Secondaries Investing for Insurance Companies

Stewart: This year, the volume in the secondaries market is going to top a $100 billion for the first time ever. A lot of money's flowing here. We want to talk about it. It's not something we've talked a whole lot about. My name's Stewart Foley. This is the Insurance AUM Journal podcast. And today we're joined by Chad Alfeld of the Landmark Partners and Ares Company. Chad, welcome to the show.

Chad: Thank you, Stewart. Nice to be here.

Stewart: It's good to have you. I often say that I'm the one who learns the most on these podcasts, and today will be no exception because I'm not well-versed at all in the secondaries market. And what would really help me is to give me a little bit of background on you and Landmark Partners, and also just broadly define: what are we talking about when we say secondaries market?

Chad: Great. I appreciate it, Stewart. And as I said, great to be here. So, Landmark Partners is a 30-year-old firm, as of 2020. I joined Landmark in 1996, so I've been here 25 years. In 2021, we sold what was nominally a privately held firm to Ares. So I am now an Ares employee and have joined the Ares platform. And we become a fifth vertical, business vertical, if you will, on that platform. And as we get to talk about what secondaries are all about and the growth that you just mentioned, why is this important to Ares and how do we view each other culturally, I think will be something important to talk about. But Stewart, if you'd like, I probably should lay some groundwork for what is it that we mean when we say secondaries.

Stewart: Exactly. I think that's the natural starting point. Let's just go big because not everybody's steeped in the tea here.

Chad: Sure. So we do this for private equity, real estate, and infrastructure. So if you think broadly about the private market asset classes and the private market asset classes which are consumed by institutional investors, and is now being consumed by high net worth investors as well, is a format that's done through closed-end funds, which means you commit capital, a manager deploys that capital, and you're in that fund for the life of the fund. There are no liquidity mechanisms built into those funds. So going back to 1990, we realized there was an opportunity where investors that otherwise don't manage those assets, right? They don't think about ‘buy, hold, sell’ every day, because they're really just sort of stuck in those assets; we decided that there was value to bringing liquidity to those investors.

And what we do in essence is become a substitute limited partner in an existing fund when an investor may want out for various reasons. And essentially, limited partners, want to have those ‘buy, hold, sell’ capabilities at their hands to do portfolio management, just like they do for all other parts of their portfolio. So that's the essence of what a secondary trade is, is we step in and become a substitute limited partner, again in private equity and real estate and infrastructure.

Stewart: You know, ‘Investment Management 101’ tells you that a liquidity provider and an illiquid asset class is likely to be able to find some pretty good value, right? I mean, what I always used to tell my students is you need to sell your house, you're probably not going to get the highest and best price if you need to sell it by noon tomorrow. So I look at this asset class the same way and say as you mentioned, no liquidity mechanism built into those closed-in funds. I mean, is it fair to say that it's a somewhat inefficient market?

Chad: Yeah, absolutely. So it's often been referred to as the illiquidity premium that can be extracted. And I think the value proposition as a buyer is that you are bringing that liquidity to the table, but importantly, we're shortening the duration to our investors in what they're investing in. So again, if we think about a closed-end fund has a certain life cycle of how it deploys its capital through time, usually four to seven years. And then it starts to begin to harvest those assets by divesting those assets over sort of the year 4 through 10. And that's what you're hoping through is year 10. And the reality is some of these vehicles are much longer lived. And we are buying those really in the part of that investment period or harvest period. So we're much closer to the liquidity.

And we as a buyer get to underwrite the actual assets in the ground, not just the management team, not just the strategy that they went to market with, but how they executed against that. And we're closer to those liquidity events. So we've got great knowledge in that. And the value proposition also includes buying multiple managers across vintage years, create a lot of diversification. But importantly, you touched on it, is that illiquidity premium. We're assessing the discounted cash flows today, and we view that we've slid down the risk spectrum as we're closer to liquidity events, but still try to extract the same return that you would be looking for in that private market asset class.

Stewart: Yeah. And I mean, you used a term. I mean I'm a bond geek (or recovering bond geek) and I mean, my fellow bond geeks, we can unite. Our ears perk up whenever we hear the word ‘duration’. And you mentioned a shorter duration of liability, and that means something special in the bond world. And it seems as though the secondaries market may be applicable to ensurers with shorter liabilities than may otherwise be the case. I mean, it seems as though folks who may not be able to do something longer in nature may be looking at secondaries if their liability tail is shorter.

