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Lessons From Institutional Investors, With Melanie Pickett
Institutional investors have helped lead the way in the alternative investment space for decades now. Along the way, they have learned the best practices for success when it comes to illiquid and private investments.
Melanie Pickett, executive vice president at Northern Trust, joins Andy Hagans to discuss lessons that individual investors can learn from the largest institutional investors.
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- An overview of Melanie’s background in finance, including her prior role at Emory Investment Management, a top 20 endowment investment program in the United States.
- An overview of Northern Trust, and how the company fits in to the larger alts ecosystem.
- Whether institutional investors are over- (or under-) allocation to alternatives in 2023.
- How the most sophisticated and largest investors approach the due diligence process.
- Lessons that family offices and individual High Net Worth investors can learn from how the largest institutional investors invest in alts.
Mentioned In This Episode
- Emory Investment Management – Official Website
- Is The Ivy Portfolio Still Relevant? With Meb Faber (The Alternative Investment Podcast)
Today’s Guest: Melanie Pickett, Northern Trust
About The Alternative Investment Podcast
The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.
Andy: Welcome to the show. I’m Andy Hagans, and today, we’re talking about alternative investments, IV portfolios, endowment models, all kinds of really interesting topics. Joining me today is Melanie Pickett who’s executive vice president at Northern Trust. Melanie, welcome to the show.
Melanie: Hey, Andy, thanks for having me.
Andy: And, you know, I was really excited to talk with you as I read about your background. I did a little research because you got your start, it looks like, in the endowment investment world, or at least that was in the beginning part of your career, and I wanted to ask you about that. Why don’t we start with that? Is that where you actually started your career, was at an endowment?
Melanie: Sure. I spent the first half of my career at Morgan Stanley focused on private wealth management and our operations and technology strategy there. But my job at Emory University as chief operating officer for the endowment was my first job in what I would call kind of the institutional side or the buy-side.
Andy: Okay. So you got your start in the institutional side at Emory, and I was not aware, so was Emory one of…even then, were they a top 20 endowment?
Melanie: Yeah. Always kind of hovering top 15, top 20.
Andy: So that’s pretty big. Okay. So how big to be a top 20 endowment? Obviously, Harvard and Yale, I just presume, are the top two. I guess I don’t even know that for a fact, but I presume. So what makes you…?
Melanie: Yeah, I mean, at the time that I was there, I think we had about 8 billion under management, and that was across the endowment, our retirement funds, operating capital of the university and the healthcare system.
Andy: And so endowments, I mean, they’re basically perpetual, right? Is that like a legal mandate or a mandate from the institution to have an endowment be perpetual?
Melanie: There are, you know, stewardship guidelines certainly with what you can do with the funds that are invested. And the way that most endowments are structured is that, you know, you’re trying to preserve and grow the corpus and then, you know, give off at least kind of 4% to 6% depending on the institution back to the endowed function. So, our job was to preserve the capital, certainly, but also to grow it. And your investment horizon is perpetuity for these institutions, and that makes the job of investing and the job of, you know, asset allocation really difficult, but also really fun for those who are fortunate enough to work for endowments.
Andy: And, I mean, that mission or the idea of perpetually protecting and growing wealth while also throwing off 4% to 6% income. I mean, that’s the dream, right?
Melanie: Plus the rate of inflation, right?
Andy: Yeah, exactly.
Melanie: Because that can even go higher, yeah.
Andy: Yeah, in real terms. I mean, I guess that’s part of the protect and grow in real terms. I feel like that mandate or mission is like it’s at the heart of so many family offices. It’s almost like the secret dream of every investor, right? Not necessarily 8 billion AUM, but to be able to amass that sort of a nest egg that you can live off of your, you know, passive income from your nest egg. And then there’s this PWR, right? The Perpetual Withdrawal Rate, I think I have that correctly. Which 4% to 6%, that seems like a really tall order, right? Was it a tall order when you were at Emory? I mean, it’s a tall order now. Was it a tall order then?
Melanie: Yeah, I mean, some years, certainly. And I think that, you know, endowments try as much as possible to explain to their board and to their donors that that’s an annual sort of rate of return over time, right? So, some years, you’re up much more and some years, you’re down. The standard deviation, you know, can be quite extreme. But I think that to your point about kind of the mission, endowments and foundations are able to attract incredible talent because they are full of people that are inspired by the mission of their organization. I, you know, went to college on a university scholarship. I’m the daughter of, you know, two public pensioners, the granddaughter of a policeman. And so I too am inspired by this group of investors. And I’m really fortunate to run the asset owner business at Northern in the Americas, which is all of our endowments foundations, public plans, healthcare institutions, insurance companies, and corporations.
