← Capital Allocators – Inside the Institutional Investment Industry
Capital Allocators – Inside the Institutional Investment Industry
Mike Kelly – Democratizing Access to the Middle Market at Future Standard (EP.473)
01:00:15
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- [00:00]
Mike Kelly
The days of financial engineering your way to higher returns, in my view are over. Where you're really going to see the outperformance in private equity are going to be faster revenue growing companies, lower multiple entry points, more fragmented ecosystem private companies and where you can add operational value that just simply tends to be more in the middle market than in the large and mega cap private company company market. Franklin Square the analogy I use is Netflix. They were packaging and distributing other people's contents, in this case GSO's middle market lending practice through BDCs. It's a little bit like red envelopes and DVDs. They had built this incredible distribution engine and pipes into all of these individual investors through the broker dealer market. It had been my background to build out asset management companies and I thought, well, just like Netflix eventually came to the conclusion that building your own TV and movie studio and putting it through your own pipes might be a good idea as long as the quality content is high. I thought we can do that here.
- [01:08]
Ted Seides
I'm Ted Seides and this is Capital Allocators. Our continuing exploration of the intersection of private wealth and alternatives takes us to Future Standard, one of the largest distribution platforms bringing the wealth channel exposure to the middle markets. My guest is Mike Kelly, co president and Chief Investment Officer of Future Standard, a $90 billion alternative asset manager focused on private middle market strategies for the wealth chain. Mike has been in the alternatives industry for three decades, starting as an analyst under Lee Cooperman and Julian Robertson, helping build FrontPoint Partners, which began the institutionalization of hedge funds, serving as CEO of Oryx USA where he led the acquisition of $250 billion global asset manager Rubico and for the last decade, turning to the democr of alternatives. Our conversation covers Mike's path from working in hedge funds to building alternative asset businesses, including lessons about incentives, leadership and culture. We then discuss his pivot from the institutional market to the wealth channel and the growth from a single strategy at Franklin Square with $12 billion in assets to a full suite of strategies under the rebranded Future standard. With 90 billion across private credit, private equity, real estate infrastructure and multi asset invest. Mike also shares his views on performance expectations and what the flood of new capital means for the institutional market. Before we get going, it's that time of year when we turn to traditions like the tradition of Thanksgiving, gathering family and friends to share what we're thankful for, one of which is the ability to eat enough turkey and tryptophan to fall into one of the best slumbers all year that nap on the couch while watching football while I'll spend the turkey days with my family. I'm particularly grateful this year for the incredible team of professionals that brings together what you hear and experience with Capital Allocators. That's Hank, our CEO Morgan, our Head of Ops, Tamar, our head of Business Development, and Liz, our Head of Content. I put our starting five up against any NBA all star team off the court. Our values of quality, entrepreneurial spirit, intellectual curiosity, respect, generosity and fun win championships. Although I I can't say the same on the court for my getting dunked on because at six one I'm the least vertically challenged of our starting five outside the office. I'm grateful for you for listening, engaging with our guests and sharing kind words all year long. This podcast is the gift that keeps on giving. So before you start the mad year end dash to calculate performance, conduct 360 reviews and shop, take this time to be grateful for the many gifts in your life. As my friend Dasha Burns recently shared on the occasion of my 55th birthday, may the best of your yesterdays be the worst of your tomorrows. While you're feeling all warm and fuzzy, don't forget to spread the word about Capital Allocators to those closest to you to give them the gift that keeps on giving. Capital Allocators is brought to you by my friends at WCM Investment Management. WCM has the courage to back future histories not evident today. Informed by their unrelenting focus on moat trajectory and elevated by insights on corporate culture, WCM's deep roots in public markets set the foundation for its approach to private investing. They didn't just want to enter the private markets, they wanted to improve the investing model itself, build something better, aligned, more thoughtful and truly long term. As a firm owned by its people and grounded in Laguna Beach, WCM is built for alignment and independent thought rather than chasing a scoreboard. WCM invests with a partnership mentality to build meaningful relationships with founders reimagining their industries. They show up earlier, stick around later, and let value compound over years. WCM's style is their edge authenticity over formality, two way learnings over checklists and stories over slide decks. To learn more, visit wcminvest.com this testimonial.
- [05:42]
Sponsor/Disclaimer Voice
Is being provided by TED sites and Capital Allocators who have been compensated a flat fee by wcm. This payment was made in connection with Capital Allocators testimonial and production of podcasts and does not depend on the success or level of business generated. The opinions expressed are solely those of Capital Allocators and may not reflect the opinions of others. Investing involves risk, including the possible loss of principle. Past performance is not indicative of future results. Please visit wcminvest.com for WCM's ADV and further information.
- [06:03]
Ted Seides
Capital Allocators is also brought to you by Ten East, a private markets investment platform built for sophisticated investors. Ten east offers institutional grade access to private equity, credit, venture and real estate without the complexity of building your own family office. Led by Michael Lefell, former co head of Distressed Investing at Davidson Kempner, TenEast's team sources underwrites, builds conviction, invests meaningful personal capital and provides transparent reporting. I've known Michael for about a decade and after becoming impressed by the quality of TenEast's offerings, its research process and high quality investment team, I became an advisor to the organization, shareholder and investor in multiple offerings. Join investors and executives from leading global firms already co investing through 10 East. Learn more at 10 East Co podcast. That's the number 10 East Co podcast.
- [07:05]
Sponsor/Disclaimer Voice
This testimonial is being provided by Capital Allocators who has been compensated a flat fee by 10 East. This payment was made in connection with Capital Allocators newsletter, testimonial and production of podcasts and was not tied to an investment performance or business generated. The views expressed are solely those of Capital Allocators. Private market investing involves significant risk including possible loss of all capital and past performance is not indicative of Future results. Visit 10East Co for our adv and other important disclosures.