Chad: Yeah. I think your ears pick up because probably not a lot of people use the word duration at cocktail parties. That's certainly-

Stewart: That may explain my social life, Chad.

Chad: That's certainly the case. It's an important factor when you think about multiple as well, the multiple on your return. If you invest in a repo, it's not going to be a lot of multiple that you have to understand the duration. So are shortening that duration. And I think it does make it applicable to investors like insurance companies. But the reality is, I think where you find this of most interest is to an investor who's starting to invest in private markets. They're just beginning their programs. And it's a way for them to step out and to do it in a way that's more comfortable where they start to lean into a longer duration. They start to build it with that short duration. But again, I would just mention the benefits also of diversification, that when you invest into closed-end vehicles, it takes a long time to get that money out and you're not diversified. And that's an important element of what we do.

The short duration, I think is interesting from the standpoint of, well, it's great for a new investor who's just starting. We find what happens through time is that you find a lot of investors start there. They start to use secondaries to build a portfolio. Then they might use a fund of funds format, people who select primary commitments and private market funds. Then they may go do investment directly or co-invest, but they tend to come back to secondaries as just a good overall element of their portfolio construction. So it really serves purposes through the life of the construction of a private market allocation.

Stewart: That's a very insightful... It's hopeful to me. I'm not investing in those markets. We hear a lot about them, but those distinctions help me digest it, for sure. So at the top of the show, you mentioned several sub-asset classes that make up the secondaries. How do they differ and how does Landmark approach each of those markets?

Chad: Sure. So I think when you say sub-asset classes, we think of private equity, real estate, and infrastructure on the one hand. And within private equity, we're talking about buyouts and venture, although predominantly, the space is buyout-oriented. And if we think about each of those successively, they have a slightly different return objectives. And venture can tend to have the highest. It's the highest risk, the highest reward potential. Then you've got buyout, and then you've got mezzanine and real estate, and then infrastructure. So we slide down that curve a bit in terms of risk and reward, if you will. So we actually have distinct teams that tackle those asset classes and that we go to market with. So we have investors that come into each and then we have teams that focus on the execution, the understanding of that asset class as a buyer. Within that, Stewart, though, when we think about sub-asset classes or subtypes is: what are we buying within each of those?

So I started off by talking about the LP side of the universe, which is an investor in a fund who wants out when that fund doesn't provide a liquidity mechanism, and they're managing their book and deciding they want out. But in terms of what secondaries covers today, it's not only LPs as a seller. General partners are also a sellers into the secondary market. So I talked about the long life of their funds. They sometimes reach the end of the life of their fund, as an example, and decide that there may be one or multiple assets that they think should have a longer runway, for different and varied reasons. And they will sometimes go to the secondary market to find a solution for that. So we think about LP solutions and GP solutions is the landscape that the secondary market covers in bringing liquidity.

Stewart: And so when you think about insurance investors in the secondaries market, a lot of insurers have been increasing their allocation to alternatives. Alternatives is a big umbrella, covers a lot of space. How do you see secondary solution fitting in there?

Chad: Sure. Well, I should go back all the way in time when I referenced our start in 1990. And so the first portfolio we bought was from an insurance company. That portfolio was interest in 30 different venture funds. So really, private market asset classes are not foreign to insurance companies, certainly. And after buying from a particular insurance company, which I'm personally based in Simsbury, Connecticut, which is outside of Hartford, and we used to think of Hartford as the insurance capital of the world. So you can imagine it was one of our neighbors. That seller is now an investor with Landmark. So they've not only been a seller, but a buyer, so to speak, using the secondary market, again, to manage their book. And so we see insurance companies that's having been investors in secondaries and sellers since 1990. And we've had insurance companies in every single one of our funds, in private equity and real estate. In our last fund and private equity, which was Landmark Equity Partners, 16. About 17% of our capital was from insurance companies, and our real estate fund, which is Landmark Real Estate Fund VIII, 18% of our capital was from insurance companies.

Stewart: So it's interesting because you and I were neighbors. At some point, I used to live in West Hartford. So I know exactly were Simsbury is. It's just beautiful there. So what does capital deployment speed look like if I'm committing to secondaries versus committing to primaries? And let's just stop there. And I'll ask the rest of my question in just a second, but just in terms of speed of deployment, can you give me a compare and contrast?

Chad: Sure. Secondaries has the ability to deploy capital very quickly. Now most of the funds, our funds tend to be four-year investment periods. Sometimes you consume all of that, but it isn't unusual to have the capital invested committed in a two-and-a-half to three-year period. So it does tend to be more quick than, say, a primary fund will be, but probably more importantly, Stewart, it also has capital coming back to you very quickly. So on average, on balance, if you're buying LP portfolios, then that asset value that you step into will generate distributions of about 25% back annually on that NAV. Now it becomes a deteriorating function through time, but it is 25% of that NAV annually. That's probably the bigger advantage is the velocity of cashflow back.

Stewart: And it's a very interesting point. I mean, you're kind of hopping on the train and it's already moving. I mean, at the end of the day, insurers have an obligation to pay their policyholders and their shareholders. How does Landmark construct adequate downside protection? If you're looking at our audience, our insurance investors. Or people insurance investment professionals, where else are you going to find a podcast on the secondaries market? The downside piece of it is always going to be on their minds. Can you just talk a little bit about that?

Chad: Sure. Now you may have to bear with me because you've opened up a door to talk about a lot of different things. One is that we believe secondary execution, by its nature, builds in some downside protection, or I'll say that better risk-reward characteristic when because of the illiquidity premium. But you also again are building a very well-diversified portfolio. So, if I was talking to you in the decade of the 1990s and you said, "Well, I got to get into this asset class," we're offering, in essence, almost an index because we try to buy the totality of the market. Whatever is being bought in the market or invested in, winds up becoming for sale. And you have about a 1% turnover, one and a half percent turnover in the asset class every year happen. So we wind up buying a broad scope of the marketplace.

And if I could say to you, "Hey, if you want to invest in the S&P 500, would you like to invest in at par or at a discount?" I think most people would say, "I'll take it at a discount." And that's the value proposition that we're bringing part of that, which is we're repricing those assets, essentially buying them at a discount to the net asset value, or at least their intrinsic value that we see. Now, the scope of the private market class has expanded tremendously in the next two decades from there. So in the '90s, I would tell you we bought the market, the good, the bad, and the ugly. Post-tech rack, what we realized is maybe we want to avoid the ugly. And so through most of the decade of the 2000s, we decided, "Let's just buy the good and the bad," because you can price properly even assets that are not great.

But I'll admit post the financial crisis, again, the explosion in the market, the number of managers, et cetera, we've decided to really lean into the good or the best-in-class managers. We think of in two different ways. One, core managers. Who are the top 100 managers in the world? That's who we want to be buyers of. The next piece of it is... and I can scratch at this a little bit and maybe talk about it later... is that we look for managers that produce alpha. Again, that's a whole ‘nother conversation. So each of those elements that the secondary execution in and of itself provides that risk-reward opportunity. And then we narrow the focus of: what do we want to buy in this space?

And then lastly, in terms of... I might say there's at least two things here. As a buyer, there are a couple things we want to do. We want to be a solutions provider to our counterparty, that being the LP or the GP. And so we construct transactions. Sometimes, those feel like preferred equity, but we construct transactions in which we protect downside and not give away the upside. Again, that could be a 30-minute conversation if I talk about how we do that.

Stewart: No, I understand. And I think you make a very good point. I remember years ago there was a gentleman who said to me... And he had done quite well for himself. And he said, "Well-bought is half-sold." And I thought that was as good of advice as you're going to get, is getting into these asset classes, as you rightly state, you're repricing. Makes total sense that there's some downside on protection sort of built in there. So Ares has been doing a lot to expand its dedicated insurance offerings and products that appeal specifically to the insurance industry. How does Landmark see your involvement in the insurance industry and how much experience have you had? And you touched on this a moment ago, but in dealing with insurance clients.

Chad: Sure. As I noted again, they have been sellers and buyers, and we also have formed a dedicated fund for an ICOLI, an insurance company-owned life insurance for that application. It is more like an evergreen type of product where we're executing the trade in that format for insurance companies. And as you noted, Ares is definitely going to market as a solution provider to insurance companies. They absolutely see the secondary trade and execution as an important element of the product to be brought forward to insurance companies. So we see that expanding for us in terms of what I noted earlier that in real estate and private equity, getting close to 20% of our capital comes from that space. We expect that to expand.

Stewart: And I mean, I think everybody listening to this knows that there's a stampede to private assets and it isn't going to slow down with rates where they are, and we can argue back and forth about whether they're going to stay here, but all the insurance folks need more return in investment-grade fixed income. And so I got to think that there's more money behind this. Right?

Chad: Yeah. We've seen that pressure to stretch for yield really for more than a decade now on a public pension plan side as well in terms of trying to meet their liabilities. How do they get there? As interest rates have compressed, again, that need pushes you back to stretching for yield. There's always a concern in that, obviously. And the secondary market space just follows it, the growth that has transpired. As I talked about that evolution, I think about the mid-2000s. In 2005, there was 10 billion that was traded in secondaries. This year, we're going to exceed, as you noted at the top of this program, exceed over 100 billion in trades. And yet that's only one, one and a half percent of the market in private equity. And most of my comments really are on the volume here are about private equity.

And the interesting thing I would note in that question about downside is we always think about demand and supply. So probably where you go to, when you think about all that growth, is how long can this be sustained? Certainly, fundraising has been extraordinary in the private markets in the last 10 years. That has been a cause for concern at times. We look at the buyout space and see what we call five to six years of dry powder volume, meaning the commitments that are coming online mean that those buyers can buy for the next five or six years, or rather, they need five or six years to deploy it.

In secondaries, you really only have about a year and a half to two years of available capital in this space. So we mentioned a 100 billion of volume this year in the market. There's probably 165 billion of capital available for the trade. We project in the next three years that the volume in aggregate for a three-year period will be somewhere between 200 and 350 billion. We may get to a 120 this year. You can see that there's a really great supply demand in our favor.

Stewart: Well, and I think it just follows that given the growth of the private markets and the growth of the primary market, the secondary market has got to follow. Just no choice. Look. At the end of the day, you've got insurance investment professionals, CIOs, and in many cases, I mean, insurance companies and even good size ones may not have a dedicated CIO. And so you've got somebody who's perhaps a CFO or somebody else. And they say, "Well, private markets are interesting to me, but I am not willing to wade in where I don't belong or take the career risk of making that decision," or so forth. So I'm kind of taking up their cause and their position and just asking this. If I am an insurance company with no experience investing in private equity or real estate or infrastructure, how is secondaries... why do I want to start there, or why or why not?

Chad: Yeah. I think we touched on this a bit. And look. That challenge is not wholly unique to insurance companies. Now, of course, some institutions have more dedicated staff, but I would argue that most institutions are resource-constrained. And I can come back to what that means in our space also. But if you want to go down that path, then the question is the how, and I think most institutions... And again, quite frankly, high net worth individuals are coming there, which is they say that this is an important element of their overall asset allocation, is to move into private markets. And then the how. And from our perspective, secondaries is just the simplest proposition because it ameliorates a lot of the potential concerns that you have going in, a lack of diversification, I got to select managers, in a secondary proposition is arguably, one could say, it's a fund of funds type of format.

You are going to invest your capital in multiple vintage years. You're going to invest with arguably 100 managers and in thousands of underlying companies in pretty quick order and get your capital out there. And we talked about the duration and what the marketplace thinks about is that you're ameliorating the J curve with respect to doing this. And there are two different J curves. One is the cash flow of cash out and the cash back. You've shortened that duration, but also is a value J curve.

So if you put your capital into a fund on day one, what you're probably going to see is value erosion because of the fees of that fund. Because if you invest that dollar, now, you're just seeing the fees against it. In a secondary fund, because you have the opportunity to buy at a discount, have cash flow coming your way, you can move away from that J curve, so to speak. And if the CIO, the CFO explores their opportunities, I think as they see fund of funds or secondaries, they can look at the secondary market and they can see how it's served and realize that there's only a handful of groups that they go to for that. And they can understand it, I think, pretty quickly what that value proposition is and why most investors use that tool to enter into this space.

Stewart: Yeah. And I mean, it's interesting because Landmark markets itself as a comprehensive partner to firms, and that seems that's more uncommon than not in the secondaries industry. So can you kind of just talk about kind of how you go about the comprehensive partner component of that?