Andy: Got it. Yeah. So, okay. To the endowment, I wanna speak about it just a little, if I even talk about my own experience. So, I’m obviously hosting the show, the “Alternative Investment” podcast. And, you know, when I started the show with Jimmy, it was like, “Well, of course, I invest in alternatives.” I love alternatives. You know, I invest in them all the time, but it got me thinking over, like, the first 20 or 30 guests. I’m like, “Well, where did that idea come from? Why did I decide as an individual because I’m not an endowment?” And I was thinking back, and, you know, one of the biggest things, number one, because I’m an entrepreneur, I learned you can make money easier in the private world many times than with publicly traded stocks. But another thing, I read a book by Meb Faber about, you know, the IV portfolio and David Swensen and, you know, through his book, I was just really inspired by the whole idea of the IV portfolio, and I’m, like, looking back at it, I’m like, “I think this podcast wouldn’t exist if it weren’t for the concept of the IV portfolio, that specific book.” So, I wanted to ask you at Emory or maybe even if you’ve networked with some of these other larger endowments, at that time, were they all following that similar IV portfolio playbook? Or was that still something that was kind of unique to Yale?
Melanie: Yeah. I mean, certainly, there were endowments back in the ’80s at the beginning of private equity really that were starting to invest in, you know, KKR and Carlisle Blackstone, you know, at the beginning of those companies. And so I think some endowments have more experience than others, certainly, in the asset class. But at the point, you know, that I was working at Emory, I would say most institutions had at least to 20% exposure, somewhere up to 50%, or 70% in the case of some institutions. Yeah, I think, you know, David Swensen, obviously, is the master of the universe in that industry, but he was very clear even in his book, right? That access to managers and access to strategies is constrained. And so not everyone can implement a high-quality portfolio and be invested 50% to 70% in alternatives. But certainly, you know, there’s widespread adoption and it’s growing. We see in our own client base, you know, at Northern that clients are increasing their investments in alternatives year over year across every investor type.
Andy: Oh, okay. So, that’s interesting to me because we’ve had a couple guests on the show, I’m thinking of when we had iCapital on, or some other guests talked about some institutional investors have more or less met their portfolio allocation to alternatives so that more of the growth… It’s generally thought within the industry, more of the growth is gonna come from that individual investor, that, you know, self-directed, high net worth investor or even RIAs or other advisors and, you know, they’re groups of clients at Northern Trust. Are you still seeing, you know, growth, I guess, coming from that institutional client base?
Melanie: Yeah, I mean, it’s an interesting thesis with respect to how retail, you know, or why retail alts will grow. I think that most institutions do have an asset allocation policy that’s typically governed by the board. And, you know, in a period of time where evaluations were really high, those market values and those allocations were exceeding in many cases the target allocation for a lot of institutions. And then, you know, the whole sort of game and alternatives relies on a circularity of cash. And so if companies aren’t being sold, then money’s not being distributed back, then you’re not opening up, you know, room in your portfolio for new investments. We’ve seen a lot of our clients go back to their boards and ask for, kind of, temporary relief on the asset allocation just so they can continue to make new deals because what happens, you know, as the existing funds run off, they will not be anywhere near their target asset allocation, you know, three, five years from now if they’re not doing deals now.
So, I think, you know, most boards are sophisticated enough to understand kind of the dynamics and the nuance behind building that type of mature portfolio, and they know that they can’t take the gas off the pedal. A lot of investors that took the gas off the pedal right after the financial crisis lost out on some really great vintage years because they, you know, dramatically dropped their allocation to making new deals, and then they weren’t able to reap the harvest that came out of some of those vintage years. I do think that, you know, there’s plenty of room to grow in the institutional space too, in addition to, you know, what’s happening in the retail space. So, insurance companies are starting to certainly diversify their portfolios more into alternatives. We have, sorry, proposals considering it in DC plans, and then certainly we see in the family office space and in the public pension space those allocations growing as well.
Andy: Yeah, it’s interesting. You know, I had one family-office guy on the show, he manages his own family office, and this was off the record, it was on the show, but I asked him how much he allocated alternatives and he said 99%. He was serious. I was like, “Wow.”
Melanie: It’s not too surprising.
