Diversifying factors

Georges Sudarskis spent a decade as the chief investment officer of the Abu Dhabi Investment Authority, growing the sovereign fund’s private equity portfolio into one of the largest in the world. The founder and chief executive of investment advisory firm Sudarskis and Partners recently talked with Monte Brem, chief executive of advisory and asset management firm StepStone, about key industry issues including why he thinks most private equity portfolios aren’t diversified enough. This is an excerpt from an on-stage interview that took place recently during our annual PE Asia Forum in Hong Kong.

Monte Brem

Monte Brem (MB): What do you think about private equity both as a diversifier for an LP, and also as a diversification means within the private equity portfolio itself?

Georges Sudarskis (GS): My theory is a controversial one. Lots of people in the industry think that when you diversify you revert to the mean, while I hold that this is wrong – that the more diversified you are, the more away from the mean you are going. This is driven by statistical findings that we at ADIA did a number of years ago analysing the performance of individual deals. And usually the idea that one has about individual deals is that it is a bell shaped curve, and this is true of public stock returns.

In PE by contrast, one has two modes, so the slope is like a camel back, two maximums. And this statistical effect creates the opportunity for better returns the more you diversify. Even in public stocks the common thinking is that 30 stocks give you diversification – this is bollocks. Diversification is achieving 200 or more stocks, not 30. And if you think about illiquid assets like private equity, I tend to think the minimum diversification should be 3,000 or 4,000 positions. And that in itself requires you to have [stakes in] at least 50 or 60 funds – and that’s low diversification.

Lots of people in the industry think that when you diversify you revert to the mean, while I hold that this is wrong

Georges Sudarskis

MB: The analysis you’re describing is different from all the analysis that I am aware of that’s been done at the fund level. Our view is that if you dove down to the company level, you actually have a stronger argument for diversification within a portfolio of a pretty small number of funds, let’s say 30-50 funds. So, you just laid out the number of funds you think would be the type of diversified portfolio you’d target; in general how would you think about this? And as a follow on point, how do you view fund of funds within the context of your overall philosophy?

GS: I hold another controversial view:  fund of funds are probably the best thing that has ever happened to the PE industry. Back in ‘97, when I was asked to join Abu Dhabi Investment Authority to lead the PE program, and I had a couple of months to lay out a strategy, I remember very well then Abu Dhabi was a very small city, nothing to compare to what it is now, and I walked along the shore thinking ‘What am I going to do about this?’ Here we are in Abu Dhabi, a place whom at that time very few people knew about, and how could I do PE from Abu Dhabi? So I thought maybe I could do direct investments, hire a talented team of investment bankers, bring them into Abu Dhabi and let them get to work on the world’s global investments. I said, ‘This is unrealistic, I’m sitting in the middle of sand, there’s nothing here, no restaurants, no pubs, no way.’

The alternative would be fund investments. Partnering with general partners and having them do the due diligence, the sourcing, the structuring, the monitoring. I thought this is more reasonable, more achievable, and actually I was sort of right, and the team, a brilliant team, marvelous team, who I built over the years at ADIA, I told them one thing: from Abu Dhabi where we sit, with the help of the general partners, you can really do a lot of things.

What I did not tell them, is that let them not forget about the contribution of fund of funds to what we do, and the amount of work of selecting fund managers – the number we had, plus co-investments, plus strategies like secondaries, was enormous work for a small team. But of course, the merit of this was incredible scalability. We started managing $200 million and we eventually ended up managing $26 billion. But I know we could have done even better by allocating money to fund of funds managers. That would have saved us a lot of time, and probably, except for the matter of frictional costs fees and others, we might have achieved pretty much the same result.

MB: What do you think is the minimum allocation that an LP should target to make sure that it has a material impact on overall portfolio?

GS: Below 3 percent of the entire pool of money to private equity is not worth bothering with. Five percent would be my threshold, and far as experience has led me to see what PE performance can bring to a portfolio I would say that an ideal allocation would be anything between 10-15 percent. Don’t forget, the world is private, most of the world’s economy is in private hands, and the public market segment of the world GDP is just the tip of the iceberg. So when portfolios are built on public stock, I don’t understand this – my guess is because it’s easy to do public stocks. You push a button, you’re in stocks; you push another button, you’re out. But, this is a wrong view of the investment universe, the world is private.

MB: There’s been a lot of studies done which show that persistence of returns of private equity is a unique thing relative to other asset classes, and that would suggest you’re going to see some herd mentality as investors follow the historical returns.

GS: Herd mentality is something that we’ve observed, that exists, and, by the way, I don’t think it’s abnormal. It’s a natural phenomenon: when you grope in the dark, you try to grope in the dark together with others, there’s nothing that’s wrong with it. And herd mentality is a kind of error protecting mechanism – like you can always sort of safely invest with IBM.

But let me revert to the question. What I found is there’s a permanent surge in reference to performance numbers. Performance number is the holy grail of the industry … But I also think that the undue reliance on performance numbers leads to herd behaviour. Because what you’re looking at in terms of performance number, is yesterday’s number. You’re looking at the rearview mirror, you’re not looking ahead.

MB: [There is a] trend [among sovereign wealth funds] toward direct investing, which I think frankly ADIA was one of the first to be quite active in. What do you think about that trend?

GS: In my view there’s no worse thing for an investor that has a private equity portfolio [than] to go into direct investments. Let me be very clear: direct investments are not co-investments. Direct investments are investments that the investor sources himself, due diligences himself, monitors himself, and it’s a very bad idea.

To my knowledge there is no documented evidence of any successful portfolio of direct investment by any investor. The only programme that I can think of was the programme funded by European government in the ‘70s. But this program had a 50- to 60-year horizon, not the type thing we are talking here.

Direct investments are really a bad idea. Number one, [if] you are an investor who has invested in a company, you bear an enormous amount of reputational risk. You buy a food store chain, one criminal injects poison in the food, the chain is under press review, you as a shareholder what do you do? Another illustration: you have to appoint board members to the company, who would be a board member in your investment team? Hundreds of issues of that sort [come into play], not [to mention challenges relating to] the process by which you take the decision to invest.

MB: We would argue that once [an LP’s portfolio contains] a certain amount of funds, you are fully diversified. George’s point  …  is  the amount of funds it takes to get fully diversified today is a lot more than it was 10 years ago, because now this is a global asset class … there’s a lot of different strategies. [But] we have a difference of opinion on the number of funds you need to ultimately have in a portfolio to get that optimum diversification.

GS: Next year if we’re still invited, we’ll continue the fight… It all has to do within the investor’s organisation, how the staff manages its relationship with the supervisory body, with the board. PE is always confronted in the mind of a board, whether it’s a supervisory board or a trustee or a body, confronted with other asset classes. And asset classes have the capability of being fungible: push a button, you’re out and push a button, you’re in.

Private equity isn’t like this, but at the same time PE is so much more interesting than any other asset classes. Our board would spend 20 to 25 percent of its time on [private equity], an asset class which represents less than 5 percent of the entire allocation. When I chatted with my board members, they [would] tell me, ‘Well, it’s exciting.’ You think they [would] be interested in [discussing the] custodian arrangement of listed securities? Not at all. This was a joy for them – the only thing that was interesting was PE.