- [07:29]
Ted Seides
Please enjoy my conversation with Mike Kelly.
- [07:33]
Mike, thanks so much for joining me.
- [07:35]
Mike Kelly
Thanks for having me Ted.
- [07:37]
Ted Seides
I'd love you to take me back to your original initiation into the investment business.
- [07:43]
Mike Kelly
I started my career at Salomon Brothers. I spent a couple of years in the FIG Banking group and then one year up on the fixed income trading floor. When I went back to business school I wanted to make the switch over to investment management and the buy side. And this is now we're going to talk about the mid-90s. So it always struck me as odd that who I viewed as the most talented investment professionals of the time were stuck in this arcane part of the investment business. Hedge funds, venture capital, what we now call alternatives. So many of them that despite their young age had made tremendous impact a part of financial services that was a pure meritocracy. And I thought to myself, I want to be part of that club. The hard part was how do I break into that club? I had an old hedge fund directory. I still have it. Paper directory of the names and Contact information for all of the hedge funds of the day. The Julians and the Bruce Covner's and the Paul Tudor Joneses.
- [08:47]
Ted Seides
How many pages was it?
- [08:49]
Mike Kelly
It's probably 20, 25 pages. I went down the list and I cold called all of them. The only one I got through to was Lee Cooperman. Lee, who notoriously was known for doing more with less, answered his own phone. Lee, one word and I made my pitch. I was a kid from the boroughs. He was a kid from the boroughs of New York. I told him that I wanted to come work for him. I would work for free and sleep on my parents couch and do whatever it takes to break into the hedge fund industry. He told me that he only hired PhDs and I was getting my MBA at the time, so I thought I was ruled out. Then he said that PhDs stood for poor, hungry and driven. And I thought well I check all three of those boxes. He said, well I'm a value investor, I like the price. You start Monday. That was the beginning of my entry into the hedge fund industry in the mid-90s. From there I went on to work at Tiger Management. Incredible firm with incredible people, super talented. From Julian across all of the analysts and PMs. After that we started FrontPoint Partners with the view to bring specialized alternatives hedge funds to an institutional investor class. If you think back in the late 90s, early 2000s, that was actually a thing we called it. The institutionalization of hedge funds was 12 years of my life. Wound up being the chief investment officer and co CEO of that firm with Dan Waters. We ultimately sold it to Morgan Stanley and ran it for Morgan Stanley for a few years.
- [10:23]
Ted Seides
I'd love to hear what stuck most in your early analyst experiences with Lee and Julian Tire.
- [10:30]
Mike Kelly
What I appreciated the most was being around really intelligent people doing intense focused work. It always struck me that one of the most important lessons was to be intellectually flexible. And what I mean by that is come to a view based on your work, but be open to change your mind if you see disconfirming evidence. Don't just find evidence that supports your view and block out anything that disconfirms your view. The other important lesson that I learned, which really came more from Michael Steinhardt than anyone else, which is this idea of a variant perception. Think about what's already in the price. You might be bullish on something, but if everyone else is just as bullish, then where is the opportunity? Somebody who says well I like to be long high quality companies and short poor quality companies. Well I Wouldn't mind being long a poor quality company if it's going to get better if I have a variant view on that, and vice versa. This idea of finding your thought process and how it differs from what's already baked into the price was a big important lesson early in the investment career.
- [11:45]
Ted Seides
What was it like sitting in those seats when hedge funds weren't even much in the institutional market?
- [11:52]
Mike Kelly
If you think about my career in the arc of asset management, when you think about the 60s and 70s, the old A.W. jones model, which then talked about the early days of barbarians at the gate and private markets went from the Bass brothers and Richard Rainwaters, that family office Memphis Mafia type capital through that 70s and 80s. And of course, as you're very familiar with David Swensen, then in the mid-80s adopted the endowment model and began to say, I want to invest the way these sophisticated pools of capital are investing. That begun the trend of institutions embracing that. When you're in the 90s, you're still at a point where it was mostly family office capital invested in these types of strategies. The early days of endowments embracing and then ultimately pension plans, insurance companies.
- [12:45]
Ted Seides
What did it feel like doing the work on companies with the rigor that hedge funds had back then compared to what seemed like a much smaller pool of active managers?
- [12:56]
Mike Kelly
Back then, information was not as ubiquitous. There was extra legwork you could do that would give you a real comparative advantage. Looking at these companies, looking at trends, identifying sources of information on macroeconomics and data, working within the companies, understanding the supply chains. There was a time when there was far more inefficiencies that created significant amount of opportunity. As time went on, as we saw through the 2000s, the passive indexation and ETFs and the capital markets, changes in the public market rendered some of those advantages obsolete.
- [13:37]
Ted Seides
What led you from, you could say working in the business, doing research on companies, picking stocks to the front point, which was institutionalizing the business itself. Working on the business.
- [13:49]
Mike Kelly
Early in my career I went into macro investing. I wanted to be Stanley Druckenmiller or Paul Schier Jones. It always struck me that people who went into investment management wanted to be the next Warren Buffett. They wanted to be the next Julian Robertson or Stanley Druckenmiller. Very few people set out to say, I want to be Larry Fink or Chip Miller and manage these businesses and grow these businesses. I thought I could spend my life trying to become the next great macro investor and I might be good at it. There are a lot of people fishing in that pond, but actually building asset management companies and managing them. There seemed to be nobody that sets out to do that. I thought, well, maybe that is my career path. If I can do that, There are few people fishing in that pond. It's a much more inefficient market and I could be a plus at that. That's where my head was at. When we were building frontpoint as opposed to using that as a platform to manage, was my original intention to go and help build asset management businesses as.