Andy: No growth coming from him, obviously, although, you know, growth in the sense that as this portfolio achieves returns, he can reinvest it. But one other thing you alluded to was, you know, some of these institutional investors may be technically overweight or were technically overweight, and so they might need, you know, special approval or whatever. I mean, is it a problem? I mean, I look at you here of BREIT, you’re comparing that to publicly traded REITs and I’m thinking there’s just a difference in valuation right now in private markets versus the public markets, at least with real estate. You know, I don’t know necessarily about any of the other asset classes, but do you think that’s holding some institutional investors back right now in the sense that it’s… I mean, if I can be quite frank, you know, probably the book value of some of these private assets is inflated, and so may maybe they aren’t actually overweight,
Andy: If someone appraised everything, you know, honestly.
Melanie: It helps and it hurts. I mean, I think a lot of investors and alternatives benefit from the fact that there’s a smoother curve to valuations, right? And they don’t mark to market, you know, as aggressively as the public market. So, I think it would be disingenuous to say that investors want them to mark, you know, on a daily basis because certainly, they benefit from it being a little bit smoother. I talked to a client last week who said that they’re just starting to get the 1231 valuations in from their private funds, and venture, you know, did not mark down as aggressively as they thought it should. And then, you know, in some cases, buyout funds and others were actually, you know, up in market value. So, I don’t think we’re gonna see this dramatic write-down that the industry was expecting to have happened in the fourth quarter of the year.
Andy: Interesting. How much do you think… Well, you know, kind of zooming out…I mean, I have to say I think it can be a good thing, a little bit of pain can be a good thing, but seeing like a BREIT in the news, in “The Wall Street Journal” talking about gated investors trying to get out of that and those valuation differences. Do you think that that kind of headline risk, does that affect anything on the institutional investment side, or is it just kind of stuff that everyone’s understood for years and nothing new to see here?
Melanie: Yeah. I mean, I think institutions are well accustomed to gates, both client-specific as well as fund-level gates. And so they understand certainly those that were investing in alternatives after the financial crisis in 2008 understand how that works and the risk that they’re taking from a liquidity perspective. And so it does take a certain size and type of risk appetite to be able to lock up your funds. And presumably, that’s what you’re getting the premium for, right? Is that you’ve accepted this illiquidity. I think that’s what feels most dangerous for me with respect to retail alts, or the democratization of alts is just making sure, you know, having grown up in a brokerage background, we wanted to always make sure that our products were suitable for clients. And so you have to make sure that your clients have that understanding of liquidity and valuation and transparency and some of the things that, you know, aren’t problems necessarily in the public market space.
Andy: Yeah, that’s interesting. You know, if my listeners can forgive me because I keep going back to the same metaphor, but you mentioned working in a, you know, brokerage background with some of these products, to me, you can’t be half pregnant, you’re either pregnant or you’re not pregnant, there’s no half pregnant. And so with liquidity, it’s either liquid or it’s not. When you see this rush to the exits with BREIT, then you kind of ask yourself, “Well, you know, did these investors really understand what they were investing in at the beginning? Did they think that this was going to be liquid?” Of course, it was liquid when everything was going perfectly fine, it was liquid when this…
Melanie: And did they read the prospectus? Are most people really reading, you know, a 200-page private placement memorandum, or, you know, prospectus on a product like that? And frankly, I don’t think most people are outside of it, yeah.
Andy: Right. And, I mean, I’m a little bit of an industry cheerleader, right? Because I like democratization, I like increased access, and I love alternatives, but to your point, you have to understand them, right? And so on that note, you know, how does Northern Trust fit into the larger alternatives ecosystem? I understand you work with a lot of institutional investors, so could you kind of describe to us for those of us who aren’t familiar with Northern Trust, you know, what the company does and where your role fits in?
Melanie: Yeah, so we’re a global custodian, 135 years old. We have two major businesses, wealth management and then asset servicing for institutions like we’ve discussed. And, of course, we have an asset management arm of the firm, which is managing over a trillion in assets on behalf of our clients as well as third parties across the industry. Our clients at Northern Trust are responsible for about 2.1 trillion in alternatives. And so across my group, we’re servicing about 90,000 different positions that are held by our clients, and that means we’re taking in, you know, information from the general partners managing the capital calls and distributions for our clients, the accounting entries, but more importantly, to our clients managing all of the investment data, portfolio data that they need in order to, you know, assess their asset allocation, their manager selection, and their overall performance in the portfolio. So, we not only do the custody, you know, which is sort of table stakes for a custodian, obviously. We do a lot of additional middle office and front office services on top of that, and that’s how I came to Northern. I was a client before and started a new business at Northern that we call Front Office Solutions focused on, you know, building a holistic portfolio management solution for both public and private assets.
