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As disruption continues in the fixed income market, many family offices are maintaining and even increasing their allocation to private credit.
Brad Conger, deputy CIO at Hirtle Callaghan, joins Andy Hagans to discuss why private credit and other select asset classes are so appealing to family offices right now.
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- Background on Hirtle Callaghan, and how the firm helped pioneer the Outsourced Chief Investment Officer model.
- A brief history of private credit, including how its typical spread has changed over time.
- Why private credit is an appealing tactical allocation for family offices and UHNW investors in 2023.
- Brad’s thoughts on inflation, and why it may sustain at a fairly high rate for the foreseeable future.
- Other select asset classes that are favored by family offices, given the macroeconomic environment and several powerful secular trends.
Today’s Guest: Brad Conger, Hirtle Callaghan
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 private credit. Everyone, excuse my voice. I’m fighting some allergies right now. But I didn’t want to delay today’s recording, today’s episode. Private credit has absolutely exploded in popularity among family offices, among high-net-worth investors. And joining me today is Brad Conger who is deputy CIO at Hirtle Callaghan. Brad, welcome to the show.
Brad: Thanks, Andy. Thanks for having me.
Andy: And in particular, you know, I really wanted to speak with you about how your firm helped pioneer the outsourced chief investment officer model because we’ve had, you know, plenty of family offices on the show. And increasingly, you know, there’s so many multi-family offices, shared family offices, there’s sort of this, I don’t wanna say gray area, but, you know, spectrum, whatever you want to call it, between a high-net-worth who’s working with an advisor and a true, you know, single-family office with whatever, $500 million in assets. So, can you tell us more about this model and maybe the history of this model?
Brad: Sure. So, our founders, Jon Hirtle and Don Callaghan were in the securities division at Goldman Sachs, and they were covering families around the Philadelphia area, Western Pennsylvania, and Ohio. And one of the things they identified is that many of the best-performing family offices were open architecture. They hired best-in-class managers, and they negotiated hard on fees, and they weren’t beholden to any single provider.
And so, they started this business in 1988 to basically take the learnings, those learnings to a broader audience, not just the billion-dollar family offices, but families that have $10 million, $50 million, and $100 who probably couldn’t afford to have an internal CIO and staff to analyze investments. But we insource that talent or recreate that talent and then provide it to much smaller family offices. And those families introduced us progressively to their favorite institutions, libraries, hospitals, etc. So, right now, our business is about half families and half institutions. But that’s the origin of the business.
Andy: So, you know, I guess help me compare or contrast it to, like, an RIA or fiduciary or, you know, financial advisor. You know, is it like the family office still has an executive or manager, but maybe they’re not specializing?
Brad: Yeah. A lot of times, the family makes a decision about what skills they want internally. And, you know, obviously, that’s primarily deal-making skills like quasi-investment banking because a lot of families like to do direct deals and buy businesses, because that’s, in many cases, how they made their wealth, and they’re comfortable with that. There’s obviously a treasury function, a CFO function.
And then there’s the choice whether you hire an internal CIO and staff. And that’s where…that’s the line of demarcation, like, if you do that internally. And we work with some where they have internal staff, but we provide advice to parts of their program. But usually, in most cases, the families that engage us have an internal finance, investment banking function, and accounting, auditing, etc. And then we are the investment advisor.
And in many cases, those families will give us what we call prescribed discretion. So, we have a view of all of their assets, they have legacy assets like operating businesses. We incorporate that. Obviously, we don’t bill on those assets, but then we design a complete investment program around their particular fact then.
Andy: Interesting. So, if a family owned…you know, directly owned some sort of legacy business at a certain industry, you might be designing the rest of the portfolio, not as a hedge, but, you know, that would be complimentary to the fact that they’re very concentrated in this other industry?
Brad: Absolutely. And we have families who have, very often, real estate assets. That would be the classic case. And for those families, you know, if it’s income-producing real estate or if it’s development, that means we’re going to de-emphasize real assets for the pool of assets that we manage, understanding that they have that covered in their assets.
We have families that have businesses that are very cyclical, so providing automotive components, industrial CapEx. And so, the portfolio we construct is going to incorporate that cyclicality. In other words, we are gonna have a portfolio that is more skewed to growth and defensive characteristics, bearing in mind what they have as part of their, you know, total asset package.