- [14:48]
Ted Seides
Institutions were first starting to adopt hedge funds, what did you see that was important for FrontPoint to deliver to institutions who were adopting it for the first time?
- [14:58]
Mike Kelly
When we started FrontPoint, many of the hedge funds at the time were run similar to a family office. We saw an opportunity to build a firm that could partner with institutional investors and help them demystify these strategies, understand what the risks were, understand how they fit into their portfolios, give them much greater transparency around holdings and around risk attributes and risk contributions, more akin to what they were used to in dealing with more traditional asset management companies, which at the time were long only companies. We set out to build a firm that brought the best facets of the traditional asset management business to alternative and hedge fund strategies. In that business, we saw an opportunity to be a key partner to institutional investors and help them embrace these strategies and how they could be helpful to them in their portfolios. This is back in 2000 and late 90s, it was differentiated.
- [16:04]
Ted Seides
What was it that you did that hadn't been in place before that there.
- [16:08]
Mike Kelly
Wasn'T the level of transparency and understanding of reporting and risks and positions, diligence down to the manager level and their process. That approach wasn't fully embraced. The culture was more about we're great investors, give us your money and will generate great returns. We may or may not be able to or want to explain to you how we go about doing that and.
- [16:37]
Ted Seides
The trajectory of that decade. Frontpoint had some great success as hedge funds were getting adopted by institutions, then had some hard times later, and would love to hear what you took away from what works when there's a big group like institutions starting to adopt a new area. And then what are some of the pitfalls along the way?
- [16:57]
Mike Kelly
When you look at capital coming in, understanding what the motivation of the capital coming in, what drives that motivation and are expectations appropriately matched with what can be delivered? At the time institutions were looking to hedge funds as diversifiers. You and I both know you can construct portfolios that extract the alpha and mitigate the Beta. The whole of the hedge fund industry wasn't necessarily doing that. There was still a lot of embedded beta in many of these strategies. Ensuring that what you were offering and what the institutions were getting was a big factor in that. In terms of learnings, being in a position where you can manage expectations and incentives appropriately is extremely important. If you think about the Charlie Munger quote around show me the incentives and I'll show you the behavior. If you want individuals to act in a way where they are collaborating and working towards a client outcome, you have to appropriately construct those incentives correctly. That's often where in investment management things go awry. Because I'm having a problem getting these guys that I'm managing to do what I want them to do. I always start by asking them, well, what's the incentive framework that you've designed to get them to do that? Because if you correctly frame the incentives, they will behave appropriately. They're rational human beings.
- [18:24]
Ted Seides
So after a long period of time of doing that, you sell the business to Morgan Stanley. How did you decide what was going to come next for you?
- [18:31]
Mike Kelly
I like to build businesses. I enjoy investment firms where there's a combination of working with investment professionals and managing people and working closely with clients, finding an opportunity to be entrepreneurial, be able to harness those experiences and skills while thinking about where the world was going and what the next big trends were going to be. That was the real opportunity and that's where I was taking the time to think through what are the next big opportunities in asset management? That arc of history of high net worth, ultra high net worth, capital, institutional capital, Embracing these non traditional forms of investing. Who was being left behind in that? The mass affluent and the individual investors. And how to bring those opportunities to them. If they're so good for the most sophisticated allocators in the world, why are they not made available to this group of investors? That was just a mission based opportunity. So I was at Orix Asset Management. I was running asset management. This is a Japanese holding company and they wanted to build vertical businesses, one of which was in asset management was helping them do that. And I bought Robeco for them in Europe, which is a several hundred billion dollar asset manager out of the Netherlands. I wanted to go back and do something more entrepreneurial again and build another business. This is now 12, 13 years ago. I had a view that the next big leg in investment management was going to be bringing alternative investments to a broader marketplace, the mass affluent marketplace, individual investor marketplace. I began to talk to some people in my network about that. View and what to do about it. Bennett Goodman and Doug Ostiver at GSO along with a good friend of mine, Scott Fletcher had mentioned Michael Foreman and Franklin Square. GSO had had a relationship with Franklin Square. They were sub advising the BDCs for them. Bennett and Doug thought it would be a good idea to go meet with Michael and talk to him about what I was thinking, what he had been doing already. That begun a series of conversations with Michael talking about his business. And it really resonated with me what Michael's vision was. He was bringing income strategies to the individual investor marketplace through the independent broker dealer channel and wanted to build that out at the time. Franklin Square the analogy I use is Netflix. They were packaging and distributing other people's contents in this case GSO's middle market lending practice through BDCs. It's a little bit like red envelopes and DVDs. They had built this incredible distribution engine and pipes into all of these individual investors through the broker dealer market. It had been my background to build out asset management companies and I thought well, just like Netflix eventually came the conclusion that building your own TV and movie studio and putting it through your own pipes might be a good idea. As long as the quality content is high. I thought we can do that here. And that began my joining Franklin Square and working with Michael and the team to turn them from this packaging and distribution company into a world class asset management company.
- [21:58]
Ted Seides
What was the product suite when you arrived?
