Sanderson Wealth Management Adds Private Equity

by Sanderson Wealth Management Dec 1, 2020 Firm News, Investment Consulting

After a three-year research process, Sanderson Wealth Management has added a new asset class in to our diversified investment strategy; private equity. We've created a video introduction to this new asset class to share insights on what it is and the role it will play in our investors' portfolios. 

Sanderson's Chief Marketing Officer, Lauren Molenda, interviews Vice President Justin Sanderson about the initative. 

 

Sanderson Wealth Management Private Equity Education Presentation

 

Lauren Molenda:

Hi, I am Lauren Molenda, I'm the Chief Marketing Officer at Sanderson Wealth Management. And with me is Justin Sanderson, our Vice President. We are always trying to improve our portfolios at Sanderson Wealth Management and private equity has been a really appealing asset class to us for a long time. So, today we are going to be discussing...

Justin Sanderson:

Private equity and its role in our investors' portfolios.

Lauren Molenda:

Great. So, let's just start really simple and basic. What is private equity?

Justin Sanderson:

Public equity and private equity are pretty similar. So, all of our clients are used to the global stock market. But what's different here is that we're owning shares of a privately held business that's not actively on the exchange, but the underlying principle's still the same. You're buying ownership in a company and participating in the success, or failure of that underlying company. Also, it's very similar to the public space where we're going to be diversified across different regions across the globe, across different asset classes. Anything that can have a public... Or a private company, it could also have a public company. And here's some examples of well-known private companies that are underlying some private equity portfolios.

Lauren Molenda:

Thanks for that, Justin. Being one of the few Sanderson team members that is not a financial advisor, I'd love to understand a little bit more about how that works.

Justin Sanderson:

Sure. So, there's one primary difference between the public markets and the private markets. And that's really about how value is created and returned to the shareholders. Through a public company, you're looking at the momentum emotion of the market, the whole market rising and falling, that sort of thing. Whereas, in the private side, we're really more focused on the fundamentals of the underlying cash flows of the company. And what they're doing, what a private equity manager is doing is they're going out and they're buying interest in companies, or an entire company in an effort to fix it. So, they buy it, something that's appealing that they think they can create value. Then, they go and fix it and create more value for the shareholders that they are representing. Then, over a period of time, they either exit through an IPO, or a sale to another private equity company. And that's really the thing that's behind it. So, most of the benefit and realization is through the waiting for the sale to happen over time.

Lauren Molenda:

Well, I've heard a lot about some of the more exciting, or buzz-wordy stages of private equity companies like VC, or angel investors, things like that. Why don't you take us through the full life cycle, so we can understand all of the important parts?

Justin Sanderson:

Sure. So, we built this graph here to look at two things together. We're looking at the stages of the private company, along with the stages of being an investor in those private companies. So, the shaded areas there, across there, the lifecycle of a private company. And that line through the middle is revenues. And you're looking through a break even point.

Justin Sanderson:

So, when you talk about angel and venture, it's a really fun, exciting asset class, but it's also extraordinarily risky. And that's not what we're going to talk a lot about today, but we're going to move back into the sort of mid and late mezzanine stages of companies as true private equity investors. And one of the things to think about is the economic value of those companies are about somewhere around 500 million stretching up into a billion or a few billion dollars into that range. So, meaningful going concerns, not early stage building up their operations, and building up revenue, but they've already kind of arrived, and have good cash flows, but our managers are going to want to push them to the next level, either through acquisition, organic growth, something along those lines.

Lauren Molenda:

So, at Sanderson Wealth Management, our investment strategy has primarily been focused on the public markets so far. So, help me understand, and our clients understand what provoked the consideration of private equity as an investment strategy.

Justin Sanderson:

So, the macro economic case for private equity investing has been becoming more and more attractive over time. Basically, over the past 25 years, the amount of public company opportunities, especially here in the United States, has shrunk. Towards the end of the '90s, we had about 8,000 public companies and, today, we have 3400. So, the amount of opportunities of investing as a public company investor have really shrunk. At the same time, the private opportunities have become more appealing as companies age, and new industry comes in. Today, we've got 2 million companies here in the United States that employ more than 50 employees. And, to us, that means it's a company that's grown beyond its founder, beyond its originator, and really a going concern that should be able to support lives and families for a long period of time. When you compare that to 3,400 public companies, well, there's certainly some investment opportunity for those 2 million companies.

