The Power Of Alternative Investments For RIAs With Richard Hillson, Founder, Hillson Consulting

 

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Richard Hillson is the Founder of Hillson Consulting, an investment consultancy that helps leading independent Registered Investment Advisors (RIAs) and family offices improve their product offerings and portfolio construction, predominantly through alternative investments that help to generate optimal portfolio diversification and higher risk-adjusted returns.

In this episode, Zack and Richard discuss:

1. The Alts Revolution – New Investment Opportunities for RIAs
2. Alternative Investing: Diversification Within Diversification Within Diversification
3. Invest Like a Pro: Diversification’s Role in Risk Management

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The Power Of Alternative Investments For RIAs With Richard Hillson, Founder, Hillson Consulting

Introduction To Richard Hillson And Alternative Investments

I have with me Richard Hillson, a good friend and an expert in alternative investments. Richard is the Founder and CEO of Hillson Consulting. Richard, I’d love to hear about your background and fill everybody in.

Thanks for having me, Zack. We’ve done quite a few presentations now and I always enjoy vibing back and forth. It’s good to be working with you again. My background in a nutshell, I went to law school in the UK. I worked for Barclays at the beginning of my career, and then went into investment banking. I set up a private equity firm in Manhattan back in 2011, and that morphed in to alternative investment boutique investment bank broker dealer.

We also ran an RIA aggregate for a few years. I’ve been CEO of a broker dealer and an RIA for my sins, let’s say in a past life. A couple of years ago, I saw an opportunity in the marketplace based on my biggest frustration, which was speaking to brokers, investors, and RIAs. Predominantly, RIAs is the dreaded A-word, alternative. Sometimes, you’d say all and you literally get this visceral reaction where someone’s whole body tenses up like you drop the F-bomb in conversation. It was just, why is alternative a dirty word? Even moderately sophisticated investors and RIAs who were running a few 100 million worth of assets was still terrified of alternatives or didn’t understand it.

I was legitimately sick of having the same conversation where, “I don’t do alternatives. That’s much too high octane for me. That’s Bobby Axelrod from Billions or that’s crypto. No, it’s not. That can be conservative real estate yield with an investment grade tenant, which is less volatile the most equity played. It was frustrating me, this lack of understanding in the space. The fact that this broad terminology of alternatives includes so many different things that it does the whole industry a disservice because more conservative shouldn’t be lumped together with crypto. It just doesn’t make sense.

I thought, “How do I change that one investor, one advisor at a time?” I essentially believe that alternatives are misunderstood, underrepresented, and need to form a part of every portfolio. How do we change that? I work with investors, RIAs, and with brokers to help them navigate and grow their alternative investment part of that business. I work with quality sponsors and quality products, such as you folks to help you educate and get traction in the fragmented RIA space. That’s what I do. Anything that furthers the cause of alternatives and makes them easier to understand and easy to navigate, basically.

Why Do Alternative Investments Have A Bad Reputation?

You’ve done a great job with it in the sense that you’re one of the leaders in educating folks in the RIA space. It’s not easy as you said. Why do you think alternatives had that bad connotation in the past?

It’s a combination of factors and we could do a whole session on this but we won’t. There’s too many other things to cover but essentially, it’s this catch-all terminology which is a problem. The other thing is, and I’m not accusing anyone of being lazy or anything here but comfort zones are just a fact of human nature. The equity market was so kind for ten years plus. Even if an investor agreed with the principal, we need to diversify into different types of less correlated asset classes in the alt space. It’s damn hard to do that when the equity markets are doing 20% almost each year. At least 15% until, let’s call it, when we’ve had the downturn.

What is the need to get outside of your comfort zone at that point? The 60/40 model was still delivering to some degree. The yield sign was poor until the last 12-18 months or so. When your equities are performing, there’s no reason to get outside your comfort zone. It’s only the last eighteen months or so that we’ve seen some of these stooge 60/40 team disciples start to broaden their horizons.

For me, it’s a combination of the misunderstanding, the misconception, and the broad terminology but then also, because we didn’t need to diversify that much because the equity markets performed for so long. It makes it very easy to stay in your comfort zone and I don’t blame anyone for that, but guess what? Now, they’re starting to see the light and look elsewhere because they need to.

Alternative investments are misunderstood and underrepresented but should be a part of every portfolio. Diversification is the key to long-term success! Share on X

One of the things that’s changed too is that there are a lot fewer public companies now than there were many years ago. If you want a truly diversified portfolio, you need to be in alts. Stocks and bonds will not cut it from a diversification perspective. We saw in 2022, the correlation between stocks and bonds is very high and both were down significantly. Folks that were in a 60/40 portfolio consisting of 60% stocks and 40% bonds. You had one of the worst years in the last 100 years. It was the worst if I’m not mistaken or close to it.

Defining Alternative Investments

What we’re seeing now is just a big move into alts broadly. People don’t even understand what alts means. Define it for folks. Alternative investments are anything that’s not a public stock or bond, generally. What that means is that includes private credit, real estate, private equity, venture capital, hedge funds, infrastructure, and basically anything that’s not a public soccer bond. The list goes on and on. If you think about some of those investment characteristics, they’re very different depending on what type of alternative that you’re in.

Crypto has nothing in common with real estate, for instance. Your private credit has very different risk characteristics than venture capital. That’s what people are starting to learn. Within alternatives, there’s a lot of different flavors and a much more variety. If you’re in stocks and bonds, it’s like going to an ice cream store. It’s like, “We’ve got vanilla, chocolate and sometimes, we have strawberries but not always.” Hopefully, you like one of the three. That’s what it’s like in the public markets.

Whereas in the alt space, it’s like going to one of the ice cream stores that’s got like 400 different flavors. Some of them you’d never touch, but some of them are amazing. You can’t find them anywhere else. That’s about alternatives and what it brings to the market. I wanted to ask you, what do you think are the benefits of alternatives broadly in terms of including them in your portfolio? Especially for RIAs and wealth managers?