- [22:01]
Mike Kelly
At the time, Michael and GSO had launched the first ever non traded bdc. They had a BDC and a closed end fund and it was exclusively at the time with GSO as the solo partner. The first thing we set out to do was to undertake external partnerships with some other managers. Golden Tree, EIG Rialto and Real Estate. And building out the product suite in other areas of private markets. Mostly around an income orientation at the time. Bringing strategies that delivered income in a world that was starving for yield into retirement accounts. We set about doing that. Then we began to internalize the capabilities. I'd hired Andrew Beckman who I knew from Goldman Sachs and Magnetar. So Andrew Beckman and his partner Nick Halebut and then built a team around that for internal private credit capabilities. That began a series of additional bolt ons of teams and acquisitions. About three years ago we made the decision to expand from income strategies into growth strategies and solutions businesses. We talked with a number of investment firms about that and came across Portfolio Advisors. Portfolio Advisors had been a private equity solutions business and been in business for 30 years helping institutional investors navigate their the middle market private equity business. So primary allocations, secondaries, co investments that began a conversation with them which culminated into us merging our businesses two years ago. There was no overlap in our strategy base. So we took our credit and real estate capabilities and combined it with their private equity capabilities and integrated that under the common future standard brand. Today we have close to 90 billion of assets under management across five different verticals. Private credit, private equity, real estate, multi asset and infrastructure. We just announced an acquisition of Post Road Group in digital infrastructure. So that will be our fifth vertical. And about 20 different investment strategies that we offer across those five verticals.
- [24:11]
Ted Seides
I'd love to tease through part of that capital allocation investment process. So as you started to go from a single relationship with GSO to what's become five assets classes, some done directly, some with managers, how did you think about in a big world of asset managers who you wanted to partner with?
- [24:31]
Mike Kelly
When we set out for partnerships, we thought about the individual spaces that we believed had risk reward that was appropriate for the private wealth channel. Varying forms of private credit stood out among them. Middle market private credit, unitranche lending, real estate, commercial real estate lending. These were areas that we felt strongly about, offered a very attractive entry point for individual investors through their advisors for what they were looking for, which again going back was very income focused in terms of the objective set. We then came to who do we believe are the best of breed managers across these different areas, GSO and KKR stood out as that golden tree in the hybrid between public and private credit. EIG and energy credit Rialto in commercial real estate lending. A lot of these were personal relationships that we had. These were people we knew very well. We knew their teams, understood their orientation towards risk. As with all forms of credit, it's not just someone who can source and originate and underwrite credit, but also someone who can deal with problems when they arise. And credit problems always arise. And so we wanted strong risk orientation and workout capabilities across those areas. That's how we decided on the varying combination of personal relationships and core competencies.
- [25:57]
Ted Seides
You mentioned expectations and incentives in the first iteration with institutions. What are the expectations of that individual wealth vertical that led you to say yield is going to be the right place to get started Backing up.
- [26:13]
Mike Kelly
Think about the post great financial crisis period of time when yields really started collapsing. Disinflation, globalization, everything driving yields down towards zero and culminated up to 2021 when we had zero interest rates at that time. The desire to have an alternative in fixed Income to what was historically high liquidity, high duration, low credit risk. Most fixed income portfolios, the 60, 40, the 40% were mostly government bonds and agencies and mortgage backed, which had high duration, high liquidity, little credit risk. To be able to complement that with credit exposures that were less liquid, that had higher credit risk, were a shorter duration through their floating rate characteristics was a nice offset in balance to what was in the traditional fixed income portfolios. And picking up an illiquidity premium, in some cases a complexity premium around that asset class. That to me was a lot of the main drivers of private wealth into private credit.
- [27:31]
Ted Seides
One of the things I always wondered is why income generating strategies are so popular with this group of taxable investors.
- [27:40]
Mike Kelly
If you look at the profile, the investments will often be put into a retirement account where taxes will be less the issue in factoring into the decision making. In other cases, even with a taxable account, the level of yield one can generate is oftentimes even post tax, fairly attractive. If you can generate high single digit, low double digit yields in private credit and map that up against a cash alternative, or where 10 year yields are, it still may be considered advantageous or on a trade off basis.
- [28:21]
Ted Seides
When you looked at the people that you wanted to partner with, best of breed managers, how did you align your incentives with them and their incentives with the ultimate investors so that those expectations can get met in a way that everyone's rowing in the same direction.
- [28:40]
Mike Kelly
In the early days of providing alternatives to the private wealth market, what was then called retail, although we don't call it retail today for good reason, there were a lot of products out there and partnerships that were adding fees on fees. Once you get through all the layers of fees and loads that are involved in these offerings, what's left for the individual investor? We wanted to avoid that situation. And the way to do that is identifying strategic partnerships where we offer one layer of fee and we share in the revenues between partners. We have contributions of capabilities to deliver that and deliver that with one layer of fees, as opposed to passing on two separate layers of fees to the individual investor. That's really been the mission of Future Standard from the beginning, which is we want to level the playing field for all investors. The private wealth channel and individual investors deserve to get the same treatment as institutional investors. So the same types of investments that institutional investors invest in, to give them more fair fees, to give them better structures where they can invest more seamlessly directly into these underlying investments. That's been the point of all of this and it's Been an evolution because it's a big sea change from the early days of those offerings and the access to those original investments to today, where you have individual investors accessing the exact same investments as the largest, most sophisticated pools of institutional capital in the world at institutional levels of fees in structures that work for them, in terms of liquidity and so forth.
- [30:19]
Ted Seides
When you're going to those managers, what does the team behind you look like that had cracked the code on the distribution so that a manager who already has a big institutional presence sees it as a net positive and is willing to share those fees with you?