Justin Sanderson:

From a more high-level economic standpoint, we can also look at the private middle market, which we're going to be talking about, makes up about 34% of the GDP. So, as public company only investors we're kind of ignoring part of the productivity of the country, and we really want to harness that. And when you look at it from a workforce standpoint, it's even more compelling because public companies make up about 75% of the non-government and non-public company employees. So, it's a really, really meaningful part of the economy that we can go and harness the productivity of these workers.

Lauren Molenda:

Justin, that all seems to make a ton of sense. Maybe we can look at some of the data comparison between the public market and the private market valuations.

Justin Sanderson:

So, we talk about public market valuations a lot. You've probably heard us talk about 10 year cyclically adjusted price to earnings ratio at nauseum over your life as a Sanderson client. And it's a really important metric. We're going to actually talk about that in a minute. But here I want to take a step back at a broader valuation metric. So, right now, what you see in this graph is the Wilshire 5000, which is the broadest US equity benchmark there is, and it's percent as a market value as a percent of GDP. So, right now, you can see where we're at today it has soared in value. So, we're about 190% of GDP being tied up in the Wilshire 5000 market value. So, it's getting pricey and historically pricey because we hadn't even seen this in the 2000s during the tech boom. So, that's concerning. And it's not that you don't want to be a public equity investor, but it's a case for, hey, maybe we should be complementing it. And that's really what we're getting at here.

Justin Sanderson:

So, that cyclical adjusted price to earnings ratio. That's an important one. So, although the last slide is a little scary at 190% of GDP, you look, it's not without reason. Those public companies have really been producing a whole bunch of money and earning. So, really today we're buying a dollar of earnings for about $31. It's high from a median and mean basis. But when you look at previous highs, we've been here before and we've been considerably higher. So, this isn't necessarily warning signs of, hey, let's be cognizant or scared of the public markets, but hey, what do the private markets look like when we talk about this?

Justin Sanderson:

So, they are very complimentary and that's really important because there's important differences between the two. One, a public company trades ownership several times a second. So, there's a high frequency of transactions, which may not necessarily align with the underlying fundamental value and the financials of the company. On the other hand, private investing, usually a transaction happens maybe a couple of times in a decade, but even that's a lot for a lot of public... or private companies.

Access to information in the public markets, well, it used to be an information advantage for us in the industry. But, now, with cloud computing and all kinds of databases out there, and really the democratization of information, all that information is really, really widely available. However, private investing, there's a huge opportunity for information advantage. And that's because a private company doesn't need to disclose to anyone its financial conditions, its financial prospects, its goals, its aspirations, that sort of thing, unless they want you to.

So, this brings up a really important point where access to this is really important. That's when we talk about what we've decided to do, we wanted to find folks that have been doing this for a very long time because that repeated access in becoming a good player in the space is really, really important.

Justin Sanderson:

Lastly, we touched on this before, but I just want to emphasize it. The investment managers, so the fund manager we're hiring, can add a significant amount of value in the private space. In the public space, somebody like Vanguard, Fidelity, BlackRock, some of these big asset managers, they can't really change the direction of what Apple's going to do. On the other hand, in the private space, a fund manager is asked and emphasized to provide a lot of value, and help the management team and help guide that business into more success. And that's really important. So, the active managers are doing a whole lot to provide value to their private equity investors.

Lastly, the holding periods are longer. So, in the public markets, you can hold things for as little as a day or less, as we've seen some day trading going on lately. But in the private markets the liquidity is a concern. And sometimes in the traditional private equity investing, we're talking about liquidity of a decade or more between being able to realize your investments. And that's an unappealing characteristic of the asset class.

We wanted to highlight an apples to apples comparison between the valuation of public companies, and the valuation of private companies because in all this marketing I've received, and we receive all kinds of marketing from private equity firms all the time, they compare the P/E ratio we were talking about before, which was 31, to an EBITDA multiple of 6, 7, 8, 9, 10, whatever the percent. And that's not really apples to apples, those comparisons aren't the same. Yes, it is a great case for private equity, if you buy into that calculation. But this is a real apples to apples of enterprise value divided by earnings. That's, I think, more calculable and accurate. And this is just to show that private equity has been relatively stable around 10, there or so, and then when they do go to that public stage, which we're looking here at small stocks, they're up about 18. So, that's a 80% increase in the multiple you're paying on the apples to apples comparison. So, there's a lot of opportunity to capture some premium there.

Lauren Molenda:

So Justin, obviously, the diversification into private equities and investment strategy for Sanderson Wealth Management is a big initiative, and not to be taken lightly. So, I assume a lot has gone into the research and decisions that have been made to get this off the ground. Can you talk to us a little bit about what that process has been like internally?