Andy: Interesting. And, you know, I know every family is different. But I guess I’m curious if you could…if it’s even possible to imagine a typical client, maybe that’s not even possible in the family office world, but, you know, how much of their assets tend to be directly owned, you know, businesses or real estate assets versus what they’re outsourcing that’s a more normal, you know, liquid portfolio or LP type investments?
Brad: So, there is no typical. But what we see is, in many cases, we are the first outside capital after a liquidity event. And so, you know, a family has a business that’s been in the family for 40 years. They have a liquidity event, they sell half the business to a private equity firm, or they have a real estate portfolio that they brought in outside and they liquified, you know, a portion of that.
And so, in those cases, we might be 10% of their overall assets or 20%. But the progression is usually towards a more liquid portfolio in the sense that it becomes less dominated by a single asset. And then obviously, for multi-generational families, by the time you get to generation three, four, by that point, usually, the family holding is simply sort of a memento, sort of a nostalgic holding in the portfolio.
Andy: Understood. You know, talking with families in this world, and, you know, I don’t have a family office, I don’t manage a family office, but one of the things that surprises me, from what I’m told, is a lot of family offices struggle sometimes even getting the basics right. I mean, and they’ll even be honest about it, somehow, you know, if they trust you, meaning, like, you know, doing things like 1031 exchanges or just sort of basic tax planning or basic risk mitigation.
Brad: Oh, yeah. We encounter that all the time. Like, particularly families that have had longstanding operating businesses will tend not to have encountered things like estate planning like GRATs, or grantor retained annuity trusts or CLATs that…devices that are familiar to financial advisors, but an operating family, they’ve really never had to deal with that before.
Andy: Have you noticed a trend of increased professionalization? I mean, is that in the family office world? Do you think that that problem or that challenge is improving over time?
Brad: Oh, yeah. I think what we increasingly see is very professional internal staff and a giant expertise network that’s been built up and, you know, they have family office networks that allow them to sort of trade ideas and best practices. And so, yeah, I think in the past 10 or 15 years, the professionalism of family offices has just skyrocketed.
Andy: Well, on that note, you know, we wanted to talk about a specific asset class today, which is private credit. And just, in the show, in covering all these different sectors within alternative investment, or I should say asset classes, I mean, almost a challenge, but I think a fun part of the show is we cover so much, right? Because what falls under the label alternative investment, well, a heck of a lot, right?
Andy: But private credit in the past six to nine months, it’s not that it’s come out of nowhere, it’s always been there. But the amount of attention it was receiving, and I would just say anecdotally how popular it is. And, you know, from where I sit, you know, the risk-reward that it represents is very, you know, attractive right now. Why is this moment, and I guess, why is this the perfect storm for private credit?
Brad: Well, I think that for 10 years since the great financial crisis, we’ve had very suppressed rates. So, treasury was 1%, 2%, and at the short end of the treasury curve and the muni curve, there was zero. And so, for sure, the Fed’s rate hiking, which started last March, moved rates up 4.5% in the span of about a year. And so, I think that’s the primary driver. All of a sudden, there was yield where there hadn’t been for 10 years.
In addition to that, the public markets became very stressed, and the spreads have widened in credit, especially in private credit. And so, you had two effects. You had the base rates going up from 0% to 5%, and you had spreads widening from, you know, 5% to 6% or 7%. So, all of a sudden, you know, there was yield where there hadn’t been before. So, I think that’s the reason it’s appeared quickly.
Andy: Yeah. And it’s almost counterintuitive because, you know, bond yields, for the first time in my life, and I turn 40 in a couple days, but for the first time in my life, this past year, bonds have been, like, an attractive asset class. I mean, I’m kind of famous for harping on financial repression where I literally have said, to me, how bonds were yielding in the decade prior to last year was, like, borderline unethical, immoral.
I mean, I honestly was outraged by it because if it’s in a taxable account and you’re paying tax on a nominal yield, I mean, and then there’s any sort of management fee, it’s a negative real yield, which I just think is absurd. But now, for really the first time, you know, depending on how far out you are on the risk curve and, you know, duration, all that, maturity and all that, you know, you can actually get a positive yield in the bond market. So, bonds are more attractive, so it’s counterintuitive. But you’re saying even though bonds are more attractive, private credit is, like, exponentially more attractive.