- [30:34]
Mike Kelly
I joined 11 years ago. Not many alternative investment firms had spent time and money on the private wealth channels. They might have had a small team dedicated to it. In order for an investment firm to undertake serving the private wealth channel, it takes a significant amount of resources, a significant amount of patience and time, because it does take time. We had a fully built national wholesale distribution capability across independent broker dealers, registered investment advisors, wirehouses, regional broker dealers with national accounts, business development, sales and marketing, education and thought leadership, all of that built out with significant resources invested in doing that. That's an important distinction because when you think about a firm like Morgan Stanley, like a wirehouse, that has a significant number of advisors and their underlying clients looking at these strategies, they don't want an investment manager to say to them, here's a bucket, go fill it up with your private wealth money. You have to work with the advisors, help them understand the strategies, the risks, educate them, help them educate their client base. And there weren't many investment firms that had that capability and set of resources and experience doing that. Through the years. Some have undertaken to make that serious investment and done it well. Still to this day, there aren't many firms that are well equipped to bring their offerings to the private wealth market.
- [32:11]
Ted Seides
If you look at that side of your business today, how many people are involved in that activity?
- [32:16]
Mike Kelly
We currently employ 600 people roughly at future standard. Of those, 140 are in that full suite of distribution and client relationship side of the business.
- [32:31]
Ted Seides
When you had these couple of acquisitions with portfolio advisors, how did you think about the buy versus build decision when you wanted to get into a new strategy?
- [32:42]
Mike Kelly
When it came to portfolio advisors, their business had been operating for 30 years. They'd been operating in the middle market space of private equity, which the middle market's a broad definition of 10 million to a billion of revenues. Private companies, there's 200,000 of them. But the focus at future standard is enterprises of a billion dollars. In valuation and down. So core and lower middle market. That was the sweet spot for portfolio advisors across their primary and secondaries and co investment business. So it matched well. With that came capabilities in each of those areas. Funds that had been around for many years. Also they had built several hundred relationships with high quality middle market private equity sponsors. And those relationships were very powerful engine for sourcing deal flow. That was a distinctive point of you could try to replicate this, but it would take many, many years to replicate this business. And you can't replicate several hundred relationships overnight. Why that set of relationships matters is today we're able to work with a given middle market private equity sponsor and say to them we can invest directly in your fund, we can co invest with your portfolio companies across your funds, we can provide you with a solution for your LPs for secondary liquidity, we can work with you at the GP level on a continuation vehicle and we can lend to any of your portfolio companies from senior in the capital structure down to junior mez solution behind a bank first lien. Why that matters is those private equity sponsors then view us as your strategic partner. There's a lot of capital out there and capital has become more and more of a commodity. Everyone in that ecosystem you need to prove why you're not just a commoditized piece of capital. This strategic partnership model is something that generates significant deal flow across our five verticals. That deal flow is ultimately what begets the opportunity for our clients and the.
- [34:48]
Ted Seides
Outperformance in the original credit strategy. And some of the others either hired people and built it on your own or partnered with someone and said what were the pivot points in those decisions to buy or build?
- [35:02]
Mike Kelly
After we separated with Blackstone, Blackstone had gone on to build their own private wealth business and undertake building their own BDCs. We partnered with KKR. There were only a handful of firms that had the origination scale to be able to undertake originating several billion dollars a year of private credit lending. And our BDCs are of significant scaled size. It made it easy to decide we were going to partner, not to try to build that from scratch. In terms of bringing Andrew and his team in in terms of opportunistic private credit and non sponsored private credit. Andrew had been doing that for many years and we had a smaller pool of capital which he took over permanent capital vehicle and began to manage that set of portfolios and built over time a team of 30 credit professionals. Today we're managing close to $10 billion across a series of vehicles both offered to Private wealth, but also to institutional investors as well as a CLO business. And now has a team of significant size to build that over time and originate private credit.
- [36:20]
Ted Seides
When you joined Franklin Square, BDCs were the vehicle where a lot of the wealth individuals were accessing. These strategies that's evolved, there's now interval funds. Love to hear your thoughts on the strengths and weaknesses of different vehicles and where you're seeing that demand today.
- [36:40]
Mike Kelly
BDCs originally were created through a congressional act in 1980 as a way to bring capital into private businesses in the United states. The original BDCs back then was more of a venture capital model. It was really only after the great financial crisis that BDCs became this private credit lending model. With proliferation of funds like ours and Ares and others, there's an advantage in terms of the ability for individual investors to invest in those vehicles at low minimums. It's friendly for an individual investor model to be able to invest their capital into BDCs for income. There are advantages for the end investors through the leverage that's allowed in the vehicle to deliver the type of income objectives that one has now. There are limitations as to what's qualified assets and not qualified assets. And structural limitations to the types of things that can be put into a bdc. The interval funds have greater flexibility on the one hand, but more leverage limitations. You might have an interval fund that for instance could have all asset backed financing strategies, which has a limitation. In a BDC model of qualified versus non qualified investments. You don't get the same degree of leverage. In a closed end interval fund. Different strategies will have different types of wrappers. Private equity interval funds Private equity ricks today are typically offered in a tender offer fund. In Evergreen Strategies, credit fits quite well into those wrappers because they're more cash flowing than private equity. You have cash income refinancings, shorter duration, three to five year assets. Whereas in private equity these are longer duration assets. The reason you see secondaries so often in private equity Evergreen Strategies is there's much greater ability to provide for leverage the structures that have evolved over time. The wrappers that you create to deliver that to investors have to take that into account. Real estate can fit well into a reit. Private equity assets into a tender offer fund, credit into interval funds. That's typically what you see in the market.
- [39:06]
Ted Seides
Where are you seeing the adoption of private equity compared to what's been. There's a massive surge in adoption of private credit in these markets.