Justin Sanderson:

Yeah, absolutely. So, the macro economic case we just sort of painted for you, in the previous section, we kind of knew, it makes sense. It's a good opportunity, but okay so now that we know that it makes sense, well, how do we actually do it, and do it with a fiduciary mindset? Because there are all kinds of private equity products out there, there's all kinds of different private equity managers with spotty track records, new track records, no track records, that sort of thing, all fighting for investors' dollars. So, to really get through a lot of the noise that is out there took a good amount of time. So, it took us about three years. And, admittedly, our investment committee here was not optimistic that we would find a solution that fit right for our clients. Happily, for all of that work, we got some pretty good fruit to bear with it, and have really tackled some of those concerns we had while getting prudent fiduciary access into these vehicles.

Lauren Molenda:

Justin that sounds like a massive amount of work. What were some of the biggest hurdles that you encountered as you went through this process?

Justin Sanderson:

Sure. I want to mention real quick, I certainly didn't do all of this myself. So, shout out to Phil Frattali, CFA, and one of our financial analysts here that also undertook this with us, and did a lot of legwork. So great job, Phil.

This is one of the hardest things to sort of conquer as a private equity investor. And one of the reasons why private equity has primarily been reserved for, basically, institutional investors, so endowments, foundations, sovereign wealth funds, that sort of thing, or very, very large single family offices that have indefinite, basically, time horizons, or infinite time horizons, and that's the J-curve. So, that's what we're looking at here. This is a J-curve, and this is real cash flows we took from an example of what an investor would have really experienced. So, in a traditional private equity fund, basically, they have a period of raising capital with about 18, 24 months, something like that. And then, they deploy that capital over another 18 or 24 months. And then, you kind of sit and wait for the private equity managers to do their magic, create value for you, that we talked about, and then sell it, and get a positive cashflow back to you.

So, what does that look like in an actual fund, is what we're looking at here. So, you, first, make a capital commitment and you say, "Hi, I'm John Smith, and here's a million dollars Mr. Equity Management." He's going to say, "No, I don't want a million dollars. I want 350. I'm going to charge you as if you gave me a million dollars, but I only want 350 this year, and I want 350 next year, and 350 the subsequent year. So, that's our evidence here on this chart by the copper bars. So, you see those, those are your draw downs of cashflow. Then, you have the gray bars. [inaudible 00:14:35] your positive cash flows that you start experiencing relatively early on in period three. But for those first three years, you are heavily out of the money, and not experiencing, or enjoying much gains. So, it's kind of a funny feeling.

Justin Sanderson:

Then, you can see that line across the whole chart here. And what we're looking at there is a cumulative cashflow. So, really you're looking at six, seven years until that investment turns positive where gosh knows what the alternative investments would've done during that time period. If you're just in the public market enjoying your success immediately. But then, you go on and have more success over time and get that appealing private equity like return of a multiple of some sort. We're looking for high single, low double digit annualized returns over that life cycle of the fund. But we don't want to sit and wait here for 12 years. And that's really what the most challenging part was, was finding a way to get into the asset class, enjoy all those great macro characteristics, enjoy the risk reduction that you get from the asset class while having appealing returns. And that's what we did was find a way past that.

Lauren Molenda:

So, that covers off on one of the hurdles that you mentioned before. I understand the second one has to do with the quality of the fund manager.

Justin Sanderson:

Yeah. That's a really interesting one. The private equity space, and this is one of the prime complaints we had when beginning this research from our investment team was, well, if you're just a median performer, you might as well not even invest in private equity because of all the headaches it causes. And they're not wrong. There's a big dispersion in quality. And what we find is, in the public markets, we're looking at a large cap US value manager performing plus or minus maybe 4 or 5% of its peers. But even that's a lot. When you look at the private equity market, you see a huge dispersion between the top and bottom quartiles. We're talking 20%. and that's a meaningful difference where you don't want to be that far underperforming, and somebody always is. So, what we needed to do was find people that are repeatedly in the top, and are good at identifying those managers on top. And I think that's really what we've done here because you might as well not be in the asset class unless you're getting sort of that top quartile or top decile performance.

Lauren Molenda:

So, Justin, that takes care of the two biggest hurdles. What other things did you have to solve for during this pretty complex process?

Justin Sanderson:

Sure. So, we had to solve for access. So, that's really finding the people that continuously get good access to these to remain in that top quartile or decile that we're looking for. We also had to solve for investment minimums. Usually an investment minimum is a million dollars plus into the asset class. And usually that's then, a concentrated position. So, concentrations another one where a manager is concentrated in an industry, in a region and all private equity funds, generally, raise capital for a period of time, deploy capital for a period of time. And then, you get a fancy name, called a "vintage" view, subscribed to a vintage of a certain private equity manager that may be great, or may be a bad vintage. And we wanted to avoid all of those things for our investors. And that's what we did.