Chad: Yeah. I think what you may be touching on is maybe the scope of transaction types that we get involved with, how we go to market as a thought partner. Because again, we've always been a solutions provider because in the early days, you're actually trying to convince someone of something that is foreign to them. What do you mean I can sell something that I thought I was locked up in? Well, if you're buying, do I really want to sell? So the interesting thing is you sell bonds, you sell equities all day long, you're comfortable that there's someone on the other side of the trade. But when you start doing this, it's less comfortable. And so again, we've always gone to market as a solutions provider. And when you talk about being comprehensive, it's I think of being a buyer from LPs and from GPs. And the biggest part of the growth in the market today is on the GP side, becoming a solution provider to the GPs.

Now, interesting, and it may be a little bit off and tangential. I would say in the '90s, GPs did not like the secondary market. They didn't like the idea of, "Wait. Someone wants out of my fund." But I think they realized, and I've got a great story that relates to Alan Patricof because he specifically said this in the early '90s, "We didn't want to see this happen." And Alan was one of the fathers in the venture industry. But he stood up in one of our annual meetings in 1996 and said, "I realized that actually that's a relief valve, that people can get out. Then they're more likely to come in." So you drive more capital into the space. And quite frankly, we saw the banks do that in the '90s. They would actually cycle capital in and then come back out.

So we become a solution provider on that side to both the LPs, and then now the GP side of it, where they think about extending the runway for assets in their funds or bringing capital to their balance sheet to launch programs. And they can bring other assets that we as secondary buyers are interested in. So I think Stewart, when you talk about being comprehensive is that we're a buyer across that full spectrum. We're always assessing where's the best opportunity. And so having a certain amount of capital and being able to have the time to deploy that and afford you that opportunity to determine where's the best place to put it.

Now I should note that how we go about sourcing as well is an important aspect of this. I touched on being a solution provider. Post the financial crisis, we started building a team which we refer to as our quantitative research group. Now again, we have dedicated deal professionals in private equity, real estate, and infrastructure. But alongside that, we've built a team of quantitative research that started with one gentleman as a PhD. We now have, I think, four PhDs on staff. There's a total of 25 people.
And what we do with that group is several things. They lean in and help us with deal sourcing, but also underwriting and understanding assets. And there are a couple of tools that I would make reference to specifically. One is an LP toolkit, where if we see someone who is an owner of assets, we can talk to them about what's in their book. So you talked about institutions having a resource constraint, like ‘a CIO’ or ‘thinly staffed’. The reality is most institutions, once they build a book of private market assets, it's hard for them to get their arms around it and really understand it. So we offer is this LP toolkit, which is a 30- or 50-page deck where we can splice up their data and show them what they own. How well have they done in the execution? And if we were in their shoes (and we have to be intellectually honest about this), what would we sell?

We create these heat maps. We do a couple of different tests to define what is it that we'd be looking at selling. Where are their laggards? Where are they not deploying capital? Where have they gotten overweighted? Now the reality is they have that in their gut, but it's hard for them to put on paper. So we help them put that on paper. And then in turn, that creates a great relationship where we have a dialogue which is away from an auction or brokered market. And then we can become a solution provider deciding what are they really trying to accomplish? Are they trying to shed unfundeds? Are they trying to shed certain managers? And then we can build a solution around that.

Now the simplest solution is we buy some of the assets you don't want, a fee simple trade. But the reality is there are other options to be had there also. And that's where we talk about that downside protection, that we can build transactions that look great to the counterparty and they look great to us. And sometimes we're not buying all of the asset. We'll buy a portion of the asset. But we had that seller essentially overcollateralize us and slip cash flows to us earlier than otherwise would be, and they participate in the backend. The other, among other tools that we have from that quantitative research group, is one that we use with GPs. And that is that we spend time with general partners to try to understand, do they produce alpha or not? So important to our execution is information, and the best place to get that information is a general partner.

