsors—some recently independent and some at more established firms. And while we do not have a contractual relationship with these sponsors, an initial deal often leads to repeat deals.
3. Broader Network. Sponsors who we interact with on a deal-by-deal basis. This group contains a combination of newer relationships that we’re continuing to develop and other sponsors that we know well but are waiting for the right opportunity. Our broader network is constantly evolving with the goal of creating repeat and contractual relationships with the best sponsors.

This network spans a wide range of sectors, geographies, and asset classes. We believe this positively impacts both the diversification and high investment quality of our portfolio.

Sponsors who fit our model tend to have a few key characteristics in common:

1. An excellent investment track record with high overall returns and a high hit rate.
2. A hands-on approach to investing supported by tools that are personal to the sponsor, not assets of the sponsor’s prior employer, such as networks of operating experts and unique sourcing capabilities.
3. A principal mindset, which means that the sponsor is primarily focused on downside protection and high returns.

Select Current Sponsor Profiles

1. Can deliver speed and certainty to a seller who needs it.
2. Participates in a complex corporate carveout that achieves an important goal for the seller.
3. Partners with a former employee to buy an asset from his/her former employer.
4. Purchases from a government entity where maximizing value is not the only objective.
5. Buys from feuding owners.
6. Has a special bond with the seller or management team.
7. Solves a headline reputational issue for the seller.
8. Purchases growth assets in the secondary market (e.g. employee shares at demonstrable discount).
9. Engages with the seller right after another deal falls through.
10. Agrees to a term proposed by the sponsor or seller that others would not agree to for irrational reasons (e.g. above-market fees for an extraordinary deal).
11. Brings value-add on day one (e.g. buying a building with a tenant in hand).
12. Purchases a small option to later make a large favorable investment (e.g. buying an option on a piece of land that can be built upon once a tenant is secured).
13. The seller is earning a high multiple upon exit (since they tend to be less sensitive to price).
14. Can finance in a different market than the seller (e.g. replace a high yield loan with a CMBS loan).
15. Sees an opportunity to sell in a different category in the future (e.g. buy from private equity and sell to an infrastructure fund or REIT).

Identifying Mispriced Opportunities:
Diving In

It is not a simple task to separate the great and special opportunities from the merely good. We do not always get it right, but we have found that prioritizing the following key factors has helped us make better decisions over time:

1. Sponsor Quality. Evaluating a new sponsor is an intensive task that involves a deep dive into his or her track record, professional network, and references. Character and ethics are paramount in our assessment. We are looking for “A” players and a consistency between prior body of work and the opportunity under consideration. As we complete successful investments with a sponsor, we are able to rely more on their judgment and diligence.
2. Alignment. It is easy to talk about alignment but get it wrong. In some cases, alignment is gray rather than black and white. Our experience tells us that alignment is stronger when sponsors invest a significant amount of personal capital side-by-side with us at the same moment we invest. But that is not enough. It is important that sponsors have reputational skin in the game such that a loss would be a significant setback for their broader ambitions. Moreover, their compensation should be tied to success and generally not provided in upfront fees and the like. While the number of losses we’ve had in the past have been limited, we’ve found that most of them involved subtle misalignments that became apparent as things deteriorated. We therefore hold alignment as among our most important criteria.
3. Transaction Dynamics. As discussed earlier, we are looking for an easily identifiable edge. There should be a simple answer to why the sponsor has been able to create a mispriced opportunity.
4. Correlation / Non-Correlation. Non-correlation is better for our portfolio, period. Our bar is significantly higher to make investments that are correlated to other parts of our portfolio.
5. Ability to Underwrite. For investments in sectors and geographies we do not know as well, our bar is higher and our sizing tends to be smaller. As we get to know a sector, and gain confidence in our sponsor partner in that sector, we are able to invest at full sizing and more efficiently.
6. Skew of Outcomes. We view investing as an exercise in assessing probabilities. We assess base, downside, and upside cases and consider probabilities for each outcome. We look for high expected returns with greater chance of upside and acceptable downside.
7. Business and Asset Quality. Wherever possible, we look for businesses and assets that will only get better with time.
8. Probability the Transaction is Consummated. Our model allows us to spend our time on opportunities that are already well vetted and have a high likelihood of being completed. This creates efficiencies for our team as we aim to vet over 300 deals a year and close 8–12.

Since 2010, we have completed approximately 100 private investments. There have been many lessons learned. While the factors above have stayed fairly consistent in that time, the way we assess each has evolved significantly.

Conclusion

Relative to other private market approaches available to families, we believe our model provides a greater level of alignment, flexibility to adapt to changing environments, protection from long-term commitments that may become undesirable, and ability to concentrate capital in areas where opportunity sets are strongest.

The investment manager, Richard Oldfield, titled his book on investing, Simple But Not Easy. We would say the same about our investing model. The approach is straightforward, and yet execution is not. We would highlight three key elements that any team engaged with our model must have:

1. A deep desire to connect with investment talent.
2. A diverse set of skills that allow for assessment of both talent and underlying investment opportunities.
3. A clear mandate from family clients that allows the team to relate to external sponsors as decision-makers.

The third element requires a ceding of control that may not be easy for some families to do, but it is critical in making the system work. Our model is ultimately about trust. The investment team must earn the trust of what we believe to be exceptional external sponsors who have other options. The team can only win trust by delivering on promises. The team must also offer speed and pragmatism. This type of empowerment may not be for all families. But for those who build trust with the right team, the rewards can be substantial.