Andy: Got it. So, as you described some of these big numbers and front office, middle office, I don’t even know all the terms because I’m not…I talk about the industry, obviously.
Melanie: You’re not an industry geek in custody, you shouldn’t know the terms.
Andy: Well, there you go. You know, but I guess you’re in an interesting position, Melanie, because you worked at an endowment, so you’re kind of an end user, I suppose, of the products and then now, kind of service provider. And during that time, gosh, there’s been so much change even in the past 5 years or 10 years with technology and so many areas where friction has been lessened. I mean, there’s still too much friction, don’t get me wrong, but there’s a lot less. So, you know, how’s your experience been with technology? How has the, you know, technology really changed the client experience and changed even the business for Northern Trust?
Melanie: Yeah, I’ll talk about some of the good ways it’s changing and then some of the ways that it’s changing that are almost tougher on the clients. But first and foremost, you know, it’s a paper-based industry. There’s no clearinghouse or central, sort of, repository of information. So, in my prior life, you know, we received 35,000 plus communications a year from our managers, and most of our clients are in the same situation. They have to even hire people whose full-time job is to manage the incoming correspondence from their general partners and from their managers. So, one of the things that we’ve been leading at Northern over the last couple of years is just, how do we digitize this paper-based process. And, of course, every investment manager, if you have 150 investment managers, you have 150 different formats of information that you’re receiving from them, there’s no standard.
And so just the job of going out to all the investment portals, getting the documents back in hand, digitizing, and, you know, curating kind of the information that you need out of those documents and then starting your operational workflow, we’ve been able to reduce a lot of that friction for our own operations team, you know, but for our clients. And so that’s, kind of, in the area of document digitization or document management. I think the rise of a number of FinTech solutions has been really helpful for our clients. So companies whose full-time, you know, purpose is to solve x-problem or y-problem, what we’re seeing clients do now is, kind of, take a step back and after acquiring, you know, 5 to 10 different software solutions in their investment office, they really are small groups and they don’t necessarily have IT resources that can kind of integrate those 5 to 10 pieces of software. So, we certainly see a lot of inbound demand for more holistic solutions such as front office solutions so that they don’t have to have, you know, a lot of different vendors and pieces of software that they’re dealing with.
I think one of the more interesting things is that because data has become much more readily available on portfolios, and as soon as you’re able to, kind of, extract it from these documents, you then really have it in hand. A lot of our clients are struggling with, what data do I need to know and need to track, and what do I do with that? So almost…
Andy: You’re talking almost like a data overload. The problem is, is there’s so much information inbound, you know, you might…not that Emory or somebody would have an organization like that, but it almost is so hard to sort through it that you don’t even know what to act on. Like, do you think that’s a… Is that a serious problem with these institutions?
Melanie: I think even for institutions, you know, that are top 20 institutions, I had a client recently who analyzed their private markets portfolio. Now that their company is, you know, Northern Trust and others that track the underlying holdings for clients, what they figured out is that 50% of their private equity portfolio were actually public holdings. And so I got a call like, “Okay, now what do I do with that information? Does that mean I should try to value my portfolio and mark those assets to market? Does it mean that I should be doing something different now that I know that is my asset allocation, really 50%, you know, private markets if half of that is public?” And so I think there are…you know, the more data you get, the more questions you’re asking yourself about, “Do I really need to track this data and what do I do with it? How is it changing my decision-making?”
Andy: So, that’s interesting. I mean, I’m thinking if I’m working in that job, gonna shoot, I wish I didn’t learn that piece of information, it just created a bunch more work for me, right? But when you’re talking about investors or family offices, you know, with your own money, you don’t really have the luxury of not acting on that information, right? I mean, what lessons, you know, working with institutional clients, you know, having worked at Emory Investment Management, do you think there are any lessons that individual high net worth investors or smaller family offices could learn from how these larger institutions manage their portfolios?
Melanie: Yeah. I mean, I think, you know, what we’re seeing across large institutions is a shift away from what we would call strategic asset allocation having these buckets like public markets or public equities, private equities, fixed income. We’re seeing, you know, organizations move towards what’s being called Total Fund Management or total fund allocation, which means they’re really looking through to the underlying exposures and setting targets for certain factors or, you know, certain more granular asset, or instrument types. And so our clients are almost not even seeing things as public versus private anymore because most of your public managers and hedge funds hold private assets and most of your private managers hold public assets, and so what do those words, you know, really even mean? And so most of our clients are really looking at their underlying exposures more so than these big, kind of, buckets that don’t really serve the market well.
So I think, you know, thinking about the portfolio, not necessarily as private versus public, but really, kind of, understanding what do you want to be exposed to, and then what are you actually exposed to? And the more alternatives you have, the more challenging that is because you don’t necessarily always have, you know, full transparency into what your managers are holding. And so, liquidity, evaluation, transparency, these are all really things that become more difficult, you know, the more alternatives that you have in your portfolio. And so you either have to have a tolerance where, “Don’t ask, don’t tell.” You understand that that part of your portfolio is not transparent, it’s not being valued daily, you can set that aside and not worry about it, but for the client that’s logging in every day, multiple times a day to look at their performance or think about the trades they wanna make in their personal portfolio, this is not the asset class for them.
So, I think that those are some of the things that certainly that we would think about. I think SVB and, you know, FTX have taught the world a lot about due diligence and what it means to do really good due diligence on your investment managers and understand how they’re managing your risk on your behalf. And so the due diligence that, you know, investors were doing in FTX or are doing in Silicon Valley Bank probably should warn people that due diligence is a real serious function. So, when I was at Emory, I built out our due diligence program and we did operational due diligence on hundreds of investment managers. And there’s really kind of a nuanced understanding that you need to know about all the service providers, all the risk that they’re managing in-house. And so I think a lot of people have taken that for granted, but some recent events, I think, are starting to open eyes towards the importance of due diligence.
Andy: Yeah, that’s interesting. Melanie, you touched on so many points that I wanna follow up on. Well, one thing about the underlying exposure, you know, because I was speaking with an ultra-high-net-worth investor, this was a couple weeks ago. And he was talking about investing, you know, direct deals in real estate and how, you know, they’re beginning to be…in his words, they’re beginning to be attractive again, not even though they are attractive, beginning to be attractive. And I asked him in reference to his family office, you know, have he thought about buying some publicly traded REITs even as a tactical allocation because underlying assets could probably be purchased more cheaply to that vehicle. He looked at me like I’d grown a second head like, “What, are you crazy? Why would I buy a REIT?” But, I mean, I’m thinking of it from, like, a textbook perspective. Like this is the asset class, it’s real estate, you can buy it through 50 different rappers, right?
Melanie: Yeah. I mean, I think the, you know, the efficacy or the way that you implement your investment view, right? You have a lot of options. You know, we certainly have a lot of investors who are just taking synthetic exposure in things like large-cap equities. Why even deploy the capital required to get that data or get that, you know, exposure in their portfolio? So certainly, there are lots of techniques, but I would say that there’s some, you know, interesting work that happens in endowments and foundation portfolios as well with respect to how they think about a certain strategy. And some of that’s really nichey, right? And individual investors don’t have time to think about the oil and gas market in Norway or whatever it is. And so I think that, you know, you have to kind of play to your strengths, and if your strengths aren’t, you know, doing that deep due diligence in nichey strategies, then that’s great. But not all institutions can do that, so they have to stick with more easy-to-understand assets.
Andy: Well, you know, you really alluded to something there with the due diligence thing, and that got me thinking because due diligence is a challenge with self-directed high-net-worth investors, right? All the way up to individual family offices is a challenge for family offices, even in the institutional world, I guess the smaller institutional investors because, to your point about SVB, there’s just so much to diligence. As an individual investor, or when I’m coaching people, I usually coach… The most important due diligence for me is like at the sponsor level, at the people level, like at that top level, like, of course, an individual product, like absolutely an individual deal, absolutely. But, you know, kind of that long-term track record. But when you put everything together and you say, “Okay, I need to do due diligence at the sponsor issuer level, I need to do due diligence at the project, or product level, or portfolio companies, you know, as a VP fund.”
Melanie: Yep. And then there are service providers.
Andy: And then there are service… I’m just like, “Well, at a minimum, well, number one, I don’t have time, but number two, that sounds extraordinarily expensive.” Is that even possible for anyone besides, like, the largest institutional investor or if you had to triage it and prioritize, you know, where do you think that investors should start?
Melanie: I think most, you know, there are firms, entire firms that specialize in doing due diligence for investors. And certainly, if someone’s using a consultant or an investment manager kind of intermediary between the alternative and them, they can due diligence that investment manager or that consultant’s practices, and probably feel pretty good. I think, you know, if you’re going in doing your own due diligence, part of it is, you know, to influence…to understand what you’re going into, and then part of it is to influence the investment manager. And frankly, a lot of individuals would probably have a hard time making the investment manager change their practice, but an institution like an endowment or a foundation can have a lot of influence on an investment manager if they find something in the due diligence that they think, you know, should change. But, you know, having done operational due diligence on investment managers, certainly, the investment strategy, the investment risk, and the people are important, but we’re also looking at all other aspects of them running their business. And I think if you had to narrow it down to a few things, you would focus on valuation. How are they valuing those assets? How frequently? Do they have the right controls? Who’s voting on it? Can they change, you know, valuation methodologies quarter over quarter? How stringently are they audited on valuation? Valuation is really important. And then I think, you know, just cash, how is cash managed? Who can move cash? Who can redirect cash? Cash and valuation tend to be the top two things that you would focus on.
Andy: Wow. Yeah, I mean, I can’t argue with cash. I mean, that’s basic controls, you know? So, yeah, I can’t argue with that.
Melanie: Lots of bad behavior that can happen when, you know, someone…a small firm has access to hundreds and hundreds of millions of dollars of cash, right? Things can slip.
Andy: Yes, as we’ve seen, or even a large firm, you know, some of these faster moving, you know, stories, FTX, and so on. But, you know, you touched on valuations, and to me, I almost wanna say it’s like an explosive topic right now. Like, it’s controversial or, you know, I don’t know. Talk to me about valuations in real estate, in venture capital, in some of these spaces. How do institutional investors, you know, view these different…you know, these major asset classes right now? In other words, you know, do they think that the smoke is kind of cleared and that we’ve reached clarity, or are we still kinda waiting for the other shoe to drop, or we’re waiting for the sellers to capitulate?
Melanie: I think it’s so much more of an art than a science than people realize. And so there are many firms, you know, incredible venture capital and private equity firms who hold things at cost really until, you know, there is a… So, for the first couple years, even if there are comps that are moving around in the marketplace higher multiples than what they bought the company at, they’ll keep it at cost. There are, you know, firms that are even more aggressive, and so even if you have…sometimes you’ll have multiple private equity funds holding the same position and they’ll market differently, which is really interesting to learn as an investor. I think that there’s really just a wide variety of practices. And so some firms, you know, will choose comps when they do the deal, and they stick with those comps throughout the life of the investment. Other firms or tricks that they can play certainly are changing the comps around to kind of cherry-pick the comps quarter over quarter or change the assumptions in the DCF model. There’s a lot of ways that you can influence the valuation. And what I worry about for our clients is that, you know, as there’s more dry powder, so much dry powder in the marketplace, and companies are going public less and less, if a private company gets sold to another private company, right now, there’s so much capital that needs to be put to work. Private equity firms were buying things at higher multiples than the companies were worth because they needed to put capital to work.
Andy: It wasn’t that… I mean, was that…?
Melanie: And so I think that that drives the comps up for everybody, right?
Andy: Yeah, was that happening in real estate too? I mean, that’s kind of my concern with real estate, is like this, you know, ultra-high-net-worth investor I was talking about who said, you know, “These deals are beginning to be attractive again,” I keep thinking, “Wow, but I wish they were really, really attractive.” But is that gonna happen if there’s so much dry powder on the sidelines that needs to be deployed to your point, you know?
Melanie: I think real estate’s about the valuation, but it’s also income-producing, right? For, you know, a lot of investors, and so that’s, you know, certainly important in this interest rate environment. I think, with real estate, most private funds are probably only marking those portfolios and really doing third-party appraisals on the portfolios, on the positions maybe once a year. And so, you know, in real estate portfolios, I don’t think people should expect that there’s a third-party appraisal and valuation being done on every asset every quarter. It’s typically only happening once a year, so that was something that we learned, you know, in our due diligence that certainly made us dig a little bit deeper on the quality of those appraisals, and frequency of those appraisals. So, I think that’s why when everyone expected a huge write down in private real estate funds, you know, over the course of the last year, most of those private funds were probably not really going to mark until they’re audited financial statements at 1231. You know, that’s when they, you know, have to mark their assets down.