To expand on one of the point, in these conversations when someone says, “I don’t touch alternatives. I have a bad experience with crypto or something.” That’s like saying, “I once picked a bad stock. I’m never picking stock again.” It’s just nonsense. Stay the hell away from crypto then if you’ve had a bad experience with crypto, but don’t let that color your decisions in the rest of the alt space. That is still part of the issue here.

Don’t let one bad experience with crypto turn you off from all alternatives. Diversification within diversification is where the real power lies. Share on X

Your question was the allocations. There’s a lot of different methodologies and ideas. The most basic would be 80% of the portfolio would go into 60/40 and 20% would go into alternatives and then pick. Some different things within the alt world. Maybe some real estate, commodities, private credit and a couple of tenth planning angles. For me, it’s more a case of having a look at what the basis of the alternative investment is. Is it a yield based, conservative yield-based player? Is it a total return potential?

It’s a total return title. That comes out the equity 60 and it’s a conservative yield play. That comes out of the 40 sides of things. It is about the subcategorization, which is important. Another thing which always frustrated me was this typical assumption. “Alts are all out of the risk part.” The 10% risk capital which is part of the 60, that’s your alternative. It’s not. It depends what type of bolts it is. If it is crypto, then that’s your risk. If it’s conservative real estate play, which is yield-based with an Amazon distribution facility, so investment grade tenants. That’s your conservative 40.

The key thing for me is having diversification within diversification whatever your allocation to all. You do want a number of different verticals within the alt space. Whether that’s real estate or commodities. Private credit/private debt is the fastest growing area in the alt space at the moment and we’ll talk a bit about that being a real trend at the moment if people start to open up within the alt space. For me, there needs to be diversification within diversification. Once you know what your alt allocation is, what’s your yield side, and what’s your total return side then there’s diversification within that into the different types of alternatives available and different verticals.

That’s a great way to think about it in the sense that it’s like bucketing in broad terms. As you said, total return or growth and then maybe perhaps lower growth, but steadier return and income. If you find a private credit strategy or a real estate strategy, for instance, that would go into that 40% income bucket. If there’s something that’s got a total return play and there’s more growth oriented. That would go into the 60% bucket.

Ultimately, it’s the diversification that adds to the portfolio optimization. A lot of people overlook that. People tend to be non-professionals, at least. They tend to be very focused on deals or specific trades or specific stocks or bonds but they’re not thinking holistically about their portfolio. If you talk to a professional, a portfolio manager, for instance.

thinking about the portfolio construction first and making sure that the diversification is there because that’s going to produce better risk adjusted returns. That’s what people tend to overlook because they’re chasing specific transactions rather than thinking about portfolio optimization. In terms of the RIA space in particular, what are some of the other trends that you’re seeing now in terms of what folks are doing?

The trend of the last couple of years is those die-hard 60/40 folks finally getting the message because they had to. Everyone knows that 60/40 going forward is a broken model but again, as we touched on earlier is, the comfort zone of equity is performing well. It makes it hard to get out positions that are still performing well. The last couple of years have been a lot more old school advisors and investors starting to look more into alt.

I affectionately call the basic real estate or REAPs as like a gateway into alt. It start with something simple and the guys who dip their toe in the water to buy maybe a basic multifamily Reit are now saying, “What else is there?” Equity in certain types of real estate is not performing. Those who still want to stay within the real estate classification are now saying, “What else is there?” We’re looking at debt in real estate rather than the equity, which was the starting point, or looking at some slightly different real estate asset classes, such as self-storage or digital infrastructure.

I worked with a company that does cell towers and data centers. It’s real estate but with a tech potential extra upside to it. Maybe advisors are getting a bit braver now and saying, “What else other than, let’s say, real estate rolling in gas is there?” That’s one of the reasons why private credit/private debt is one of the fastest growing areas of the market because typically, it’s a yield play. We’ve seen a bounce back to 70 degrees, but give an inflation where it is. People are chasing things with higher yields because they need to.

In just about every presentation I’ve sat in on, everyone’s talking about the fastest growing asset class being private credit/private debt. It’s reassuring for me to see, first of all, that old-fashioned portfolio folks are starting to embrace alternative or at least dip their toe in the water. Now, folks who just dip their toe in the water are asking what else is out, which is good for the industry. A lot of that is because of the education and the effort of so many different groups of putting and to make it easy to custody or bail or diligence. All of these things which make it easier for someone to inch outside their comfort zone.

Previously, “I’m going to do all alternative.” That custodian doesn’t hold it up back to my comfort zone. The first excuse to get back there but the industry is changing and making it a lot easier for the mass went high net worth without interest being ultra-high net worth and family offices which used to be the traditional alternative investment.

I agree with you in that private credit. Real estate is both a great entry point because they tend to be lower risk and a little bit easier to understand. Certainly, most people understand real estate intuitively because they often own a home or they’ve been involved in some commercial real estate at some point. It’s pretty straightforward. They understand there’s a physical asset. It generates some cashflow and then they get a portion of that cashflow.

Private credit is no different. It’s just loans oftentimes to corporations that tend to be smaller and non-public and what you’d see in the public markets and the bond market, for instance. It’s nice as well because most of these loans in private credit are floating rate. All the interest rate hikes have not only not hurt investors and private credit. It’s helped them because now, they’re interest rate yield has gone up over 500 basis points in months.

That’s something I like to remind people. When you’re buying bonds, these are almost always fixed rate securities meaning they have interest rate risk. As rates go up, the price of that bond goes down and that’s what we saw in 2022 when credits spread performed fine, but rates went up. That devastated the returns on treasuries, mortgage-backed securities and fixed rate corporate bonds. That’s what’s nice about private credit. You get corporate credit exposure, but you don’t have that fixed rate.

Also, certain types of private credit have equity participation usually through equity warrants. That could be in mezzanine credit, for instance, or it could be in venture debt in my firm strategy. That’s a nice little kicker because you’re getting that steady income and you’re usually pretty senior in the capital structure. you’re going to get paid before the equity holders if things go wrong. You also have a lot of participation in upside which is nice. You’re not necessarily giving up growth when you’re in certain private credit strategies, which makes it very appealing from multiple perspectives. People want safety but they also want to participate in the upside and you don’t see that in corporate bonds.

Explaining Venture Debt And Its Advantages

It’s not the perfect segue to start talking about your guys’ strategy in terms of, you know that I’m a fan. I’ve been an advocate venture debt and to you folks. Let’s swap roles for a moment here. When we’ve done our presentations, I put on the hat on behalf of the advisors to say, “Here’s some of the questions that I would ask and I get asked about.” Let’s start with the basics. What is venture debt and tie into that is?

I know we spoke earlier about people’s whole-body reaction when you say the alts world but we have a similar thing here. With venture in the name, it scares some people and I don’t believe that’s justifiable, but people assume and risk profile based on it just having venturing in the name. Let’s address that. As action point number one, talk about what this means and why having venture and retired isn’t a reason for everyone here to go running for the hills the second we are we say that.

It’s a great point. I think you’re right. If we could rename venture debt to something else, that would be great for folks in the space in terms of the ability to make this visible from a fundraising perspective and less scary. The reality is the word venture in venture debt means it’s less risky because what venture debt is it’s loans to venture back companies. It’s basically short duration. Typically, 2 to 4-year loans that are floating rate to the best venture back companies in the world.

These companies essentially have the ability to raise a ton of equity capital, but the founders don’t want to sell more stock in their company than they need to. That’s pretty intuitive. If you have a company that’s doing well, why would you want to sell ownership now if you think it’s going to be worth a lot more later? Founders are very keen to use venture debt because they can raise some equity capital and then complement that by borrowing some money at a much cheaper cost of capital. Also, much less diluted capital.

Venture debt offers short-duration loans with upside potential. Founders use it to fuel growth without heavy equity dilution. Smart move! Share on X

Ultimately, these loans do come with equity participation but it’s substantially less than a straight equity race. Think of a standard loan. It might be a 3 to 4-year loan. Mid-teens, all-in cash yield called 15% to 16% yield and then another 50 to 100 basis points of equity in the company as well. The total returns are somewhere in the low 20% range or sometimes higher. There’s very low volatility in those returns because the majority of returns are coming from the credit component, which is contractual.

The interest is coming in every month. In fact, for these loans as opposed to quarterly. They’re floating rate, so you don’t have any interest rate risk. You’ve got that steady return and the upside skew with some of the companies that eventually get bought and go public. You could have big time returns on single positions.

The first question I asked you when we first started talking is about how this fits with the equity component. Is this seen as adversarial? Is this seen as competing with them? How did they feel about the fact that the debt goes at the top of the cap table, essentially? You sit above the equity side here. I can’t imagine or at least when we first talked, I couldn’t imagine how the venture guy’s like that, someone sitting above them as far as that’s concerned.

Ultimately, most venture equity investors work hand in hand with the venture lenders. In fact, venture lenders get most of their deals directly from the VC firms who call them and say, “I’ve got portfolio companies that could utilize debt. They’ve reached that stage where they’re generating revenue and they’d like an additional round of growth capital,” essentially to extend around the runway and help them grow the business. Whether that’s their marketing efforts, software or text stack. Maybe it’s opening a new office and a different location.

Think of venture debt as growth capital and it comes after the equity race. One of the common misconceptions about venture debt is that it’s for companies that need capital. If you can’t get enough equity raise done, then you should go try to get a loan and that’s just not the case. What happens in reality is that venture lenders are funding the top. You call it 10% to 15% of venture back companies.

These are companies that will do an equity raise but then they’ll do maybe 15% to 20% of that round in debt to save himself some dilution and also to reduce their weighted average cost of capital. I’ll give you an example just to put it in numerical terms. I think it helps people understand. Say there’s a company that wants to do a series C financing around and they want to raise $50 million. They might go out and do 40 in equity. After that equity round has been closed, they’ll tack on $10 million in debt.

They get their $50 million but the founders have saved themselves $10 million in dilution exceptionally. Now the equity VCs, to your question, are appreciative because this capital is helping to de-risk their investment as well. What they want to see is the company be successful and reach an exit just like the lender does. They’re not combative. They’re much more collaborative in the sense that everybody is aligned and they all want this company to do well over the longer term and have a successful exit.

That doesn’t mean they need to IPO. It means they could get bought. It means they could become a steady run rate company that never does another round or they might do another big equity raise later at a much higher valuation, which benefits all the existing shareholders as well as the lender. Think of VCs and venture lenders as partners. Even when things go bad, from what I’ve seen looking at over 5,000 historical deals dating back to about twenty years ago. There’s very few situations where it hasn’t worked out amicably in the sense that everybody’s incentivized to help the companies as much as they can and extract as much value as they can. Not to necessarily be fighting over.

There’s a lot of teamwork that goes into it and it’s the relationships between the VCs, the portfolio companies, and the lenders. Think of it as like a triangle. Almost like a three leg of a stool. Those relationships between all three. It’s those strong relationships over time that lead to a very successful outcome.

We’ve looked at plenty of dates in some of our previous presentations in terms of the default, the risk, and things like that but it’s the first thing. When we first ironed out, in my mind. This not competing with the equity sign with it being complimentary. The next thing that went through my mind is, “If you’ve done the $10 mil on top of $40 mil from some of the smartest guys in the room. They’re not going to let this default and the debt, which has priority, get everything.” That feels like another reason why de-risk. In sitting above these guys, they are not going to let this default and essentially, the debt holders would then own all of the IP and the assets. Is that a simplification or is that one of the reasons why we do see things remarkably low default?

