The Long View

Fran Kinniry: Applying the Vanguard Approach to Private Equity

Episode Summary

The leader of Vanguard's initiative to offer private equity investing discusses his views on private equity's role in a portfolio, how Vanguard will structure its offering, and why the firm is bringing it out now.

Episode Notes

(A note to listeners: We recorded this interview before the recent sell-off began, and that is why it's not discussed. We'll address the recent downturn in future installments of The Long View. Please enjoy this episode and thanks again for listening.)

Our guest this week is Fran Kinniry. He is a principal in the Vanguard Investment Strategy Group, which develops Vanguard's investment philosophy, methodology, and portfolio construction strategies. Kinniry has been a leading researcher on topics like capital markets, portfolio design, and investment strategy. He was recently tapped by Vanguard to lead the firm's initiative to offer private equity investment management to certain institutional and high-net-worth clients. Before joining Vanguard in 1997, Kinniry was a partner and senior portfolio manager for institutional asset manager Executive Investment Advisors, and before that he was the portfolio manager for H. Katz Capital. Kinniry is a CFA charterholder and earned his Master of Business Administration and bachelor's degree from Drexel University.

Background and Research
Fran Kinniry bio


"Vanguard and HarbourVest Announce Private Equity Partnership." The Vanguard Group, Feb. 5, 2020.

"The Role of Private Equity in a Nonprofit Portfolio." The Vanguard Group, Nov. 15, 2019.

Vanguard research library

"Vanguard Advisor's Alpha," by Donald Bennyhoff and Fran Kinniry, Vanguard Research, July 2018.

John C. Bogle: A Look Back at the Life of Vanguard's Founder

Episode Transcription

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research at Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.

Ptak: Our guest this week is Fran Kinniry. Fran is a principal in Vanguard's Investment Strategy Group, the group that develops Vanguard's investment philosophy, methodology, and portfolio-construction strategies. Fran has been a leading researcher on topics like capital markets, portfolio design, and investment strategy. He was recently tapped by Vanguard to lead the firm's initiative to offer private equity investment management to certain institutional and high-net-worth clients. Before joining Vanguard in 1997, Fran was a partner and senior portfolio manager for institutional asset manager Executive Investment Advisors, and before that was the portfolio manager for H. Katz Capital. Fran is a CFA charterholder and earned his MBA and bachelor's degree from Drexel University.

Fran, welcome to The Long View.

Fran Kinniry: Thank you.

Ptak: So, maybe we'll start off just placing you to the context of Vanguard's efforts. Can you talk just a little bit in practical terms about the work you and your team do and how it fits into the firm's broader ambitions, so to speak?

Kinniry: Yeah, sure. First, as a little background, I'm pretty familiar with the relationship with Vanguard and Morningstar, and my relationship with you, Jeff, and Christine. I've spent most of my 22 years here on portfolio construction and asset classes, and also Advisor's Alpha, the value of advice. And so, in that work, I was continuously looking at different asset classes and strategies and solutions that could improve investors' outcomes. And it kept coming back to a gap, if you will, in private investments. We were public investors through our past of being on the public equity side and on the public fixed-income side. And our investors at Vanguard are 100% liquid, meaning there's no illiquid portion of their portfolios if they are at Vanguard. And we kept coming back time and time again that the research would show that our investors could improve their outcomes if they had some position in private investments, if they had the holding period and the patience, and we could find a world-class private equity manager. And so, all those things came together. And that's where we are today.

Ptak: That's helpful. So, maybe, I think it would help some of our listeners who I would venture to guess are liquid investors--there are open-end funds and exchange-traded funds and the like, and are a bit less familiar with private investments. So, when you did your research, what was filling that slot of the overall portfolio? Was it looking at private equity funds? Was it looking directly at private firms and how they had performed over time?

Kinniry: Yeah, we canvassed the whole gamut of how we could potentially enter the private equity area. And just to back up one second to your question is, most investors at Vanguard will be 100% liquid. And so, the question is, we kept coming around to is, do you need 100% of your portfolio liquid every single day? And some investors may. Let's take a very older-demographic investor who's spending a significant portion of their assets. But if there is an illiquidity premium, which we see in almost all asset classes, including public markets, where bid-ask spreads are wider in less liquid investments. So, could an investor take advantage of having assets that were less liquid if their holding period matched up to that? So, an investor who has 20-, 30-, 40-year horizon and let's just say that they decide to put 20% in privates, they would still have 80% of their portfolio liquid. And so, the conclusion kept coming back to having some portion of investments that were illiquid for some investment demographic could improve outcomes and add diversification to their 100% liquid portfolio.

