Observations

Institutional investors face a conundrum as decades of emphasis on ‘alts’ and ‘clever’ begin to impact liquidity on top of lagging returns, hidden costs and underappreciated principal risk.

Private and public equity market landscapes have shifted

Institutional private equity is fast becoming an overbuilt, overvalued and overallocated asset class as a whole, evident in ongoing exorbitant, if disconnected deal multiples, damaging fees and costs, stilted distribution pacing and associated limited partner illiquidity. This, in turn, has created capital management challenges evident in GPs moving further and further down the investor sophistication scale to gather fresh assets to support unsustainable industry fundamentals. Returns are naturally set to trend further below common public equity benchmarks, much like hedge funds have over the last 15 years, with the HFRI Equity Hedge Index underperforming the S&P 500 in all years but 2022.

That said, traditional public equity markets, outside of a narrow group of companies driving popular benchmarks to record highs, are faced with their own challenges. Flows to passive index instruments and the exponential growth of ETF offerings, many leveraged explicitly or de facto, along with associated fee pressures, are together hollowing out active management firms and pushing out proven talent from the industry, perpetuating any number of zombie strategies and underlying zombie companies.

From the 60/40 Model to Alternative Overload

Traditional 60/40 Allocation

⬇

Yale Endowment Model

⬇

Alternative Investments

It transpired over several decades, as the institutional investment model morphed from a traditional 60/40 public equity/fixed income allocation to the famed Yale Endowment Model. The newer approach was conceived to provide endowments and other scaled longer-term investors with further diversification into then emerging alpha pools in private assets. Such assets were associated with higher returns characteristic of extended risk, nascent development, and asset class immaturity. This evolution allowed many asset allocators to achieve positive returns with perceived lower “risk” away from visible daily marks, all coincident with a well-timed secular market backdrop of declining interest rates.

Low rates, as well, catalyzed other capital markets developments over the last quarter century – and a mushrooming of firms seeking to capitalize on associated fund flows toward “alternatives”, however defined. These pools have included private equity, hedge funds and a resulting massive re-allocation of any remaining public equity exposure to passive instruments. In general, an overwhelming amount of overall investor attention has been focused on the “clever” over the last 30+ years, with an associated tolerance for sometimes egregious fee structures and opacity in exchange for apparent uniqueness of attributes in a strategy, not least real or perceived lack of correlation to the general economy and/or the S&P 500.  

Common Investor Missteps and Misconceptions

As public and private market capital further crowds into a burgeoning array of alternative investment products – from private equity to hedge funds to private credit to index funds and ETFs – new and different market inefficiencies have naturally emerged as a result, some now hidden in plain sight.  We believe a majority of institutional and individual investors under appreciate how meaningfully the ground has and will continue to shift beneath them. Many have neither internalized, nor proactively positioned for the natural homogenization of, and danger to, asset returns as “alternatives” further proliferate and the cost of capital, equity and debt, coincidentally move higher from generationally low levels.  These investors as a group, broadly:  

  • Mistake clever for intelligent

  • Perceive dampened volatility as dampened actual risk to capital

  • Associate “alternative/private” investments with “differentiated/non-correlated”

  • Misconstrue illiquidity as an asset than a liability, paying a premium than receiving a discount

  • Ignore private investment net relative performance and IRR manipulation tools

Notwithstanding current conventional wisdom and equity market realities, Royal Elk principals acknowledge innovative, forward-thinking asset allocators aware of the differentiated opportunities this lopsided environment presages.

We believe that broadly, down-market, frequent lack of scale and/or operating leverage exposes meaningful alpha to be harvested with thoughtful and well-timed deployment.  Together, there are opportunities to align.