- [39:16]
Mike Kelly
It's still early, but the education learning curve advisors have come up and have understood these evergreen structures and are now looking at opportunities to invest in growth strategies in private markets. The offerings themselves. The advantages of a private equity evergreen structure are that your capital is drawn immediately and invested. You have vintage diversification, you mitigate the J curve. You're not waiting for capital drawdowns, you have continuous compounding as opposed to waiting for your capital to get called and brought in. There's a managed expectation of putting your capital to work. The trade off, and there's always trade offs include the fact that these are not liquid strategies. So they're in semi liquid structures that that you're not going to generate the same level of returns in a private equity evergreen structure as you will in a private equity drawdown structure. You might be looking at high teens, net IRRs or higher. Given the fact that you have to manage for liquidity, you're not going to generate that level of returns. The returns will be more likely a 12 or a 13%. You're trading off the return there. The advantage goes back to continuous compounding and J curb mitigation, vendor diversification. So those are the trade offs that you need to weigh between locking your capital up for 10 to 12 years in a drawdown vehicle, if you have the investment minimum to satisfy that, or investing in an evergreen strategy, you get lower investment minimums, but you're going to trade off returns for that.
- [40:54]
Ted Seides
How do you think about the increasing adoption, particularly in the private equity side, as it relates to where we are in the cycle? Rates are a little higher, private equity prices are higher than they were in the past. And you can look back at the returns and say they have been great. But most people think this is a harder starting point. As the advisors are talking to the wealth channel about coming into this for the first time or growing it significantly for the first time. How do they think about the expectations for what forward returns will look like.
- [41:24]
Mike Kelly
On the private credit side of the business? The state of play today is you have tighter spreads. There's a lot more capital in credit than there has been. You have higher base rates. We did exit zero interest rate period. So if you're looking at a floating rate loan, SOFR's a lot higher than it was three, four years ago. The expectations have to be base rates are coming down, distribution rates and yields will come down in those private credit floating rate vehicles in the middle market. Once you move into smaller companies or mid sized companies, you do get an additional premium of spread for those types of opportunities. When you move into more opportunistic credit and non sponsored based credit, you have even more of a premium that gets added. The trade off is those are riskier, those are more fragmented, more risk, more return. And weighing the trade off across that is the job that we undertake in diligence. But also the advisor needs to think about in terms of what's suitable for their clients and their objectives. On the private equity side, if you think about private equity going back 10 years ago and decomposing returns, private equity returns had witnessed increasing degrees of leverage. We saw LBO multiples of leverage of 6, 7, 8 times, decreasing cost of financing that leverage each turn of capital as debt capital became cheaper. And multiple expansion, which we saw prevalent over that period of time. Well now fast forward to today, cost of financing's higher by hundreds of basis points. You're not getting much multiple expansion on large and mega cap LBOs that are trading at 17 to low 20s times EBITDA. You really can't lever beyond 6, 7, 8 turns of leverage on these LBO terms. The days of financial engineering your way to higher returns, in my view are over. Where you're really going to see the outperformance in private equity are going to be faster revenue growing companies, lower multiple entry points, more fragmented ecosystem private companies and where you can add operational value that just simply tends to be more in the middle market than in the large and mega cap private company market. So I do think that the outperformance that you've seen over time with middle market private equity funds over their large and mega cap peers is only going to not just continue, but move even higher.
- [43:59]
Ted Seides
It's easy for us to talk about the historical perspective and where we think it might go today. It strikes me it's harder for that end owner who doesn't have the history in the market to understand and calibrate their expectations of what they should get out of private equity. How does that education process get to that end client so that they're not disappointed five or ten years from now if returns are okay, but they're not what someone might have pitched them looking backwards.
- [44:29]
Mike Kelly
You do need to understand history to start. You need to understand what the historical returns have been. You need to understand the underlying fundamentals that drive those returns. Revenue growth, EBITDA growth. If there's leverage being incorporated, how much leverage is incorporated, what is the cost of that leverage? So there's the quantitative metrics that have to go into it. Then there's the fundamental and qualitative understanding of impacting these companies and helping their businesses. There are private equity firms who have expertise in industrial services and they have great firms that work in healthcare services and they are used to working with these businesses, improving their governance and people and innovating and adding value. And what impact the contribution of not just capital but their partnership can have on the underlying company and its fundamental prospects. It's that shared appreciation of the drivers to then translate that into what the return potential of a business like this is over a course of five or seven or 10 years and trying to translate that into a base of expectations for what you're offering to people and how that compares frankly against public companies, large cap stocks or the Russell 2000. And I think the education has to move across the full understanding of investments that they have in their portfolio today and the trade offs of liquidity and complexity and fees.
- [45:59]
Ted Seides
How do you think this will play out in the 401 market?
- [46:02]
Mike Kelly
Defined contribution is 12,13 trillion of assets. 401 s a significant piece of that. Much of that in target date funds, qualified default options. Ultimately we will see more partnerships between traditional asset managers and alternative asset managers that create structures like collective investment trust to be put into target date funds and 401k plans that have a mix of liquid traditional investments and less liquid alternative investments. Now private market alternatives might comprise 10, 15% of that pool, but I've always viewed that as a missed opportunity to begin with. If you're someone in your 20s or 30s and you have a multi decade long horizon to invest your retirement assets, why should all of your assets be in 100% daily liquid instruments? It doesn't make any sense to me and it never has. At least having the opportunity to avail yourself of an illiquidity premium over a long duration. Long duration assets that can diversify your exposures and enhance the returns of your exposures makes common sense. We will inevitably see that find its way into defined contribution in the 401k market. One of the reasons we like working with advisors generally is who better to determine the suitability of these investments than an advisor is closest to the individual investor client and knows whether or not those trade offs because there's no right or wrong. So alternatives aren't better than traditional investments. They're different. They bring different trade offs in liquidity and fees and complexity and knowing those trade offs to make a sensible decision around whether those trade offs work for a particular client in a particular situation. That's why we work with advisors is they're best suited to help make that determination.
- [48:03]
Ted Seides
I'm curious. In this space, almost like Mag7 in Concentration, there are a small number of mostly large public alternative asset managers who have addressed this market with products and distribution. What's it like competing with them in this space?
- [48:22]
Mike Kelly
I have nothing but admiration for our competition. They are the best at what they do. Our focus is on private markets. Our focus is on the middle market. At Future Standard. We do think that's distinct from some of these larger alternative players who are operating in the large and mega cap space. They're providing equity and credit capital to companies that 10 years ago would have been publicly traded. That is the upper middle market. Distinguishing what we do from what they do is important. We think that our offering has differentiation and brings something to the table for clients that they can access with those large players. But I think it's tremendous that individual investors now get access to the likes of Blackstone and KKR and Ares and Apollo. These are tremendous firms. It's a great evolution for all individual.
- [49:18]
Ted Seides
Investors as you've addressed this market. You joined Franklin Square at some point in time. It was renamed fs. There's a theme here. Now Future Standard. How have you thought about the branding exercise for all of your team to go out and distribute your product?
- [49:35]
Mike Kelly
It's important that we have a common brand and identity. At Future Standard. We did not set out to build a multi boutique firm. If you look at the most successful alternative firms and talent shops, they have a common cohesive brand and they do that for a very good reason. Despite having a series of acquisitions we wanted to identify across a common brand and a common platform with the proposition that future is about anticipating what's next in the marketplace on behalf of our clients and standard about raising our standards and what we can deliver for our clients. That's the identity upon which we have identified ourselves as future Standard.
- [50:20]
Ted Seides
As you see this wave of money increasingly coming into the space, what risks do you have your eye on?
- [50:27]
Mike Kelly
I don't weigh the risks as much as the quantum of capital coming in because that question often gets asked around whether or not private markets and private credits a bubble. If you look at the sheer amount of economic activity US GDP going from 1112 trillion of GDP pre great financial crisis to 30 trillion today, the number of banks and the consolidation in banks and their move away from lending to private bank companies and middle market companies, the rise of the number of private companies and companies staying private, all of those trends speak to more and more opportunity for that capital coming in. It's a supply demand matching. The bigger risks revolve around this idea of management of expectations ensuring that why investors are Embracing this match up with what can be delivered. It's awareness, education and expectations management where it has the greatest surface area for risk. That's why we spend so much time on education for the advisors and their clients and thought leadership. These are less liquid opportunities and there's no guarantee you can exit. If you want to exit, that lesson will be learned. There needs to be an appreciation you are getting these characteristics of returns and diversification and access to an illiquidity premium. The trade off is you may not be able to get out any moment that you want to particularly get out. That matching of expectations needs to be clear and well laid out. That's the biggest risk.
- [52:05]
Ted Seides
So in addition to making sure there's a calibration of what people understand, there's the potential very large volume of capital coming into these strategies. We've already seen it in private credit and maybe it happens at private equity. What does that mean for say the institutional owner who's there today who sees a lot more demand than they had.
- [52:24]
Mike Kelly
In the past, they should understand that it's here to stay. This isn't a temporal situation. The demand from private wealth will be the fastest growing source of capital into alternatives for the foreseeable future. If you're an institutional investor or allocator, you can think of it as competing with your capital. You can look at it as displacing your capital. You can think about it as an opportunity to potentially partner with that capital or use it in some advantageous way. If you think about that last category, there are institutions and we work with a number of them, who will seed vehicles that will be primarily offered to private wealth channels. By doing so they will gain economics and ownership in the revenue stream of those vehicles. There are institutions that are buying GP stakes in managers who for the first time are offering their strategies to private wealth. So they will take advantage of the growth of that channel on those businesses and the value of those businesses. And there are institutions that are using that as an opportunity to avail themselves of liquidity in the secondaries market. If you take endowments that are looking at selling some of their private equity venture positions, the primary demand for those secondary positions are coming from evergreen private equity vehicles. If you try to continue to carve your assets away from that trend, you can do that you can avoid by investing earlier stage companies, you can invest direct co investments, you can create SMAs. There are ways to carve out opportunities that private wealth capital will likely not enter directly, but we're going to see more of it. So institutional investors should Learn to coexist with it.
- [54:25]
Ted Seides
What created the tipping point? For a decade ago, you thought this would happen. And it's really only the last few years where we've seen the adoption really kick in. On the credit side, maybe it's starting to in private equity.
- [54:41]
Why now?
- [54:42]
Mike Kelly
These opportunities always take longer than one thinks. We felt the same way when we were building frontpoint. We were wondering if this institutional trend was ever going to happen. It pays to be early, but it also requires a lot of patience. In some ways, what I would call the golden era of the market backdrop that started in 1987 when Volcker stepped down, ended in 2021 with the end of zero interest rates. And thus began a cycle of more challenging backdrops for say, stocks and bonds together in a 6040 portfolio and for bonds generally and long duration fixed income instruments. That accelerated this trend of wanting to put assets into private credit private equity vehicles. We also had a tremendous evolution in structures in private wealth, in the platforms themselves. So the wirehouses and large RAAs and their level of sophistication and their build out of resources, the operational and regulatory complexities were being solved. The infrastructure that firms like iCapital and Case were putting in place to help facilitate these investments, all of that took time. It was a confluence of all of that coming together over the past decade to provide the ecosystem with the ability to seamlessly gain access directly into these investments. Those things just take time.