That’s a big part of it. It all starts with underwriting a quality company. A company that’s got traction, a revenue base, that’s growing, and got a strong management team. A good lender will first underwrite the operating company. Is this a good company in terms of its credit fundamentals? In addition to that, it so happens that they have this strong equity sponsorship group that you would not see with a non-VC backed company.

It’s almost like an extra layer of risk protection, but it’s not what you’re ultimately relying on. It does help quite a bit if you’re finding companies that are tech focused. They’re growing very quickly, typically. They’ve got huge scale ability and they’ve gone through an equity raise which means they’ve gone through diligence. There’s been smart VCs who put their money where their mouth is. It’s not just the company saying, “We’ve got a good model.” They’ve gone out and convinced top VCs to give them $20 million, $30 million, $40 million, or $50 million before we even come in as a lender.

The lender is going to do their own deep due diligence and underwriting process. It starts with a quality company and then sizing the deal correctly makes a lot of a lot of difference. You want to make sure that companies are not over-levered just like any company. Some debt is good. Too much debt is bad. That’s true for any company. The way that we think about it is you keep the loan to value in the 10% to 15% range meaning figure out what’s a fair valuation for this company. Not what’s a hyped-up valuation at peak market. A real conservative realistic evaluation and then lend no more than 10% to 15% against that.

That means the company could lose 85% to 90% of its value and you’re still unimpaired as the lender. If you think about it in steps, the first step is to find a company that’s a strong operating company. It’s got revenue. It’s growing quickly. It’s got great prospects, then you take that company and you provide it with some debt but you size that debt appropriately versus the enterprise value and versus the revenue that they’re generating. Also, versus the cash they have and the strength of their balance sheet.

You’ve already checked a couple boxes and then you’re going to look at what is the collateral and what is the recovery value if things go wrong. If everything in the world goes wrong for this company, will I still be able to come out whole as the lender? The reality is that most venture loans have recovery rates if they do default North of 90%. You’re going to say, “That sounds crazy. How could that be?” I will walk you through a quick example and you’ll see mathematically why it works out. It’s very easy to prove even to non-believers.

Say we make a three-year loan to a company. Typically, these loans are structured so that the first year or so is interest only. Say I make a loan to you, Richard. You’re paying me a 15% interest that first year, but you’re not paying down any principal on the loan. In year two, the loan starts to amortize meaning in month thirteen, you’re going to start paying back principal along with interest. In a three-year loan that starts amortizing after year one, if it’s straight-line amortization that means you’re going to make 24 payments over two years paying back the principal on that loan.

Say I’ve made you a $10 million loan. The first year, you’re paying me a million and a half bucks in interest 15%. We get to year two, the loan is amortized. You’ve had one year of amortization meaning you’ve paid off half the principal now as well in year two and you’ve paid me another year of interest. If you do the math, I got 15% year one for interest, 15% in year two and you paid off 50% of the principal by the time we get to year two or the end of year two. I’ve got $0.80 back on every dollar I invest in your company in two years.

If you went belly up on that day, I’d still have 80% recovery in terms of dollars in and what I’m bringing out. The reality is, this is why loans are so low risk because you’re making loans to companies that typically will have two or two and a half years of runway. You’re making loans to companies that have great traction and they’re growing. It’s not like they’re going to go from, “We grew 60% last year,” and all of a sudden, we’re out of business. That doesn’t happen. It’s very rare.

You’ve got these companies that you’re monitoring on a monthly basis as well because you’ve got monthly interest payments coming in. You’ve typically got board observer rights also as a lender. You know in real time what’s going on with this company and you’ve got covenants that protect you as a lender as well. Typically, there’s two covenants at least on most deals. One will be what’s called a performance to plan covenant meaning the company has a certain revenue target in their plan. If they miss that by a certain threshold, that will trip the covenant.

There’s also typically a minimum of liquidity covenant meaning the company has a certain amount of cash on their balance sheet at all times. You’ve got all these protections built in and the structure of the loans is such that you are de-risked immensely as the lender. To recap, you’ve got a very good operating company. You size the loan appropriately. You don’t over leverage the company and then you structure the deal in a way that de-risks it as well with covenants. There’s other things you can do as well. There’s what’s called delayed draw features.

Say, you want to borrow $10 million and I think $10 million is a little bit too much debt for you at this time. I could say, “We’ll make you a $10 million commitment, but we’re only going to release $5 million dollars day one. For you to unlock the remainder of that loan, you’ll need to hit certain milestones and grow your revenue by a certain percentage.” It basically ensures that your leverage iis never too high.

There’s many things you can do as a lender in this space to keep the risk very low. It’s one of the big misconceptions. One of the biggest is these loans have binary risk because people think of venture lending and conflate it with venture equity, which is silly. It’s like conflating how a small cap stock is going to fare relative to an investment grade bond? They’re not at all related. Even the stock in a bond of the same company isn’t related in terms of how they perform.

I’m constantly having to explain to people, “Not only is it less risky than venture Equity. It’s less risky than corporate bonds,” because you’re all protected against interest rate increases. The recovery rates on these loans are higher than you’d see in high yield and higher than you’d see in the leveraged loan bank market. Higher than you’ve seen some cases in the investment grade market, which is crazy to think about but it’s true. That sums up why there’s low risk in these investments but it’s hard to get people to listen. They hear venture and they say, “I don’t want to invest in venture.” I say, “You don’t even know what we do and you don’t even know what venture debt is.”

Misconceptions About Silicon Valley Bank’s Failure

Let’s also address one of the other biggest. I think we’re getting there in terms of getting the message out now. Certainly, a few months ago, one of the biggest misconceptions was about Silicon Valley. At the time, I feel like the general public’s view was that Silicon Valley Bank when under because it was making a high-risk venture lump, which is completely not true. That felt like the understanding of less sophisticated investors or whatever.