Andy: Understood. Okay. So, you know, I understand you’re working with so many different institutional investor clients and so, you know, I imagine you get to speak with a lot of them. What are they, you know, so kind of individual investors could maybe soak some of this up. What do they see as the threats risks right now, and what do they, conversely, what do they see as the opportunities for this year ahead?
Melanie: Yeah, for these institutions, it’s all about risk-adjusted returns, right? And so everyone that had been really pushing yield into private asset classes sees that they’re going to need to go even further. And so we’re certainly seeing an uptick in things like private credit, direct private equity. So, you know, beyond the GPLP structure, a lot of our investors going directly into operating assets, whether they be infrastructure, farmland, timberland, real estate, and the like. And so…
Andy: That would be like a Yale endowment. You know, I’m so big, I don’t even need to invest in a timber fund. We’re gonna hire our own timber manager, whatever you call that.
Melanie: Managers, and manage those assets themselves. Yeah, and if you think about real estate kind of broadly or farmland broadly across the U.S., the names of who you expect would be managing the most farmland in the country are not necessarily the names you would expect. And so you have to be a certain size and scale to do that, obviously. But we’re seeing certainly, you know, our clients push a little bit further than just traditional alternative funds in the hunt for Yale.
Andy: Does that change? I mean, how do you think that changes the industry if it’s almost like…? I mean, but if I’m connecting the dots of everything you’ve told me that Northern Trust is beginning to get insurance companies as clients who are investing in alternatives, I’m like, “Does this end with insurance companies or owning farmland and local self-storage facilities?” Or like, how does that change the industry? It seems like, you know, you’re pointing to vertical integration almost.
Melanie: Yeah, and, you know, many of our families certainly who come from significant operating companies are starting to manage more of their supply chain. And so you can see their investments certainly becoming much more vertically integrated. I think that it’s a good thing overall for the market. Again, back to your, kind of, original statement around these being mission-driven investors, these are highly sophisticated, highly diligent institutions who, you know, preserve and protect their capital. And so I think that having a seat at the table with those companies directly and having that influenced by those institutional investors is a great thing from a governance perspective, you know, across the industry. So, most of these institutions have… All of these institutions, you know, have great, incredible programs and resources around the companies that they’re operating directly.
Andy: You know, one theme, Melanie, throughout our conversation to me that, you know, just the idea of higher standards. You know, you brought up due diligence and, you know, how you viewed due diligence, and I hear that, I’m like, “Wow, that’s a high standard.” And by the way, I agree with it. Like, it’s not that I disagree, I’m like, “I agree with it.” That is the standard, should be the standard. And you’re talking about these institutional investors, and I mean, it sounds to me like, again, it’s kind of like they’re raising the stakes in the sense that they have a standard, you know, and level of professionalization in their organizations. It’s a good thing. Are there enough talented asset, you know, talented and experienced asset managers? Are there enough talented and experienced professionals to go around to kind of allow everyone?
Melanie: Yeah. I mean, it’s a great question. I just interviewed someone today to run a large alternative investment operations team for us. And, you know, what we’re finding in the marketplace, really just on the service provider side, is getting someone who can actually understand private equity and how it works and what some of this nuance is. That commands a premium in the market. And so certainly, the supply is not keeping up with the demand across both service providers and institutions. And so, you know, we’ve had a couple of clients this year that have lost people in their investment office, have asked us to sort of second our employees into their investment office, almost like we’re a staffing firm because it’s difficult to find this talent. And so I think that certainly, you know, I’ve been focused on trying to identify institutions like universities and others that we can work with to try to grow the talent because, again, we can’t hire enough of it.
Andy: Yeah, wow. Well…
Melanie: Yeah, I do think, you know, these investors are taking this very seriously, that standard of care. But there’s an inclination, I think, by a lot of people. If you look at FTX and some of the early investors in FTX, I think a lot of the subsequent investors said, “Well, if X invested in them, then I’m sure they’re fine,” right? And so people get sort of into this mentality where if Yale, or if Harvard, or if you know Sequoia, if whoever invested in it, then I don’t need to do my full due diligence because I presume that they did a level of due diligence. And I think that’s a little bit dangerous for people, is relying on someone else’s due diligence is a big leap unless you have verified somehow that they did that.
Andy: Do you see that happening with institutional investors at, you know, the same kind of, I don’t want to use the word lammings? I mean, we’re all human beings, right? We all have the same…you know, fall into the same behavioral traps. Do you see that same psychology in the institutional world, or do you think there are more controls or safeguards that prevent that kind of behavior from happening?
Melanie: I mean, you know, it’s a clubby world, right? And so there are certain managers who have very, you know, constrained strategies, capital-constrained strategies, and so you’re all kind of fighting to get in with some of the same managers. And so, you know, in some cases, it’s not even that you’re following the lead of another peer, it’s that, you know, you’re just trying to get in that fund. And if you’re too pesky about the questions you ask for the due diligence you want to do. Sometimes the fund will just pass over you and go to the next investor who’s not asking as many questions, so that dynamic happens. And then I think, you know, a lot of these endowment foundation healthcare organizations are small organizations managing really complex, you know, global multi-strat funds that are being managed with a tiny little staff in some cases. And so it’s not that they, you know, don’t take due diligence seriously, but they just don’t have the resources to do it fully each and every time. And that’s where, you know, we really see people that are leaning on a due diligence firm or an investment consultant who can help, you know, scale that due diligence for them.
Andy: So, would that be… You know, I know we’re running short on time, but I kinda wanna bring this back. You know, you work with so many institutional investors, you know, you worked at Emory Investment Management, Northern Trust is kind of really ingrained in this ecosystem of all these larger and more professional investors. And so, you know, it sounds to me like you’ve really soaked up a lot of best practices that are important, right? They’re really more than best practices, you know standard of care, I think, was almost like medical terms. When you’re a custodian of others’ money or a steward of others’ money, and you have this mission that goes beyond just, “I’m trying to get rich or whatever,” you know, you have to take this stuff more seriously. So, you know, if you’re a smaller family office and, you know, you’re trying to invest in alternatives, what helps you fill in the gap? Is it just, you know, kind of understanding, “Okay, these are the needs, we really do need this high level of due diligence, but we can’t do it ourselves, we don’t have the expertise or budget, so we partner or outsource strategically?” Or what does that model look like for a smaller family office?
Melanie: Yeah, I mean, I think, you know, what we see most institutions doing is certainly partnering our outsourcing, co-sourcing the activities that are not value added. So, if you’ve got a limited group of operations professionals, you don’t want them, you know, grabbing documents from portals and keying transactions into a system, you want them focused on those higher value add activities, like due diligence. And so certainly at the bottom of the value chain of tasks, you know, we see a lot of institutions partnering with service providers and vendors who can start to perform those functions for them. I think there are other ways to protect yourself. You know, I think there are a couple of little-known nuances in the industry. One, the fact that a lot of investment managers refuse to take fiduciary duty in the alternative space, which I think is criminal, but if you can kind of legally protect yourself with respect to fiduciary duty, that can absolve a lot of the risks that you’re trying to identify in an operational due diligence practice.
The other thing is that most private equity funds are not being audited to the capital account partner-level capital statements. And so, you know, an auditor will come in and audit the fund, but they’re not auditing that your allocation and your activity with respect to how the legal document portrays, you know, how fees are paid, how compensation is paid, that’s not being audited for you. And so it’s not very expensive to ask the GP to have capital accounts audited as well. And so many, you know, general partners, when we would ask for that, would say, “Oh, it’s gonna cost $5,000. Well, okay, we’re, we’re happy to pay that because that $5,000 is a great investment with respect to knowing that, you know, the general partner is doing right by you from a financial perspective.” So, you know, there are tips and tricks that, you know, can help you mitigate your risk without having a full due diligence offering. But that’s, you know, some of what I would suggest.
Andy: I love it. Melanie, I know we’re running short on time, but I love these little insights into the world of institutional investors, how they think, how they operate. And I do think it’s good, even if smaller family offices or high-net-worth individual investors, if they can’t implement, obviously, those same systems, they don’t have that same staff. I still think it’s wonderful to just, kind of, soak up that mindset and to understand, “Okay, this is how the pros do it. You know, like, literally, this is how the pros do it.” And so at least you kind of know that’s out there and, you know, you can kind of do some self-reflection if you’re an individual investor like, “Okay, I invested in this private equity fund or that private equity fund. Realistically, did I even do any due diligence, or if I did, what kind or what authority did I look to?” So I just think soaking up those best practices is really valuable for our audience. And that being said, Melanie, where can our audience of advisors, high-net-worth investors, and family offices go to learn more about Northern Trust?
Melanie: Yeah, so northerntrust.com/solutions is the best way to find out more.
Andy: All right, sounds good. And I’ll be sure to link to that on our show notes as well. Melanie, thanks again for joining the show today.