Benz: So, let's just talk about the availability of private equity in Vanguard's menu today. As a retail investor, not a huge investor, I can't just go buy a private equity fund from you today, right?

Kinniry: That's correct. So, we were staging our offer. We started in our OCIO business, which is our outsourced CIO, which is mostly endowments and foundations, where Vanguard is the advisor. So, just for the audience who may not be as familiar, Vanguard is a direct investor, meaning you can just come and buy the Vanguard S&P 500 or the Primecap Fund, but you can also have Vanguard manage the funds for you in an advisory capacity. We started this program in our institutional advice program, which has been around for more than 20 years. And those are classic investors that would benefit from having some allocation to private investments. That's where we're starting, but that launched February 5. And we're, as the press release said, working quickly to try to bring that to high-net-worth investors, both advised and/or direct.

Ptak: So, you talked about how you identified it--I think maybe you used the word "gap"--that being private firm investments. And so, what are the benefits that you expect it will confer? It sounds like maybe enhanced returns. I think there were some diversification benefits that you thought it would confer. Can you drill down and talk about what in your research gives you confidence that it will confer those kinds of benefits?

Kinniry: Yeah, sure. Vanguard has always tried to think of the market landscape holistically. And when you think about being market-cap weighted, which an investment like the total stock market is, which means you own the sectors and you own growth and value in their market cap. The gap that we identified is that the private--investable private space--so, we'll leave around all the small businesses that are not in private equity-backed firms, but the investable private equity space is 20% of the public space. So, just following in our whole history of wanting to own the market, to say you would own equities, that would be a combination of public and private just from an opportunity set. So, that would be step one.

Step two, there has been an illiquidity premium, it has been around 3%. We do believe that as the market becomes more institutionalized and more well accepted, that will probably go down. So, we're not counting on that illiquidity premium to be 300 basis points or 3% in the future, but we certainly believe it will be there. It's been there in all other asset classes--you take corporate bonds or treasury bonds or a small-cap stock to a large cap. So, we do believe the liquidity premium will be there. And then, the third leg is, if you can find world-class talent--so, this is very similar to Vanguard's public active offer where we identify world-class active managers and we bring that to the market at a competitive cost. Our active funds have done very well even relative to index funds. A lot of people know Vanguard of indexing. But our active funds, when we put them all together, they've outperformed the index funds. And so, if you can combine talent with low costs or reasonable costs, that is a benefit to investors.

The last thing I would say is, in the private equity space, the dispersion between the first, second, third, and fourth quartile--so, you all do this at Morningstar every day and you do a great job of showing what the different quartiles are in the public world. And they're much tighter, the differential between Q1 and Q4. In the private equity space, they're much wider. And there's also more persistence. And I know you also cover persistence. In the private space, there's much more persistence. And so, to us, that gave us the assurance of entering the space for diversification and the ability to improve outcomes through alpha.

Ptak: And can you explain for our listeners, what it is that confers greater persistence within private equity compared to the public markets, let's say?

Kinniry: Yeah, sure. I would say in the public markets, it's really an auction market, right? So, if manager A and manager B have a hypothesis on a stock, all information is, especially now after-- I won't get too technical with the audience--Reg FD, where it's really just fair disclosure that public information has to be disseminated to the market equally and fairly, which makes total sense. The private markets are private. And so, you are actually now dealing with the owners. And so, the owners actually do have asymmetrical information. So, when you're investing in, you know, these are pre-IPO. So, these are very early seed companies. You're investing with the founders. And so, there is a significant information asymmetry in private equity versus public equity.

Number two, the way the funding cycle works in private equity is the managers who have been doing this for the longest amount of time and have been able to raise the most money, they're the consistent folks that get the first call or the first access to the top GPs, the general partners. The best analogy I have found to use for the audience or someone who is just may be new to, is a lot of auctions that you may be familiar with--let's say, an art auction or a line auction or a sports memorabilia auction--it typically opens up to the public on a Saturday, but the preferred buyers get access on Thursday and Friday called a private showing. And so, the private equity market works that way, meaning that the top general partners--if Jeff, Christine, and myself were all thinking about being private equity investors, and I've been doing this for 40 years, and I was one of the first investors in GP ABC and Jeff and Christine came around 10 years after me, I'm going to get the first call to that deal. So, the persistence is quite strong. We think it has to do with the information advantages and also this idea of having a preferred seat at the best table. And then, so what happens is the largest and the longest get first access, and then what they pass on goes to the next tranche. And then, that gets passed on to the next tranche. So, it's not a true auction market, where I'm going to put out a strike price on stock ABC.

Ptak: And so, given what you described, how do you think--obviously, Vanguard boasts tremendous scale, but it's in public markets. So, when you think about the competitive dynamics and how it is Vanguard can compete in order to add value for its investors given some of the dynamics that you described, how did you reason that you'll be able to compete successfully so as to add that value?

Kinniry: Yeah, I think that's where our brand and our scale really comes to our favor. As you could imagine, given our size and our value proposition and us being owned by our investors, we were a very attractive partner to the who's who of private equity. And so, in our search process, we've met with pretty much every private equity firm that you could probably name. And I think we were being very well positioned from all of them, because they knew what our distribution capabilities were. They also knew that we are a very patient active manager. Our history speaks to our understanding that alpha is cyclical, managers are cyclical. And so, I think we were very attractive to the entire opportunity set of private equity managers. And we believe we had found, well, there's no doubt they're one of the largest, most respected--now, we're talking about HarbourVest now--with some of the best performance that's out there. And the reason we were able to get them and get the terms we got for our investors, I believe, was because of the Vanguard name, our ownership structure, and aligned interest with our investors.

Benz: So, you've been doing due diligence, so your firm has, on liquid managers for years. What were the differences in terms of evaluating private equity managers versus the managers of Vanguard's other active funds?

Kinniry: Yeah, that's right, Christine. And a lot of people, again, think of Vanguard of indexing, but Jack Bogle started Vanguard on an active. So, our roots are actually active. And for our entire history, we've had a pretty good reputation of evaluating public active managers and then being quite successful with that. We're not perfect, but we've been very successful in our active fund selection. We follow the same process on the same template. So, we look at--you all probably are familiar, but maybe your audience isn't--we follow the four Ps. So, we're looking at the people, the most important thing is the people. So, what type of organization; what is the ownership structure; what is the tenure; what is the turnover; how is control within the firm spread out; is it very dominated by the few individuals; is it private or is it public? So, the people part of it has been an area we really focus on. Then, we wanted to really look at their process, their philosophy, and their performance. So, those are our four Ps.

But we saw an organization that was very, very aligned; everything they talked about was generating positive client outcomes. The other thing we didn't get into so far, and we might get into it later is, most people associate private equity with high fees. But the fees are actually very much aligned to client outcomes because most of the fees that come in private equity are what would be known in a public space are performance fees. In the private space, it's called carry, which means that they only get a portion of their performance fee after they hit a certain hurdle. And the hurdle rate is quite large, meaning that investors will be very happy if they're actually paying high fees, because it means that they had high returns. So, everything we saw in HarbourVest, we saw alignment of their clients doing well first. And if their clients did well, then they would get a piece of that, which is much different than some where it's the firm first. But this was the whole entire firm, we got a really good sense that the culture and what they were trying to accomplish was very much aligned with Vanguard, which is putting clients first and it shows up in their 35-year performance track record.

Ptak: I'm not saying it's easy, but you could have chosen, I suppose, to build this in-house, could you not? But you're partnering with HarbourVest, which sounds like a firm that you consider to be very, very credible, and it's accepted in the marketplace. But when you went through that build versus buy, suppose you would call it, how did you arrive at the decision that you were going to go out and partner with somebody?

Kinniry: Yeah, I would say a couple of things. One, it's very difficult to enter without significant scale. So, let's say, in our first year, and even our first three years, we generate X. To do a private equity structure really well, you probably need on the order of somewhere between $8 billion to $10 billion almost out of the gate. And I could explain why. So, inside, so if you think about what's inside one offer, when you all know about our Target Retirement Fund, it's one fund. But inside the Target Retirement Fund are thousands of equities and thousands of bonds across the world. And the same thing with HarbourVest. Inside of HarbourVest there's going to be somewhere between 35 and 45 general partners. There's going to be between 500 and 800 holding companies. They're going to be diversified across the world. They're going to be diversified across stage, which means, let’s say early seed. So, you think of like the first investor in Facebook, the first investor in Twitter, the first investor in Uber, all of which HarbourVest was investor one in early seed, but then also, late-stage traditional leveraged buyouts. And so, in order to build that, most of the top general partners don't want to deal with small assets, and small is relative, I get that. But most of the significant general partners, the barrier to entry is couple of $100 million right out of the gate. So, to put it all together, you would need significant assets, one could say $5 billion, $10 billion, $15 billion out of the gate. So, that's almost impossible to start from zero to build anything close to this.

Second is, we've had a long history of outsourcing to world-class active managers. And so, I would be a little naive to think that me and my team could replicate the 500-plus individuals that are HarbourVest and have been doing this for 40 years. So, we feel very, very confident in our decision of partnering with them as opposed to building on our own.

Ptak: You do have a very significant quantitative capability. Did you ever consider doing something like leverage small-cap value, which I think some research has found has been a decent proxy for the risk-and-return profile that one can get from private equity investing?

Kinniry: Yeah, there's correlations out there that if you lever up certain assets, such as you mentioned small-cap value, you can get close to the beta. Or if you owned all private equities and so there is no beta, does that get you the average private equity fund? But we don't want to have the average private equity fund. The average private equity fund has returns that are just slightly above the public markets. We wanted to make sure that we felt we could find a manager that it gives us the probability of being above the 55th or 60th percentile. They've done that consistently. And because the dispersions, as I mentioned before, are so wide between the quartiles, it doesn't take much that, you know, if you're--or I shouldn't say it doesn't take much because I'm sure it is a lot and they do a great job with it. But instead of just picking, think about just picking out 25% from each quartile and that gets you very similar to the public markets, meaning you had no skill, you just randomly picked. If you're able to just slightly increase your odds to, let's just say instead of 25 in each quartile, you're able to do 30 and 30 in Q1 and Q2, and then 20 and 20 in Q3 and Q4--because you're not going to be perfect, you are going to find some fourth quartiles in there--your returns quickly get up to about 800 basis points over the beta, if you will, or the median public equity firm or levering small-cap value. And given their history, that's what they've been able to do. We're confident that they've done it through all kinds of market cycles. And given their capabilities and their experience and their teams, if you can slightly pick more out of the Q1 and Q2 general partner universe, it quickly mounts to significant alpha over doing something like a leveraged small cap or micro-cap, or us trying to build it on our own.

Benz: So, a question is about timing. So, you announced your entry into this space about a month ago or so. And valuations looked pretty full at that time. I'm not sure what has happened since then. But there's lots of leverage in that area, lots of capital sloshing around. Did the timing of your entry give you pause?

Kinniry: No, not at all. That's a great question, Christine, because one could say, everything you said is true. And I agree with everything you said, first off. But the way--again, back to my roots of asset allocation and portfolio construction and what my role here at Vanguard is--is private equity. Let's just say you were a 70-30 investor--70% equity, 30% fixed income--and we didn't have this offer and now all of a sudden, we have this offer. That will be funded--let's say, you wanted to now do 20%--that would be funded from your public equity. It would not be funded from fixed income. And so, one could argue that the public-equity valuations were as stretched if not more stretched than the private space. And so, the market environment and where valuations were, gave us no pause. In fact, it--I'm not saying it accelerated it, but if we had 70% in public equity, and we could have had 50% in public and 20% in private--pretty sure this environment here would have benefited our investors over the, obviously, it's a very short time period. But we believe this is a timeless strategy. Whether P/E ratios are above their average or in the top quartile or in the bottom, we are funding it from equities, right? So, I think if we start with high-risk, high-volatile assets, and then they have an adjective in front of them--that adjective, one is private, and one is public--we think of that as your mix. So, this would not be funded from fixed income. It would be adding diversification for an investor who has all public equity and decided to move a portion to private. You would get diversification, you probably would have some return smoothing because the correlations are not at one, you might get some behavioral benefits because these assets are not marked to market and we all--you know, I've done most of my career on behavioral finance as I know you guys do a great job with that. We know it. One could call it a phantom behavioral benefit. But whatever it is, if investors do better because they cannot sell it, then we'll take that. Whatever the rationale is, we do see that the inability to potentially trade it could actually benefit when we look at cash flows and IRR to TWR.

So, for all those reasons, the timing did not give us any pause. We would have done this in 2009 or 2015. The why now is probably because the space has continued to grow. So, the opportunity set is much larger than it was. I mentioned it's 20% of equities if you try to break it up. The second is, is Vanguard's real belief and advice. You all are familiar with the work that I've done on Advisor's Alpha. We think that now that we are a leader in advice, this makes perfect sense in an advised portfolio. And that's where we started in our institutional advice. And then, next will be our personal advisor service, our retail high-net-worth advice. And so, we actually think it works really well in an advised capacity.

Ptak: Why do you make that distinction between advised and unadvised? Why do you say it works so well in an advice context?

Kinniry: Well, so, when you're the fiduciary of the relationship, I think there's the ability to explain to the investor up front, you know, this is a long investment. We want to be very clear that this asset is not liquid. When you're buying the asset, you need to be committed to the asset for a--you know, let's say, you're probably not going to get your initial investment out for four to six years and then there will be some residuals that could last as long as 15 years. And so, a self-directed investor may or may not look at just the performance. Let's say, we're out in 2040 and someone looks at the 20-year return of this and decides to buy it self-directed versus advised, we want to make sure that the investors are in it for the right reason. And we would be very confident in an advised capability if they would. On a self-directed basis, we have a very, very large, ultra-high-net-worth self-directed investor, most of which already own private equity. So, we're confident that they understand the asset class and will know the asset class. But certainly, in an advice capacity, where it's part of a multi-asset-class solution, we think that makes great sense. So, that's one of the main reasons why we entered now is our real belief in advice and how much advice adds value to the client portfolio.

Benz: So, a little bit of a tangent question. You mentioned IRR, internal rate of return, and TWR, time-weighted return. Can you talk about the difference, first of all, but also what Vanguard's data says about what different investor sets do in terms of those numbers? So, do individual self-directed investors do worse than advisors? And I know you've examined this data and you think about it a lot. I’d just be curious to get your perspective on that.

Kinniry: Sure. Thanks, Christine. So, IRR measures the returns based on the cash flow that is in and how that cash flow comes and goes. And so, it's often very complex, but it's often maybe best just to use an example. If I just put in $100 on the very first day of the year, and I add nothing and I take nothing away, and I reinvest the dividends, then my IRR and my TWR on December 31 are going to be pretty darn close to each other because there was no cash flow whatsoever. However, if I'm adding money through the year or taking money out through the year or I got--let's say, I was spooked because of the last … You know, we're recording this today, in March, early March, mid-March, and the market has been volatile. And if an investor decided to pull out and then maybe invest later, their IRR to TWR is going to look a lot different because the cash flows really matter there.

TWR is just a time-weighted return. It's not influenced by cash flow. It's the number that funds report. And it's really--the TWR measures the manager or the asset class. And the IRR is actually the investor’s return. And so, what they actually--they can't eat or spend TWR. They can make sure that the two are close to each other by not market-timing. Research shows, and I know Morningstar has done a great job with the research in their own gap--the Morningstar Behavioral Gap--which is very well done. I've done a lot of these studies on the IRR TWR in Advisor's Alpha. And what it shows is--depending episodically that investors trail the returns of the funds they invest in by 1% to 2%--some of that, one could argue, is a little inflated, because if clients are just dollar-cost averaging in a 401(k) plan. But for the most part, investors’ behavior, meaning that they sell closer to the top and they buy closer to the bottom. You don't see that in target-retirement funds, or you don't see that in single-fund solutions, because people don't usually time multi-asset-class funds. It's one of the reasons I think we so much believe in advice is, if we can probably add more value just through behavioral coaching than many other features that are out there. And so, that's another reason why we want to make sure that if private equity and advice given the--if Vanguard really believes that advice can add value, which we do and we've demonstrated that over the last 20 years--and let's be honest, it's hard to stay in the market in periods like today or 2008.

