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Institute for Private Investors
The Changing Role of Private Investorsin the Capital Markets
Gregory Friedman, Chief Investment OfficerGreycourt & Co., Inc.
October 2007
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I. Institutional versus Private Capital…the way it was…why its changed…the way it is
II. How we’re different…principals versus agents…tax sensitivity…sheer mass…ability to replenish capital
III. Can we survive and prosper?…is alpha drowning?…are we truly competing?…what we must do.
OverviewInstitute for Private
Investors
Private investors haven’t changed
Institutions have…
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RISKY investments used to be the exclusive domain of individual investors…
Institutions started
investing only in:
Equity 1950s
Real Estate 1975
Venture Capital 1975
LBOs 1981
Hedge Funds 2002
Private investors used to be the only game in town…
The Way It Was...Institute for Private
Investors
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Changing Taxation…1940’s
Inland Steel Pension ruling…1948
Performance reporting…1966
Consultants appear…1969
Passage of ERISA…..1974
Update to Prudent Man Rule…1979
Introduction of PC…1981
Government policies…
Evolving laws…
Technological advances…
Caused explosive growth in institutional capital.
What Changed?Institute for Private
Investors
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0.0%
20.0%
40.0%
60.0%
80.0%
1950 1960 1970 1980 1990 2000 2007
Government policies…
Evolving laws…
Technological advances…
Caused explosive growth in institutional capital.
The Pros Take Over…Institute for Private
Investors
Percentage of U.S. stocks owned by pension funds, mutual funds and other professional investors…
9.8%
74.1%
As of March 31st Source: Federal Reserve
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Yale’s David Swenson writes book explaining his secrets…
Traditional markets tank at same time…
Other endowments face board pressure to emulate Yale…
Flood into Alternatives Started With a Book…Institute for Private
Investors
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Institutional investors…
Late to alternatives game…
Swing a BIG bat!
Tsunami of Institutional Capital…Institute for Private
Investors
Swensen Publishes…
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Large Endowments Led the Way Into Alternatives…
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If a LITTLE is good, a LOT must be better…Right?
Institute for Private Investors Some Late to Game but Dive Headfirst…
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US Endowments and Foundations control more than $550 Billion in assets.
Increases in hedge fund allocations have principally come from bonds and cash…
Institute for Private Investors
Changes in Endowment & Foundation Allocations
1994 to 200612-Year
Asset Class 2006 AllocationAverage Allocation (%) Change (%)
Equity 57.7 0.8
Fixed Income 20.2 -11.0
Cash 3.4 -3.1
Change in Traditional Assets -13.3
Hedge Funds 9.6 8.0
Private Equity/ VC 2.8 2.0
Real Estate 3.5 1.5
Natural Resources 1.5 1.2
Other 1.4 0.7
Change in Alternative Assets 13.4
A Tsunami of Institutional Capital…
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If you thought Endowments and Foundations control a lot…
U.S. Pensions control some $4.5 Trillion in capital…
When they show up… Watch Out!
Institute for Private Investors A Tsunami of Institutional Capital…
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Private investors and Institutional investors are structurally different:
Taxability
Cash flow needs
Time horizons
Ability to refresh capital base
Fundamental structural differences lead to different needs…
Private Investors versus Institutions…Institute for Private
Investors
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Private investors and Institutions have quite different decision-making processes:
Principals vs. Agents
Business Acumen vs. Investing Acumen
Personal Well Being vs. Reputation Risk
Investing in Individuals vs. Investing in Organizations
Fundamental differences in needs leads to different decision making…
Private Investors versus Institutions…Institute for Private
Investors
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Near Term: Maturing private wealth will feed growth in endowments & foundations (e.g., Gates & Buffet)
Long Term: Wealth shifting overseas
1. EM pensions funds to grow
2. Growing pools of sovereign capital
3. Slowing GDP in western world
4. Eventual repatriation of US$ assets
5. Rising importance of non-US individual and institutional investors
Emotional differences lead to different decisions…
Balance of Power Will Shift Even More…Institute for Private
Investors
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Institutions have lower return expectations from hedge funds than private investors had demanded…
Institutions Expect Less…Institute for Private
Investors
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Low volatility hedge funds and fund of funds may soon not be attractive to private investors…
Are Institutions Ruining Hedge Funds?Institute for Private
Investors
Historic Returns
Institutional Expectations
Pre-tax Gross Return 17.0% 14.5% 12.0% 10.8%
Pre-tax Net Return - HF 12.0% 10.0% 8.0% 7.0%
Pre-tax Net, Net Return - HFOF 10.0% 8.1% 6.2% 5.2%
After-tax Net, Net Return 6.5% 5.2% 4.0% 3.4%
Expected T-E Bond Return 4.8% 4.8% 4.8% 4.8%
Advantages to Hedge FOF 1.7% 0.5% -0.7% -1.4%
Do Hedge Funds Make Sense for Private Investors?
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Hedge funds may soon not be as attractive to private investors…
Are Hedge Funds Still Appropriate?Institute for Private
Investors
Yes…but…private investors must carefully seek out strategies that are sustainable and offer attractive after-tax net returns:
Seek skill not arbitrage
Seek firms having aligned interests
Favor tax-efficient strategies
Don’t avoid risk but diversify it
Capitalize on institutional herd mentality
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Access to top tier fund managers is CRITICAL in private equity…
…and with the competition from institutions it’s now even harder to get it.
Institute for Private Investors Is Private Equity a Fool’s Errand?
Not if we live in Lake Wobegone where we’re all above average…
BUYOUTU.S.
VintageYear IRR +/- S&P IRR +/- S&P
1995 12.7% 0.9% 6.1% -5.7%1996 10.1% 0.4% 4.9% -4.8%1997 10.8% 2.4% 2.5% -5.9%1998 10.9% 4.9% 6.4% 0.4%1999 8.4% 5.0% 0.6% -2.8%2000 17.3% 16.2% 6.4% 5.3%2001 18.3% 15.4% 11.1% 8.2%2002 19.8% 13.6% 5.1% -1.1%
AVG. = 7.4% AVG. = -0.8%
Source: Venture Economics
U.S. MarketTop Quartile1
U.S. MarketMedian1
Buyout Returns thru Dec 31 2006
Otherwise, yes!
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Low fees
Tax efficient
Low correlation
Expensive & tax inefficient
Active Long-Only Managers Will Diminish in Importance…
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Private investors need to protect their own interests as managers will increasingly pander to institutions…
ConclusionInstitute for Private
Investors
Institutional capital to surge
Big managers to get bigger
Private investors less important
Products increasingly tax-inefficient
Traditional long-only managers squeezed
Beta becoming cheaper
Alpha will remain expensive
Private investors must follow own path
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Gregory Friedman
Chief Investment Officer
Greycourt & Co., Inc.
(503) 226-0470
Fax (503) 226-0471
www.greycourt.com
Contact InformationInstitute for Private
Investors