Brad: I wouldn’t call it exponentially. I’d say its relative pricing hasn’t. Relative.
Andy: Well, I exaggerate a little bit, Brad, you know, come on. You’re right. Not exponentially, relatively. We’ll stick with relatively.
Brad: Yeah. Definitely.
Andy: But yields and, you know, 10%, 11%, 12%, 13%, 15%, I mean, you know, I guess, what are even the, you know, universe of reasonable yields that you’re seeing in private credit right now?
Brad: Great question, because private credit to me is like, you know, a Rorschach test. It means different things to basically everybody. It spans everything from non-performing distressed loans to bankrupt companies, reorganization companies, all the way to performing loans or structures that, you know, have characteristics that are really investment-grade, that are basically, you know, single-A rated. So, there’s this broad spectrum, okay?
What we think, our approach is, look, our clients, and probably all of your listeners have tons of equity exposure. They have businesses, they have stock portfolios. When we look at private credit, what we think is interesting is how can we capture yield with the lowest possible risk. Not no risk. So, our view is there’s no reason to take equity-like risk in your fixed-income portfolio, meaning we don’t buy all that… We’re not saying it’s not a reasonable strategy, but we just don’t buy non-performing loan strategies or distressed or workout. And that’s where you’re getting into the mid-double digits, right?
We believe that right now you can make loans senior in the capital structure, first lien, secured by good businesses or assets, hard assets, or financial assets in the area of 10% to 11%. And in other words, there’s so much rich yield at relatively low risk there’s no reason to stretch, go down in quality to take a preferred equity position, or a convertible preferred, or a mezzanine loan that will get you 15%. Our view is just take the 10%. And it’s really a way to get yield at low risk rather than take incremental risk to an equity portfolio.
Andy: I understand. And it is way more attractive right now. I mean, because you’re talking about very high-quality private credit that’s asset-backed that does not have equity levels of risk. And if we rewind with interest rates and bond yields a couple years ago, that kind of private credit may have been yielding 6% or 7%, roundabout.
Brad: Exactly. Yeah.
Andy: And an investor like me, I’m gonna say like, “Why bother?” Like, it’s just not…
Andy: It doesn’t really get my attention. Once you hit double digits, I do think, you know, maybe 9%, but once you hit 10%, I think everybody starts paying a lot more attention. So, that’s really what you’re talking about here, is this 10% or 11%, it still represents, you know, I don’t know if you’d called it the AAA of private credit or whatever, but high-quality private credit.
Brad: Yeah. It’s high quality.
Andy: And so, when families or ultra-high-net-worth investors are allocating…well, first of all, have they always been allocating to private credit in your experience, or is that a new application?
Brad: No, exactly. You know, their view, our view is completely concurrent with what you just said, which was at 6.5% on an after-tax basis, that really doesn’t justify the work, the documentation. But, you know, at 11%, it starts to justify it.
Andy: So, it’s almost a more tactical allocation. I mean, maybe it will be permanent in portfolios, but it’s more just of the moment.
Brad: Honestly, for taxable investors, I think so because, you know, it’s very conceivable that in the next two years, we run into a slowdown of the economy and the federal tax rates down. And all of a sudden, base rates aren’t 5%, they’re 2%, and spreads are more normal, and then you’re back in the single digits. So, I don’t think families should consider this a permanent allocation. I think it’s more opportunistic.
Andy: Interesting. Now, you know, as an investor, I try and think of everything in triple net return framework, right? Net of inflation, fees and taxes, like, gross returns, gross before fees, before tax, before inflation, they really don’t matter, right? It’s not…
Andy: It doesn’t really come back to me. So, like, really, what do I care? So, in private credit, is there any tax-advantaged way to go about it? I mean, you know, the only thing I can think of really would be, you know, putting that allocation inside a SEP IRA or IRA account. Is that really what it is though? There’s no equivalent of municipal bonds in the private credit world, right?
Brad: So, there are insurance wrappers that people at size, meaning more than 25, let’s say above $25 million, can avail themselves up, which is very tax-efficient. But, you know, for anything below that, you’re right, it’s best for the non-taxable assets.