So, what we found was that we can solve that by finding evergreen funds. What that means is these are funds that aren't going out and raising capital, and then deploying it in very tight timeframes. These are people that are perpetually raising capital, and perpetually investing. And, by doing that, there's no J-curve effect because you're buying in day one with access to these companies already. And they're just buying them more and more companies, and more and more opportunities as the time comes.

Additionally, as anybody that's been involved in private equity may know, your partnership structure can be a headache for tax purposes. And that was something we want to get the benefits from the asset class, but we don't want to create a big headache for our clients at the same time either. So, having something as a 1099 reporting vehicle, and also somewhat regulated was really important to us too. The liquidity was really, really important and it goes, again, to that evergreen structure of the raising capital. And you're able to get in or out on a quarterly basis, which is really, really nice.

Lastly, our roots to Ernst & Young, certainly, run deep, and operational due diligence, and auditing was really, really important to us. That this was done well, done by a big accounting firm, they have good sound practices in place, and that was really important for us during the process too. And then lastly, the challenging part, is there are a whole bunch of people out there providing private equity services, but one of the common things across the space is fees look any sort of way. So, I've seen fees from in the ones and twos per cent. And I just saw last week a proposal across my desk with somebody with a retail share class at 7% annual fee. And that was really a challenging one because when you look at returns net of all fees, they weren't all appealing if they're taking 4 or 5, 6% off the top. So, it was another challenging one. And after all the search, we filter it down to 12 folks, and whittled it down from there. And are really pleased with what we're providing to our clients today.

Lauren Molenda:

Thank you so much for all of that information and breakdown, Justin. It was really clear and I think it's going to be not only a significant but, ideally, a welcome change for our clients.

Justin Sanderson:

Yeah, I think so too. It's a change to our process. But the big thing is it really benefits the portfolio. The risk return metrics and the improvement returns should be meaningful for our clients, especially in environments today where it's not appealing to be a bond investor for the intrinsic value of generating income because, basically, you're locking in a real return loss. So, it's an important asset class to be adding as a complement to the rest of the portfolio. And that's an important thing of where does this fit in the portfolio? It's not necessarily an equity alternative to us, or a public equity alternative. Our global stock allocation will remain intact.

But what's important is the addition of this to the non-traditional space and, perhaps, funding that with things that are a little more out of favor, and may be out of favor for some time, like real estate, like risky bonds. We're worried about the fault risk. Infrastructure, well certainly, infrastructure and consumption isn't being used as much as it has been in the past. So, it's a really appealing asset class to sort of get back to fundamental cash flows to the ability of a good management team to go in, improve a business and generate great returns for its investors.

So, I'm excited about it. And I'm also excited about the other things that are going to follow. So, this isn't going to be the only sort of foray into this private investing space we're making. We've got a couple of other research initiatives going on right now. We're taking a look at real estate and private real estate, specifically. We're taking a look at private debt, which is a challenging space, for sure. And then, for some clients that did like that part in the very brief part we talked about angel and venture capital, that's a really fun asset class. The portfolio statistics, perhaps, aren't as compelling as private equity in general, but it's a fun asset class to think about and, perhaps, have out sized returns over a long period of time.

And then, lastly, taking a look at some investment opportunities that have values more in lined with our clients own values. So, whether that's environmental, or social, or corporate governance, or impact investing. That's something we've been keeping an eye on, we've done some research and identified some opportunities there. And, actually, most of our portfolios actually do have an ESG fund in it, just nobody really knows because they're just good investment funds that happen to be that way. So, we've got a lot more coming, and a lot more in store, but I'm excited about all of it.

Lauren Molenda:

I am too. Thanks so much for taking the time to talk about that today. And, as these new initiatives roll out, I'm sure we'll be back with more videos helping folks understand what we're planning here. And, in the meantime, if you want to talk more about private equity, or anything else that's on your mind, feel free to give your advisor a call any time. We're happy to help.

Justin Sanderson:

Take care everyone.

 

Disclosure

© 2020 Sanderson Wealth Management LLC. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting, or tax advice from their own counsel. All information discussed herein is current as of the date appearing in this material and is subject to change at any time without notice. Opinions expressed are those of the author, do not necessarily reflect the opinions of Sanderson Wealth Management, and are subject to change without notice. The information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed.