Considerations for Allocating to Private Capital

In the next market cycle, we believe active asset management will be crucial to navigating the challenging environment created by high equity valuations and low interest rates. At Balentine, we look to spend our active management budget primarily in private capital.

In Private Capital, meaningful excess returns are more persistent than in the public markets, and true active management beyond the point of purchase takes place. In our view, this persistence is due to the high growth nature of private companies and the control managers have over the outcome.

High growth: Companies in the private markets can double or triple earnings year-over-year as they expand from ideas to country-wide products. Once a company has reached the public markets, the growth can continue but typically at a much slower pace.

Control: Private capital managers can also add value through the control they take of the company. Managers can take a long-term view on replacing management, starting or stopping a product line, or expanding into new markets all without the worry of missing a quarterly earnings number.

To capture the excess return that comes from high growth and control, investors must be willing to accept illiquidity, or not having access to their money for an extended period of time. This illiquidity is necessary as it gives private capital managers the resources to let their theses play out without selling assets crucial to their operations. The illiquid nature and dependency on the general partner for success drives our due diligence process to be robust and repeatable. We evaluate private capital managers with the following criteria:

 Teams have a history of working together

 General Partners have seen multiple economic cycles

 Have proven ability in managing a fund — we typically stay away from first-time funds

 Have a clear succession plan in place

 Investment process is clear and repeatable

 Manager has an apparent edge in deal sourcing

 Changes in the process over time have led to better results  Philosophy aligns with current market opportunity

 Return comes from the improvement of the underlying company or asset and not from leverage

 The People, Philosophy, and Process categories manifest themselves in consistent first and second quartile performance

 Underperformance is explainable and lessons learned have led to process improvements

When assessing where to invest in the private markets, we look to asset classes that have an established history of excess return and that can absorb billions if not trillions of dollars and maintain that level of excess return. These asset classes are private equity, private real assets, and private debt. We then seek managers that align with our due diligence criteria in the following sub-asset classes:

 Venture capital is an investment in early-stage, emerging companies with high growth potential.

Venture capitalists typically take a minority stake in the company and use their talents to assemble the right leadership team, create repeatable processes across the company, and leverage their network to grow the business.

 Growth equity is an investment in a more mature company which typically has a proven product and is looking to expand or restructure the company. Growth equity managers typically take a minority stake but can have a controlling stake.

 Buyout equity, or leveraged buyout (LBO), is when a private investor borrows money to purchase a controlling stake in a company with the goal of creating efficiencies, increasing margins, and then either selling it to another private investor or taking it public.

 Value-add real estate investing is the purchasing, repositioning, and selling of real estate — typically involving older buildings in economically strong areas diversified across residential, commercial, industrial, and retail properties. The focus of value-add real estate investing is driving improvement, which is opposed to core real estate’s “buy and hold” process geared toward collecting rents.

 Infrastructure and natural resource investing is the purchase and operation of key infrastructure, such as sea ports, airports, or energy generation and distribution. Similar to value-add real estate investing, the manager will typically reposition the asset to garner a higher exit price while collecting cash flow from operations.

 Secured Lending is lending to small and mid-size companies which cannot access the public debt markets. These loans are high in the capital structure and typically have strong covenants. Loss rates tend to be low, and yield tends to increase as EBITDA of the borrowing company decreases.

 Non-secured Lending is junior to senior debt and therefore earns a higher yield. This debt is typically used for leveraged buyouts or when companies already have senior debt in place. Loss rates will tend to be higher than senior secured but can be offset from a return perspective by managers taking a small equity position in the company.

 The ebb and flow of markets bring myriad dislocations and therefore investment opportunities. Balentine is constantly on the lookout for these opportunities that can be accessed in the public or private markets.

An investor’s private capital portfolio should be sized based on the need for return and balanced by the level of spending. The higher return an investor needs, the more private capital to which they should allocate. This needs to be balanced, however, on the level of spending from the portfolio. We complete strict scenario analyses to ensure we size the illiquid portion of a client’s portfolio under the level which would inhibit the same level of spending. Below is a chart that depicts this relationship:

7%

6%

5%

4%

3%

2%

1%

0% 0% 10% 20% 30% 40% 50% 60%

Source: Balentine

The size of the private capital portfolio determines the final allocation. The more assets that are allocated to private capital, the more funds can be used. Balentine utilizes a core – moon – satellite approach that goes from broad based, diversified funds to more focused, sometimes thematic investments. This is depicted in the following chart:

$5,000,000+ in private capital

$2,500,000 in private capital

$1,000,000 Assets in private capital 3c-1 options

We believe the next market cycle will be a defining one from a return perspective. Portfolios that can handle the complexity and illiquidity of private capital should distinguish themselves from portfolios that cannot. Balentine has invested material resources to ensure we can build the private capital portfolio that our clients are going to need for the next cycle.