Now, general partner doesn't necessarily always want to spend a lot of time with a secondary buyer, but if you can offer them something, they certainly will. And the GP alpha toolkit that we have is something of that nature, which is we can take all of their data and assess whether or not they produce alpha. That is something that's really interesting to them. Now, we can't go out and publish what those results look like, but and they can use that mutually to our benefit as we think about building a portfolio and where do we want to invest capital. So I think when we talk about being comprehensive, it's bringing a broader set of tools to the table. And the other thing I would want to lean into, and I expect you'll ask me about this later, is again, coming onto the Ares platform, what does that do for it? It broadens out the set of tools that we have available to us, quite frankly, in addition to those tools that I just described, to be a great buyer.

Stewart: Just to wrap up, Chad. So Ares CEO Michael Arougheti spoke not just of the business sense it made to partner with Landmark. And then I'm going to quote something here, "Similar values and the same commitment to building a collaborative and entrepreneurial workplace." Can you talk a little bit about the Landmark integration at Ares and what your experience has been and so forth?

Chad: Sure. It's been fantastic. If you had asked me 18 months ago if we would find ourselves on a platform like this, I would've said no. We very much valued our independence and we've been of an entrepreneurial spirit as we've built this organization and really view ourselves as having been one of the pioneers of the space, doing very creative things in terms of how we execute, not only cracking open these markets, but how we execute and we evolve through time and as this market has developed. But as we thought about moving forward and got to know Ares, we realized that we were so like-minded in terms of being entrepreneurial and collaborative. And their culture, quite frankly, is one that has reinvigorated us in some ways. Now, importantly, beyond that culture, we realize as we're on this platform, the benefits that accrue to us and to them.

And I think that Mike would say Ares' interest in the secondary market was that it was an important tool in their arsenal to bring to bear for their limited partners and investors, and likewise, that they found us of like mind being solutions providers. But as we step into this platform, we believe that Ares is one of the largest globally non-bank direct lender in the world, and that whereas Landmark Partners has 65 investment professionals, the Ares platform has over 700 investment professionals that are in the spaces of private equity and real estate. And in that credit, what Ares is most well known for, in credit, that we have access to all those resources and relationships. And as that direct lender, they bring those GP relationships to us. Landmark has always thought of itself as having great relationships, general partners, but clearly, the Ares platform accelerates that access to those relationships.

Stewart: That's good stuff. And it helps me understand the structure as well. So that concludes the secondaries market portion of the program. And this is into the ask me anything section, which you might not have been prepped for prior, but I want to take you back to the... I've taught for years, and my students benefited from stuff like this. So this is where we're headed. I want to take you back to a day that you'll remember well. It's the day that you graduated from college, your undergraduate institution. Now, regardless of what revelries may have taken place the evening before, you are bright-eyed and bushy-tailed in your cap and gown. And your last name starts with A, so you're going to be early on up on that stage. They call your name. The crowd goes crazy. You shake hands with the president. You get your picture taken with your diploma, and down the stairs you go. At the bottom of the stairs, you run into yourself today. What do you tell your 21-year-old self?

Chad: That's an excellent question. Unfortunately, I would say, "Don't have so much revelry," would be maybe number one. I think I've always understood this a bit, but if it's just about patience more than anything else, that as you move through life, that you need a certain amount of patience as you go, and yet at the same time, bristle and be an entrepreneur, that you want to keep trying to move forward at the same time that you have a certain amount of patience. I think knowing that you'd like to live life in the rearview mirror, and yet you never can, but attempt to try to learn from your experiences as you move forward. And there are going to be... If I think about what we do on a day-to-day basis, there are transactions that often your gut tells you that we try to parse what we do quantitatively. And sometimes, it's your gut that you need to follow more than anything.

But sometimes, the regrets are more the things you also didn't do as much as the things that you did do. And the reality is you're just going to have a balance of those things. And hopefully, it's a balance, right-

Stewart: Exactly.

Chad: ... more than anything else. I'm not sure that despite being able to speak to myself, I'm not sure that I would listen. There are plenty of things that my father tried to teach me. And again, in the rearview mirror, I wish I had followed more of his advice. So I'm not sure my graduating self would listen to me today either.

Stewart: Well, I think it's worked out pretty well. Chad Alfeld from Landmark Partners and Ares Company. Chad, man, thanks for being on.

Chad: Stewart, really appreciate it.

Stewart: We appreciate your listening. If you have ideas for podcasts, please email us at podcast@insuranceaum.com. My name is Stewart Foley and this is the Insurance AUM Journal podcast.

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