If you just take a million-dollar investor on January 1 of this year and they were 60-40, that investor is probably off somewhere around 15%. And so, I always try to put it in dollar terms, right? So, that investor who had a $1 million, probably now has somewhere around $850,000 and so they've lost $150,000. And the only way you're going to stay the course--you know, a lot of people think “stay the course” is buy and hold; it's not. Actually, stay the course is an active process and it involves making decisions. You would be selling bonds and buying stocks to keep your portfolio at 60-40. And research has consistently shown that that process of setting your asset allocation and rebalancing to it, in the short run, it's painful. A lot of investors don't do it when we watch cash flow. It's gotten a lot better. And I think it's gotten a lot better mainly because the amount of money that is in advice. The entire advice space, it used to be more loosely will rebalance. And I think a lot of things have gone to auto rebalance where the decisions have been taken out of the hands of the advisor. And so, we actually think that's a great thing. And we're seeing cash flows even here at Vanguard in the … As our cash flows, we're looking at them very closely. We're seeing significant cash flow into equities and out of bonds in this environment, which would be very contrarian to history. But I think it shows that A, many people are taking advantage of advice and the advice is doing what it's supposed to do.

Ptak: If I may, I wanted to return back to HarbourVest and talk in maybe more specific terms about that implementation, if we can call it that. So, I think that you had mentioned earlier in the conversation that there are 35 to 45 GPs. Did I hear you correctly on that?

Kinniry: That is correct. And each year--just so context for the audience--each year, it will be a different vintage, right? So, we have the Vanguard HarbourVest 2020 Fund. But then, next year, we'll have the Vanguard HarbourVest 2021 Fund, which will be different. The main things will be the same, you know, how it's divided up between stage, strategy, and geography. The number of GPs will probably be plus or minus three or four or five. But that's right, on average, it's going to be around that number, Jeff.

Ptak: So, for one of our investors that's may be trying to visualize this and liken it to what they see in liquid investments, would the best analog to this be sort of like a really big fund of funds that has many hundreds of underlying securities through the funds it invest in?

Kinniry: Yeah, I mean, that's a good example. I mean, I use the target-retirement fund. But if we wanted to look at maybe an active fund, some people may be familiar with our STAR Fund, or our Diversified Equity Fund, which is the fund that then owns other funds, and then those funds own companies. And that is an example that would port very well to the public market.

Ptak: So, how did you settle on that format? It's obviously--private equity is a very diverse and, for that reason, somewhat misunderstood space. So, how did you decide that this is the right one, given the goals that you and your clients have?

Kinniry: Yeah, a couple of things. One, we talked earlier about how much you would need to actually start something like this from scratch, and then the experience, you know, the relationships and the experience to do this. So, we were very confident that this is the way we wanted to go and sometimes fund of funds, both in the public space and the private space could have a negative connotation as opposed to why don't you just do it on your own. And the bottom line is, if you have a professional who can do it for you, and who has either unique access or the ability to do this, and to give you broad diversification and you can manage the fee to a level that what you're paying them is very reasonable, then that's going to make sense.

I mentioned earlier the STAR Fund or our target-retirement funds--one of the huge advantages of putting it all together is behavioral, meaning that, within our, let's call it, fund-of-fund process, growth and value go out of favor; large, mid, small go out of favor non-U.S., U.S. go out of favor. When we see people owning the underlying funds--and this gets back to Christine's question on IRR TWR--we see people do time the individual components, but it's rare within these fund of funds that people would time a value, small value, which has been terribly out of favor last 10 years, in a fund-of-funds structure, because they end up only with one NAV or one return. They don't go and behave as if they just own the individual components. And so, within this process, we're going to have venture capital, we're going to have traditional buyouts, we're going to have secondaries and direct investments. The way a fund of fund works in private equity is, some they're going to other general partners, for some part of the assets, they are acting as the conductor of the orchestra. But for about half of the portfolio, they're investing directly. And so, I mentioned the conductor of the orchestra for about a half, but the other half, they're actually the musicians. And so, they're actually investing directly with the general partners directly and they're also becoming a much more of--and maybe the audience isn't familiar--but the private equity market has now created its own secondary market. HarbourVest was one of the first participants and the longest participant in the secondary market. And it's exactly what the word would think about secondaries.

If, let's say, because of this environment, a group of individual investors or institutional investors decided not to fund their future commitments to 2021 and 2022, people will allow exit strategies. And they put those all together and then it's negotiated on the secondary market. So, this is a private equity that may have been launched in 2017 or '16 and it comes to market, and you can buy these assets, and HarbourVest as I said, has been one of the first in the space, in the secondary market. So, you actually can see what's in there, touch what's in there, value it based on whether you feel it has compelling value for the life left of the investment. And so, for all of those capabilities, we feel very confident that this was the best way to go for our investors to give them the best chance to outperform.