It’s completely different and creates an opportunity in the industry. While we’re heading off some of these misconceptions, why don’t we address that head on as well. As the elephant room, let’s say, is what happened and why is that not a reason now to be terrified with venture debt? It makes it more compelling.

Silicon Valley Bank failed because they mismanaged their interest rate exposure. Essentially, they had a lot of deposit inflows and had to put that money to work. They couldn’t put enough to work in the venture loan market and so they wound up buying a lot of treasuries and mortgage-backed securities in 2021 in particular. Now, that was probably the worst time in history to do that because rates were still low and Silicon Valley Bank had a ton of inflow. They put a tremendous amount of money to work in these fixed income securities that didn’t have much credit risk, but had a lot of interest rate risk.

A lot of these were long duration and longer maturity fixed income securities. When rates started to go up in 2022, those securities fell quite substantially in value. That led to Silicon Valley Bank having a lot of losses on their balance sheet and they had taken off their interest rate hedges in 2022. They completely mismanaged the situation and were caught off guard. Ultimately, those losses are what led to what I call a loss of confidence in the bank, which kicked off a bank run and gave in to modern technology and social media and the speed of digital banking. They were basically out of business in less than 24 hours.

What’s interesting is a lot of people saw this from afar and didn’t realize what was going on. Now they can look back and it’s crystal clear and there’s no dispute. They blew himself up because they didn’t know how to manage their interest rate risk. Their venture loan book was the jewel in their crown and remains as such. That’s ultimately why First Citizens Bank bought them because they have this great ecosystem and connectivity with a lot of startups and VCs. That was what made them valuable. Everything else about the bank in hindsight was not valuable at all, quite frankly.

Clearly, they didn’t know what they were doing at the top of the house. I’m not afraid to say that. It’s pretty clear. It’s an embarrassment to the banking industry, quite frankly. That said, it brought a lot of eyeballs to venture debt because they were the biggest lender in the space. Some said they were up to 50% market share. Maybe even more. What this meant and what it means going forward is that you’ve had this big event that’s basically shifted the supply and demand and balance.

Now there’s an immense amount of demand for capital from startups, but the supply has been pulled back because SVB is no longer making as many loans. A lot of other regional banks as well have pulled back on lending for other reasons. Look at what’s going on with commercial real estate. That’s the next shoe to drop. When we see the 3rd quarter and 4th quarter number, it’s going to blow a hole in a lot of regional bank balance sheets. They’re going to have to pull back lending immensely.

That’s also going to cause a loss of confidence on the part of depositors, which means you’re going to see deposit outflows who are not only fleeing because they can get higher yields in treasuries, for instance and T-bills. They’re all going to flee because a lot of these banks are going to have losses that are greater than their tangible equity value. Imagine you’re a depositor in a bank and you see a headline in the Wall Street Journal that says, “Your bank has losses greater than the equity value in the bank.” You’re thinking, “I should pull my money out,” because most of the deposits at some of these banks are uninsured.

I won’t name all the banks now, but there’s a long list of regional banks that are going to be in this boat and it’s going to be sinking. What this means is less capital is going to be provided by banks to startups and other corporations. There’s this big gap in the market because on the demand side, we’ve had three years of record funding in venture equity. There’s all these companies that are funded in 2020, 2021, and 2022, and guess what? They’re going to be coming back to market because the average funding cycle for startups is about two and a half to three years.

All the folks that got funded in 2021 are going to be looking for capital again in 2024 to keep the lights on and keep growing. Where are they going to get it? They’re not getting it from the venture equity investors because the market’s pretty much shut. It’s hard to get an equity check these days. Capitals are incredibly expensive. The check sizes are smaller. It takes a ton of time to get deals done. VCs got blown up the last couple of years. They’re sitting back saying, “We’re out. We’re taking a conservative approach. We’re not throwing money at everything like we were the last three years.”

It’s very hard for founders to raise equity capital and it’s very expensive for those that can. That means they’re going to look for debt capital to complement whatever equity capital they can raise. The problem there is that the debt capital is being pulled back because SVB and other regional banks are pulling back. Now, if you’re a founder, you’re dire straits in some cases. It hasn’t hit everybody yet because they’re flush with cash from what they raised in their rational bull market in ‘21 and to some extent, that first part of ’22.

You’ve got all these companies that are going to realize pretty soon. “Our runways are running pretty short. We better get back to the market.” Guess what? They’re going to be in a queue with thousands of other companies all thinking the same thing. What that means is, to sum this up, this is a supply and demand story, which is ultimately the first thing you should be thinking about as an investor. I’ve mentioned this on the show before. Every single person I talked to will mention two things to you as being critically important.

The first is the versification. We already hit on that. The second is to look for opportunities where there’s greater demand than there is supply. It’s Econ 101. It’s what drives prices up. If there’s more demand for capital than there’s supply and I’m a supplier of capital. That means I’ve got great negotiating power, great leverage and I can charge more for capital. I can also be incredibly selective about the companies that I choose to lend to.

The amount of deal flow we’re seeing right now is just mind-boggling. We don’t even have time to look at every deal because there’s so many. It’s like, you have  to hit a high bar to have a phone call and just to have a zoom meeting because there’s so many people in the queue. That’s not going to change. In fact, it’s going to ramp up tremendously in 2024 because we’ve had a little bit of a reprieve. The markets have done okay and the economy’s held on a lot better than people anticipated.

It’s giving people a little more runway than they anticipated if you think about where they’re forward-looking view was months ago, but that’s going to change. At some point, the market is going to have a real recession. At that point, imagine if you’re trying to raise capital. Not only do you have these supply and demand and balances, but you’ll also have a full blown recession and public market valuations are getting smoked. How are you going to raise money? If you’re somebody who’s got dry powder as a capital provider and you’ve got a clean balance sheet. You’re going to have incredibly attractive vintage years in 2024, 2025 and 2026.

The summary of why this is a great opportunity at the moment is we lost the biggest player in the industry in SVB, but not because of this part of their business. I’m not on that side of the business, but we lost the biggest player. The other lenders in this space based on a number of reasons are probably going to be laying out less capital and more conservative.

The equity side of things is going to be more expensive or just not available because it’s going to be tough to get equity in this space. Therefore, anyone who’s got the capital to deploy can be even more selective and can charge more of a premium on the debt side of things. That feels like a pretty nice convergence of a number of factors which make this an interesting time, if not hugely compelling time to look at this asset class.

Summary: Why This Is a Great Time For Venture Lending

I don’t think I could design a better macro environment for a venture lender. I should say though that if you’re a venture lender with a clean balance sheet. I would not want to be eventually a lender or any lender who was making a lot of loans at the market peak. They will do fine, honestly but, that said, 2021 is going to be a terrible vintage year for almost every asset class and loans are no different. I do think private credit will outperform most other asset classes. Venture debt will outperform most in private credit. That said, would I want the portfolio that I underwent in 2021? In simple terms, hell no.

It’s because these are short loans, you’re not locked in like a real estate transaction where it might be a five year, which summary adjustment. Those legacy portfolios are scary.

You nail that one of the reasons why venture debt will outperform in the 2000, 2021 and 2022 vintage is because alone are short duration. By the time the economy cracks, a lot of those loans will already be paid off. As I said, before they derisk pretty quickly because you’re getting high interest coupons and their amortizing. It’s a great time to be a venture lender in general but it’s the best time to be somebody with a clean portfolio who can be very risk averse knowing that things are going to get worse probably before they get better.

If you go in with that mindset knowing we think the public markets are going to get smoked. We think real estate’s going to get hit hard, especially commercial real estate. We think that inflation is still running rampant and has not been tamed. We could be entering a stag inflationary environment. If you go into it with that as your base case and you underwrite conservatively knowing that’s probably what you’re going to face.

The likelihood of loss is very low. In other words, prepare for the worst and hope for the best. With that, I want to turn it back to you. I want to ask you a couple of questions. One is, in terms of lessons you’ve learned from watching others or your own endeavor’s, especially around risk and mistakes. What are some of the takeaways you’ve had?

The industry is getting easier to diligence and that was always the problem, is a new sponsor came to market. Most RIAs don’t have the team or the bandwidth or the disposable capital to get a lawyer to do background checks on the managing team for a new sponsor coming to market. There was always this risk not just from a, “I want three years of track record.” You think, “I also want to see in three years whether any skeletons come out for new friends coming to market.”

The industry’s got better with a third party of diligence firms who will do a report. That helps diligence offices, RIAs, brokers or whatever, sleep better at night because they have got a third party rapport which they’ve not paid someone bespoke to do it. The sponsor has paid for that. I think that helps a lot. It used to be hard for the newbies to crack the space because you need capital to build a track record but you don’t get the capital until you get there.

That was always a risk and there were some bad actors in the space. Alts is becoming more mainstream. That means more people coming into it, which means the chances are there’s always bad actors in every space, but because alt is becoming more mainstream, there’s much more support around the industry. It’s important and I think we’ll see this going forward. Those guys who allocate heavenly to real estate or commercial real estate, either the last company years because they would dipping their toe and water. They are doing the right thing now, which is looking at other asset classes.

It’s this diversification within diversification. It’s my number one takeaway. Someone gets on board with, let’s do alternatives. That doesn’t mean just doing one part of alt because as we talked about, some of the legacy portfolios in real estate are going to be a real drag. There are trillions coming up in refinancing in the next eighteen months or so, on the real estate side of things which is a concerning statistic. Rates are a lot different and therefore, the opportunity and asset that was profitable previously now needs to be refined.

If everyone had put 20% of their overall portfolio into just one type of alternative, there might be some issues there. It’s this diversification within and if we’re even talking about private credit/private debt, diversification within diversification within diversification. It’s, let’s look at this space. Let’s pick up some medium or small business loans in this space. Let’s look at some secured against real estate and then let’s look at some venture debt as well.

Let’s say that we’ve got a reader who’s a three-man RIA team that runs $100 million or something like that. We get it that you’re wearing so many hats already, portfolio manager, business development, and climb relationship manager. There’s a lot going on there, but it is so much easier to get into some stuff and to build the small portfolio than five years ago where basically you needed a full-time employee to handle the old side of the business because it was hard to navigate. The industry now does mean that we can diversify and it’s not a complete Black hole as far bank is concerned like it used to.

You made a great point about the diversification within the diversification within the diversification in the sense that if you like a strategy, let’s say, you like venture debt. You say, “This is interesting to me. It would be a great addition to our portfolio, but I don’t know what manager to choose.” That’s like saying if you like technology, would you just go buy one text stack? Would you say, “I’m only going to buy Apple but I’m not going to buy Google.” No, you diversify and you buy a handful.

If you look at who does well, it’s typically not funds or RIAs that are betting on like one particular manager. They’re basically betting on a strategy and then diversifying within that strategy. My advice to the people is, if you’re intrigued by venture debt and you understand the value proposition. Don’t pull your hair out trying to figure out who’s the best of the ten good venture debt funds out there. Pick three that are different in how they operate within venture debt.

I had a potential investor in our fund and still a potential investor saying, like, “I don’t know if I should invest in you or Hercules.” Hercules is the biggest venture lender in the space. They’re publicly traded. They’ve got like three billion plus in assets. We’re very different. Why don’t you go buy Hercules? You can buy their stock on the NASDAQ. It’s publicly traded. It’s liquid, but that also brings with it some risks. Their deals are much different from ours. They are doing like a big deal much larger. Three to five times as big as our deals.