Andy: Interesting. So, I guess, do you have any…? Predictions are always dangerous, but I can’t help myself. You know, since you mentioned that this might be a tactical allocation to private credit, what do you think happens next? I mean, do you think interest rates are going to fall and that the yields are coming back up?
Brad: Well, I think we’re here for a while. And I’ll tell you, this maybe gets into asset allocation, which is off-topic, but, you know, I don’t think inflation is going to disappear, and therefore, we’re in the sort of higher-for-longer camp. Like, we don’t think the Fed is gonna cut rates. And they won’t, as long as inflation stays in the 4% to 5% range. And so, that means… And then in terms of spreads, I think there’s a reasonable chance that these spreads actually persist for a year or longer. So, you’ve got high rates, a combination of high rates and high spreads, and that means that it’s probably worth thinking about. But when I said it’s tactical, I mean on a three to four-year view, not a permanent strategic allocation.
Andy: Well, Brad, you mentioned you’re in the camp of higher-for-longer, and I want to ask why, you know, just what are the specific facts or theories underlying that camp?
Brad: Okay. So, the first is that inflation is resistant. I mean, it was 9% last year, and now it’s 5%. And that first reduction in inflation was very simple. There were supply chain complications and businesses could not get goods. And then there was also the COVID complications. People left the workforce, so labor was…
Andy: That’s the low-hanging fruit…
Andy: …so to speak. Okay.
Brad: And, you know, what we’re gonna face right now, and I mean for the next medium term is businesses, this is unfortunate for consumers, but I think they got the opportunity to test pricing power that they haven’t had in 10 years. And you saw that with Hershey earnings, all the consumer products, Mondelēz, Kraft, and Pepsi, they’re putting up prices 10% in their…
Andy: We see it at the grocery store. We see it… I mean, you, you know, go buy a fast food meal, it’s like $12 now. And you’re right. It doesn’t matter what inflation falls down to. You know, even if it hits the threes, so many of these prices are never going back down, right? So, we’ve all come…
Andy: We’ve lost purchasing power.
Brad: It’s 3 on top of…or 3 or 4 on top of 9, and, you know…
Brad: So, yeah, you’re right. It never goes back. So, that’s one issue, is that…and I don’t wanna blame the companies, but they’ve learned to explore their levers, right? And it’s working. The other thing, and these are sort of very long term, but the green transitioning is real, and it’s gonna cost money. And that means the cost of doing business are higher.
So, you know, we all want, you know, biodiesel, we all want windmills, we all want renewable power, but fundamentally, it’s all more expensive than natural gas. And, you know, the other issue is we learned during COVID that you can’t buy everything from China, right? And that reliance on a single point of failure for a supply chain was very dangerous.
And so, what we’re gonna see is businesses are gonna start…they’re gonna start diversifying their supply chains. They’re gonna use Mexico, they’re gonna use Vietnam, they’re gonna bring some back onshore. These things are gonna be more expensive, right? Because, you know, nothing can be cheaper than producing something at scale in China. So, I think those are things that are secular trends.
And we know…the other thing we know is that when inflation gets high, it gets volatile. So, if you look at the ’70s, right, we breached the 4%, 5% level, it goes to 12%, it comes back to 7%, it goes back to 10%, goes to 5%. It becomes very unpredictable. And so, I think that the combination of those things means it’s going to be very hard to bring inflation out of the system and go back to a world of a 1.5%, 2% 10-year treasury. That’s where I think the Fed will draw the line.
Andy: That’s really interesting. You know, in energy, petroleum, I mean, it’s in everything, right? And even as we shift to renewables, even that requires traditional sources of energy. But as you said, it’s not going away and it’s going to be more expensive, right? It’s essentially if you wanna be green, you have to make due with less. I mean, I think it’s kind of what I’m hearing. I think that’s scientifically true, you know, if you look at energy efficiency. You say it’s not going away though. Is that because of top-down? I mean, is that because of mandates and things? Like, is that really the reason that it’s not going away, or is it…?
Brad: Yeah. It’s a societal choice. And I feel like the momentum is unstoppable now. I think as a society, we’ve made a choice that this is the route we’re going on.