Benz: So, what have you learned from managing other nontraditional strategies like market neutral to this point? And did you take those learnings to bear on this process of getting into private equity?

Kinniry: I would say it's more similar to the question we asked earlier about our history of evaluating managers. So, while this gets called an alternative strategy--I mean, the whole alternative strategy space is, it's just two words: alternative strategies. What market-neutral does and the alternative-strategy fund does is almost not even in the same fruit group, or vegetable group, as private equity. Those are strategies using public equity for the most part or strategies using other publicly available trading vehicles. This is a totally different asset class. So, this is private assets that are not in the public space that our investors have no access to prior to this. And so, we feel this is a separate asset class, not a different strategy within a public asset class. And it gets back to how we think about how you would do manager selection and the four Ps.

Benz: So, when you looked at private equity being additive to portfolios, what sort of percentage allocation came back as being a good spot to land?

Kinniry: Yeah, the good spot to land is probably too high for most investors' appetite. So, we're also thoughtful about, you know, if you were just to run through any kind of model or any kind of mean-variance optimization, it would tell you very quickly to have a corners illusion, which would mean have way more private equity than people can think about it. So, I think that's where you kind of move away from a Sharpe ratio or information ratio, because if you just go there, it's going to have way … And maybe that's what some of the largest endowments and foundations are doing. You can probably see most of the top endowments and foundations are 40%, 50%, 60% private equity. We're not faulting them at all. That probably makes the most sense given the return profile we see. But we want to also say that we're working with investors that probably could not stand 60% private investments.

And so, we think about what is the liquidity ratio, and you all are familiar with our glide path. And while the glide path is on stocks and bonds, I kind of think of the private equity glide path of how close you are to needing the--you can almost think about funding or a liquidity glide path. So, if your time horizon is 20, 30, 40 years, which most endowments and foundations are, and to be honest, most, let's say, individuals under 50 are, you could be at the higher end of some allocation. Also, how much you're spending, right? If you're in distribution mode or you're in retirement income, or your endowment has a 5% spending strategy, you're going to make sure that you have enough liquid assets to make those spendings. So, the asset allocation that comes out of this is going to really probably depend more on where you are in your liability versus contribution. So, where you are in meeting your liabilities, how soon and how much more than any kind of information ratio or Sharpe ratio, because the information ratio and Sharpe ratio is probably going to take you to a much higher allocation than is prudent unless your super endowment that has tremendous grantors that are giving every year and you're able to make your 5% contribution through donations or donors or a young investor, right? So, someone who is an affluent investor, let's say a high-net-worth investor. And the reason why I keep saying high net worth is because there is certain regulatory implications to be a qualified investor in private equity. Typically, you need $5 million under current regulatory. And so, that's why we started in the endowment and foundation space and probably where we will go to the ultra-high-net-worth business rather than core retail. Regulatory environment does change. The SEC has commented on trying to make this more applicable and more accessible to core retail clients. They see the benefits in that, I believe. But right now, it is for qualified investors for the most part. And think about the easy for the listeners, the investors that have $5 million in investable assets and above.

Ptak: So, I think the press release announcing your entry into private equity stated it would eventually present an incredible opportunity to individual investors. I may be sort of gently paraphrasing that, but it said something to that effect. And so, I wonder if you can just--as you think about your proposition and why you would describe it is incredible. I know that you have conviction in it, but for individual investors, what is so enticing about it?

Kinniry: Yeah, two things. One, anytime you can diversify a portfolio beyond … So, if you have portfolio A without private equity, and then you can say what does a portfolio look like with private equity? You are adding diversification because it is a unique asset class that does have correlations below one to stocks and bonds. On top of that, if the illiquidity premium is even half of what it's been--I mentioned, it was 300 basis points in the past. Let's just say--and I'm not saying this is the number--let's say it's cut in half and it's 150 basis points. And let's say that you're able to add alpha to that portfolio. And again, I'll use the example, if you can just slightly pick more out of quartile one and quartile two and the way the dispersion works, you quickly could see a portfolio that outperforms public equity by 500 to 700 basis points. HarbourVest has never actually had a fund open and then run through its entire course that has not outperformed by less than 500 basis points. That's every fund.