They are doing a lot of life science deals, biotech, etc., that we don’t do. It’s a very different risk spectrum. They also have a giant existing portfolio that was under and over the last few years predominantly. Whereas, we’ve got a clean portfolio that’s only forward looking. I would say to somebody like that, “Go buy a public BDC that specialize in venture debt. Invest in RIA as an LP and then find another private fund that’s bigger with a longer track record that’s like a hybrid of the two.”

Now you’ve got diversification in terms of stage and size, but you also look for venture lenders that have a different industry focus. The risks in early-stage life sciences are going to be very different from energy, for instance, or real estate technology. I like this idea of diversification. I also want to remind people. You don’t have to just choose one. The whole point is, in fact, not only do you not need to. You should not. You should be diversifying across every strategy that you like. If you like real estate, pick your three best real estate managers that have different strategies. That’s a piece of advice that I wish more people would hide.

This is probably the two most common push backs that advise. One is liquidity or illiquidity. I wrote an article about why illiquidity is a good thing. I’m happy to share that with anyone, but the second thing is about track record and being terrified of new managers. I get it that if you’re going to allocate to four different people in this space, as you said, pick up a Hercules public company and then pick a couple of emerging managers or whatever, because that’s a risk reward play in itself.

Key Takeaways On Diversification And Risk Management

People are scared of new managers because of lack of track record and also, they might not have been around long enough for any skeletons to come out the closet, but guess what? A new manager is not going to have a legacy drag on their portfolio. That is significant at the moment. That’s a risk reward play in itself in the diversification within the diversification.

Make some allocations. Only smaller emerging newer managers because that performance won’t have legacy drag. That’s the risk trade off there rather than wait three years to get a track record because that’s what historically we’ve done. That’s a diversification play as well, the age of the manager. Especially in this environment where there’s so much legacy drag on some.

Those are two tremendously valuable points. The point about investing and emerging managers is backed by a lot of research that shows that emerging managers outperform. Most institutional allocators know this. They’ve read their research, but they still don’t do it because there’s a little bit more career risk. They know that they’re on average. They’re going to outperform with the emerging managers, but they don’t want to invest in these folks often times because if they do happen to pick the lemon then it’s going to look bad for them.

That’s said, emerging managers do, if you look at the data, outperform consistently. A lot of that has to do with incentives and the fact that emerging managers have a lot more skin in the game. If ARI doesn’t work out, Zach Ellison is toast. If you invest in Hercules and they make a bunch of bad investments or their stock gets blown up and it’s down 70% like it was in April 2020. Who cares? Those folks can leave. They’ll wind up somewhere else.

Silicon Valley Bank, half of those bankers are gone now. You had a relationship with SVB and you thought it was going well. They’re gone. They’re somewhere else. Do you want to interact with the managing general partner of a fund or do you want to be talking to a 28-year-old VP who’s going to be somewhere else just looking for their exit ticket? That’s not true just for venture debt. It’s true for every emerging manager.

These folks have skin in the game. They’re all-in. They have to make it work and the performance reflects that. One other point I wanted to make about the illiquidity, being a good thing. I’m guessing it’s because it forces investors to not over trade and it reduces the behavioral biases that lead them to sell at the lows and buy at the highest. Am I right?

Emerging managers have skin in the game and consistently outperform. It’s time to look beyond track record and embrace fresh talent. Share on X

There’s a number of points I hit on but two of the main points are the illiquidity premium, which is even if it’s saying, “I need to go fund,” or something which has to have a decent amount of liquidity. That probably means that 10% to 20% is sitting in cash because they might have redemptions. That means that a manager like you can’t deploy the full amount into the strategy that earns the down money because they have to sit there and cash for the quasi-liquid opportunity.

The illiquidity premium is huge. If there’s two reach, one private and one public and all of that characteristic of who’s out including their yield. People are going to go for the liquid public one. The private one has to offer an incentive to tie up your capital for a period of time. That other point is the fact that humans are emotional and therefore, illogical some of the time. Think about the beginning of COVID when so many people pulled out of the market.

I was one of the people and we thought we were going to have a disaster, which never happened at that point. The people who tried to time going back into the market clearly didn’t do it well because that’s just how things work. If you like something because it makes sense and it’s a five-year play. Stick by your guns.

If something’s illiquid, it means you can’t make stupid decisions because half of the time, the stock market peaks and drops are driven by sentiment emotion and it’s not a true representation of the actual value. If something is valued based on its assets independently by a third party like a nave, then that’s the true value. Not because they missed earnings by $0.1and suddenly took a 20% hit which just makes no sense. It gets us away from that emotional and impulsive investing which is an issue.

I’ve got two thoughts on liquidity that are irrelevant. One is with drawdown funds like a traditional private credit fund or private equity fund or venture capital fund. The fund only draws down on investor capital when they have an investment to make. When people say, “I want to be in something liquid.” My response is, “You’re going to have all the money in your control, so you’re 100% liquid until it’s invested.” If it’s invested in a venture loan, for instance. It’s immediately kicking off roughly 15% cash yield. You’re not as a liquid as you think because the cash is only being drawn as the fund makes investments. That’s the first point.

The second is how much liquidity do you need in your portfolio? Folks that want to be 100% liquid are giving up yield. They’re giving up in return. There’s a trade-off. There’s no free lunch. If you want liquidity, you’re getting lower return full stop. My thinking is, would you ever sell 100% of your portfolio? If the market was down 30%, would you say, “I’m going to take 100% of my investments and I’m going to liquidate them and go stick it in a treasury bill?” No. Anybody who does that as a moron.

The reality is you’re going to want some of your portfolio to be liquid and a lot of your portfolio to be earning return in that illiquidity premium that you talked about. What that percentage of liquidity needs to be in your portfolio? It depends on your individual needs, but it’s not 100%. It’s not even close to that. I would venture that at somewhere for most people in the range of less than 25% and for institutions as well. Whenever somebody says, “We need to be liquid.” My first thought is this person even has no idea how to run a portfolio, to be frank.