- [56:13]
Ted Seides
What opportunities most excite you, both on the investment side and on the business side?
- [56:20]
Mike Kelly
In terms of opportunities, if you're looking over the long arc, there's still tremendous opportunity in private credit. Despite recent concerns about individual credits, despite the fears that there might be a bubble forming, we are still under capitalized in private credit to where the opportunity set is the amount of dry powder and private equity, the number of companies that want access to lending capital. We are just scratching the surface on areas like asset based finance, which is a multi trillion dollar market. We're only just beginning to offer those in private credit. There's still significant room for growth there. In the secondaries market, we have a $10 trillion private equity market globally only $200 billion of volume in private equity secondaries. This year it's 2% of the stock. In private credit, that number is 100 $120 billion, almost $2 trillion of stock. So small amounts of secondary markets will grow. We're in the very early innings of secondary markets for both fund level GP led single asset secondaries, pre IPO secondaries and things of that nature. That area is another big area for growth. Outside of that, AI gets a lot of the press in terms of what that will do for the economy, for financial services and healthcare and all of these businesses. The area that probably doesn't get a lot of press is longevity. And what I mean by that is the reality is our children are going to live much longer lives than our parents ever did by decades. What is that going to mean for investment products, for insurance, for retirement plans, the complexion of asset allocation and how we design portfolios? We're just starting to think about these things and it's changing rapidly. Kids today have a life expectancy, I think 103 years old or something to that effect. With AI, who knows how long they'll live. But we do. We don't really design insurance and investment products encompassing that and the duration of what that's going to entail. That's a huge area that needs to be further explored. Digitization and tokenization of private assets will come and it's going to provide a significant amount of opportunities in the future.
- [58:41]
Ted Seides
What excites you most about Future Standard over the next couple of years?
- [58:46]
Mike Kelly
Delivering for clients. We're in a new regime. In the market backdrop, it's going to be more difficult. Higher uncertainty, higher volatility, higher inflation. The old playbook is not going to work for the markets we're heading into and helping investors, both institutional investors and individual investors navigate that and offering them investment strategies that will work well and provide the kind of income growth and diversification that they're going to need. That's what excites me.
- [59:16]
Ted Seides
All right, Mike, I want to ask you a couple closing questions before we dive into that. I'm going to just share this. Our closing questions are brought to you by Oldwell Labs or owl. OWL is the very best software I've seen for allocators, defined and track managers. And I've seen a lot of them. So if you haven't seen owl, check them out at oldwell-labs.com ted that's o l--w e l l labs.com ted and trust me, it'll be worth the look. All right, Mike, what's your favorite hobby or activity outside of work and family?
- [59:50]
Mike Kelly
Anything fitness related? The more intense, the better. I used to enjoy triathlons. I'd say nowadays I like lifting heavy objects.
- [59:59]
Ted Seides
What's one thing most people don't know about you that you find interesting?
- [60:04]
Mike Kelly
I am the son of a single Irish woman who gave birth to me and put me up for adoption. She was living in The United States. She died shortly thereafter. Sadly. I was adopted by two amazing parents. My dad was a World War II veteran, age of 16. An NYPD cop in a few precincts, South Bronx and Queens. He was an amazing guy. My mom raised me and my four siblings and just passed this year. I owe her and my dad everything. They gave me the gift of education. I was the first in my family to go to college. How I wound up here but for the grace of God and some amazing parents, I'll never know.
- [60:48]
Ted Seides
Great. Which two people have had the biggest impact on your professional life?
- [60:53]
Mike Kelly
I have to start with Lee Cooperman. Without him, I don't think I would be here for giving me the opportunity to break into the alternative investment industry. And then I would say Gil Caffre. Gil was the head trader at Tiger. He was my partner at FrontPoint. He's been my mentor now for, gosh, about 25 plus years. Just someone who impressed me with his integrity and how to treat others with integrity. Outside of that, there's honorable mentions Julian Robertson and SUNY Harford. Anyone who gave a young me a shot deserves a place on my personal hall of fame.
- [61:33]
Ted Seides
What's the best advice you've ever received?
- [61:36]
Mike Kelly
I don't know where it originated from, if it was the Bible or Bruce Lee, but something to the effect of so you believe, so you will achieve. My own interpretation of that is about mindset. The mind can be the greatest limiter to your own progress, but it also can be the greatest force, accelerator if harnessed correctly. If you believe that you can achieve something, that growth mindset can take you very far.
- [62:03]
Ted Seides
Great, Mike. Last one. If the next five years are a chapter in your life, what's that chapter about?
- [62:08]
Mike Kelly
Well, as you know, Ted, I have two teenage boys and our kids know each other their whole lives. For Kristen and me, it's quality time with the family. Now that we'll be empty nesters here in a couple of years in a work setting, it's more towards servant leadership. So helping others, teaching others. I've been blessed in my career what I've been able to do. Now I'd like to help other people achieve what they're setting out to do.
- [62:36]
Ted Seides
Well, Mike, thanks so much for sharing these great perspectives on the institutionalization and now democratization of all terms.
- [62:43]
Mike Kelly
Thanks very much for having me.
- [62:45]
Ted Seides
Ted.
- [62:46]
Thanks for listening to the show. If you like what you heard, hop on our website@capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.
- [63:01]
Sponsor/Disclaimer Voice
All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital allocators or podcast guests may maintain positions in securities discussed on this podcast.