Andy: Yeah. Let’s hope it’s the right one, right? It’s gonna be an expensive choice either way. Well, you know, on the topic of insourcing or diversifying supply chain, you know, do you have…? Your firm, you have this thesis on private credit. Obviously, it’s more tactical. But with those underlying factors that you’ve identified, are there any other investment theses that you know that your firm…you know, looking in the next couple years, so, I’m hearing, you know, sticky inflation, I’m hearing green energy is here to stay. You know, so what other…? I guess from the family office perspective, ultra-high-net-worth perspective, for me, portfolio allocation is never off-topic. You said it earlier in the conversation, you referenced that. To me, that’s never off-topic. To me, that’s always on topic. So, you know, how else is this…are these factors affecting how you advise families or just your investment theses for the coming years?
Brad: It’s not gonna be a surprise. But I think, you know, the amount of innovation in the economy is let’s say…I mean, some of my colleagues say it’s accelerating, let’s say it’s not decelerating for sure. And companies are staying private for longer, we know that, the number of public companies is falling. And so, in all of these trends, we’re talking about new energy, sort of renewable energy, green transition lend themselves to private startup-driven innovation. And so, we do believe that people should allocate to private equity, as well as private credit because much of the value add, value creation will be in the private sector, non-quoted sector.
The second thing is, you know, we have emphasized active managers. So, we don’t do…we don’t pick any stocks internally or any securities internally. We hire best-in-breed managers and equities, small, large, international. And I think that skill, you know, they’ve had a…but they’ve had a rough time when rates stayed low, and all you had to do was buy NASDAQ. I think active managers, stock pickers got a bad reputation, right, because, you know, if all you have to do is buy Apple, Microsoft, Google, Netflix, Meta, it made stock picking look easy, right?
Brad: And I don’t think it’s easy. And so, we have emphasized managers who can identify changes in trends, changes in underlying competitive dynamics of businesses, and allocate capital dynamically in that environment. So, both, you know, opportunities in private, opportunities to make active selection decisions are important.
Andy: Absolutely. And that’s interesting, you know, you mentioned innovation and investing in private equity. I don’t know if, you know, in your verbiage, if that includes venture capital or…
Brad: It does. Yeah.
Andy: So, my question on that is, I mean, I totally agree that the pace of change is not decelerating. Maybe you can’t say it’s accelerating because it’s already very high. But it seems like right now, in the venture capital world, maybe private equity world, the secondary market is offering discounts, right?
There’s just these certain little pockets, like, with publicly traded REITs. It’s like, “Hey, this is on sale, like, you know, even if you wouldn’t normally buy this.” Like, I’ve mentioned to family offices, “You love direct deals in real estate, I get it. I do too. But publicly traded REITs just might be better value right now.” And I’m thinking, you know, I know GPs at venture capital funds, and I love ’em, and they’re doing amazing things, but I’m thinking for my LP money right now, today on, you know, May 11th as we record this, thinking, “I might be trying to buy stuff on the secondary market at a 30%, 40% discount.”
Brad: Absolutely. So, you know, I agree. It’s true in both those sectors. I think the discount of REITs to the NAV of REITs to their public valuations is higher than it’s ever been. Obviously, there’s lots of issues. And so, we would rely on active managers too. We have a REIT specialist. And that’s something we’re considering. I totally agree, secondaries. Although we have…we raise vintages of private equity that we commit, and our recent vintage has a lot of dry powder. And so, to the extent companies are being created today at more favorable valuations, it’s sort of the same argument you’re saying, “I can buy an existing fund at a discount.”
Andy: No, that’s a good point, because even if you’re deploying new capital today into a new round at today’s valuation, it’s probably gonna have roughly the same discount.
Brad: Same opportunity set. Yeah.
Andy: Well, Brad, thank you so much for sharing your insights today. I always like to hear about the family office world. You know, I’m not directly in the world, but I talk to so many people in it. And it’s really interesting how the ultra-wealthy invest their money, how families invest. I think there’s a lot that high-net-worth investors can learn from that. So, thank you so much for being so transparent, sharing your knowledge with us. And that being said, where can our audience of high-net-worth investors go to learn more about Hirtle Callaghan?
Brad: Thanks a lot, Andy. I enjoyed the conversation. If any of your listeners are interested, they can go to www.hirtlecallaghan.com and find out more information.
Andy: I’ll be sure to link to that in the show notes as well.
Brad: Great. Well, thanks a lot. I enjoyed talking to you.
Andy: All right. Thanks, Brad.
Brad: All right. Bye-bye.