My often pushback to advisors is, “With all due respect, if you are doing your job properly and planning long term. You’ve got to have some illiquid assets in that because if you need 100% liquidity, either you are in one hell of a unique situation or you’ve just not done your longer term-planning. You are leaving money on the table.” That sometimes gets the message across because an advisor says, “You’re right. We are leaving money on the table. We need to get together and do a 5-10 year plan,” which is in the benefit of everyone as well. We’re on the same page on that.

You nailed it in the sense that most good advisors rightfully will tell you that you should be thinking long term. That’s how the best investors think. If you think about like Warren Buffett. The best 100 investors of all time, I bet you like 90% of them are long-term oriented investors. If you’re investing long term, meaning 5, 10, 15, or 20-year type horizons then why would you need liquidity? How can an advisor tell you, “You need to plan for the long term. We’re going to build a twenty-year plan and include the next generation in that wealth planning potentially as well, but by the way, you should be buying liquid investments.” It literally doesn’t make any sense.

If somebody says both of those statements to you, then you should be thinking, “They don’t know what they’re doing. and I should probably find somebody who does,” because it doesn’t make any sense. It’s just not logical. We’re just about out of time. I wanted to get your partying thoughts on where we’re headed the next couple of years, how people should be thinking about that and preparing for it.

I’m going to say a lot of things that I already touched on. The alt space is the place to become easier. The biggest trend is continued simplification. Custodians billing and reporting lower minimums. That’s a huge thing. In one of my presentations, I have two pie charts which show even five years ago, let’s say, the minimum investment was $250,000 into most quality alternative investments. You need a million dollars to even have a four-way diversification in alts, which probably means your net worth needs to be North of $10 million if you put in a million dollars in alternative.

Most of the minimums are coming down and we’d spoken about you are now having a more of a feeder vehicle to cater for some of these smaller ticket sizes because we thought that was important. In some cases, you can get quality alternatives for $25,000 rapport, which means $100,000 gets you a four piece alternative portfolio. Which means your network might just be a shade over a million dollars. That is huge in terms of for advisors the difference between being able to serve these clients with a million dollars net worth in the alt space compared to $10 million where they might have two clients that check that box.

The analogy I’ve used is the alt space used to be the AmEx Centurion card and now it’s the AmEx platinum card. It used to have to be ultra-high net worth to be able to build a proper alternative portfolio. Nowadays, you don’t need millions. When I was at Barclays, they called it the mass alt, which is standard high net worth investors. The alt space is changing. It’s becoming more accessible. The minimums are dropping. The custody is easy and the third-party rapports. All of it is making it easier for everyone.

We’re going to see not just a continued growth in the space, but we’re going to see continued growth of different types of asset classes so that things like private credit/private debt, which will not necessarily be commonplace, are going to become more commonplace. It was someone from Apollo, in an interview said he could see in the near future retail investors having more than 50% alternatives from their portfolio and I don’t disagree with that. I don’t think it’s that far away because the endowments have had more than 50% allocation to alts and for the last ten years. That’s the way the industry is going. Alts is going to become more accessible, easier to invest in, and that’s going to be a bigger part of every rapport going forward.

That’s the big trend and those that get ahead of that are going to see a lot of inflows to their own business because they’re going to have access to differentiated strategies and differentiated managers and they’re probably going to have higher risk adjusted returns as well. All those are going to lead to more asset aggregation for those that can get access to alts.

That’s a different advantage and it’s a competitive disadvantage if people don’t have access to some of the more sophisticated strategies because their competitors will. Clients are getting smart. Clients might have read something on SVB and say to their advisor, “What have you got available in the venture debt side of things?” If you don’t, that’s a problem.

That’s what I’ve been mentioning to people on the RIA side of things, like you got to get smart about all these strategies. Whether or not you invest, it’s your prerogative but if your clients are asking and you don’t have an answer, they’re going to find somebody who does. With that, I wanted to thank you for coming on. It’s always great talking to you. What’s the best way for folks to contact you and find out more about what you’re doing?

You can find me on LinkedIn or Richard@HillsonConsulting.com. It’s’ the best way to get in touch and happy to speak to anyone. Whether on the investor side, the RIA broker side or on the sponsor side in terms of how do we educate and how do we lessen these barriers in the space because everything is about how we make alternatives easier to navigate and more accessible for everyone and connect quality product with the end user.

Thanks again for coming on. Thanks, everybody, for reading with Zach Ellison.

 

Important Links

• Hillson Consulting
• Barclays
• Hercules
• Third Seven Capital
• LinkedIn – Richard Hillson
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• Richard@HillsonConsulting.com
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• DISCLAIMER – 7 in 7 Show

 

About Richard Hillson

Richard is a financial services entrepreneur and an expert in the field of alternative investments. Over the course of his career he has helped many investment advisors grow their businesses, serving as a trusted advisor and gatekeeper to quality institutional product.

Before founding Hillson Consulting, he co-founded Third Seven Capital, LLC a privately owned, boutique investment bank specializing in alternative investments and was also CEO of an RIA aggregator.

Richard is a British national who began his career at Barclays Wealth and has since worked with a variety of companies as an investor, banker, strategic advisor, and board director. He studied law at the University of Nottingham.

At Hillson Consulting, Richard’s focus is to work with advisors to improve their offerings, particularly relating to alternative investments. This involves educating advisors and their clients on this misunderstood asset class and helping them navigate access to the best-of-breed offerings.

Richard regularly writes discussion pieces for leading publications and his educational presentations on alternative investments are CFP CE approved. He was asked to adapt his presentations to be a guest lecturer at Universities and business schools and most recently presented to the economics faculty at the University of Nottingham.