So, if we're able to kind of even do half of that, let's say, 250 basis points, and then add 150 basis points of illiquidity premium, to get a 4% return in this environment. I do worry--like, my biggest worry from the market volatility that we've seen in the bond, where are returns going to come from? If stocks--let's just stay with stocks as being a wild card asset and very hard to predict. It's a lot easier to predict bonds when you look at the current yields. And if the 10-year Treasury is below 80 basis points and the 30-year Treasury is below 1%, and you want to try to create a return for 4%, or even 3%, I'm just not sure where those returns are going to come from. And so, private equity can--I'm not saying it comes out of bonds. You keep your bonds at 30% or 40%, or 50%, wherever you are, but by complementing your public equities with private, you could easily see how it could go very, very well in something more goals-based, or returns-based. And we've all talked Jeff, you and I, and Christine, you and I, on what is the benchmark. And I've always felt the benchmark is what are your goals and objectives. And so, if we move towards a more goals-based, like, I need 5% as an endowment or I would like 3% or 4% as a high-net-worth investor to preserve purchasing-power risk of inflations too, it's going to be hard-pressed to do that without private equity in the portfolio.

Benz: So, one thing that's been top of mind for me is, if you're in touch with the Boglehead-type community where people use these very plain-vanilla strategies and achieve incredible results. I think there's been some concern that this is an illustration that Vanguard is kind of getting away from its roots of serving those folks. So, can you talk about that? Can you talk about--I assume you don't think that's the case--but just talk about why those investors shouldn't be worried that Vanguard isn't going to lose sight of serving them well.

Kinniry: Sure. Yeah. Definitely. We're huge fans and you know, Christine, I've spoken at and attended a lot of Boglehead conferences, and Jack and I were dear friends throughout my entire career. I would say this is aligned entirely in Jack's vision and what I mean by that is, Jack would be the first one to say this and I have the book, the first index book that he ever wrote that he signed for me sitting here on my desk.

Vanguard and Jack Bogle did not invent the index fund, and Jack was very clear--Samsonite and Wells Fargo had an institutional index that was available before it was available to retail investors. What Jack did amazingly well is stand up for the little guy or stand up for the average guy. So, indexing was around, active management was around, Wellington was around (Jack was fired from Wellington). It was not accessible to the average investor. It was not accessible to clients with under $100 million or $50 million. What Jack did is he brought indexing to noninstitutional non-billion-dollar portfolios and the same thing with active. So, his entire history was trying to make more accessible institutional mandates that served investors well.

As I mentioned, we started as an active managed firm, not indexing. Indexing came along later. And to be honest, if you go look at the fees of when Jack started, the fees were actually--I don't want to say quite high--but let's say, 10 times where they are now, maybe even 15 times where they are now. And what drove costs down was accessibility and scale to the average investor. And I would say this follows in that exact same template. Institutions have been using private equity forever. This is a 1% asset class where the ultra-high net worth, family offices, the top endowments and foundations and pension plans have been invested in this asset class for 20 or 30 years doing extremely well. But it's been closed to a $50 million endowment. No one is going to know--it's almost impossible to get a fair shake for a $25 million or $50 million endowment. It's almost impossible for a $5 million or $10 million family to go get private equity in a fair way that a Harvard or Yale would have private equity. We feel we've done exactly what Jack did with indexing and public active, is bringing a world-class private equity that was pretty much only available to clients over a few hundred million dollars and brought the price point down for that and the access down for that.

We hope eventually that it does even broaden--I mentioned the qualified investor rule and the SEC looking into that. Our hope is eventually that others see our entry here. The regulatory environment sees the benefit of the asset class, that eventually it even comes further down. Like, one day, hopefully, it's available to all investors if they're in some type of advised or multi-asset class single-fund solution, because we think it would actually add value to those investors. But for now, we have to work within the regulatory environment that's there. But for all the Bogleheads who follow us so closely, and we really appreciate all they do, I would say this is exactly Jack's template when he started Vanguard.

Ptak: What will the fees be?

Kinniry: So, the fees are a little unique in the fact that because this is a private placement, so anytime we do a public fund, we have to do a prospectus and the fees are public. We're not allowed to disclose legally. I'm not allowed to disclose the fees, because it is a private offer. I'm not even allowed to put it in any kind of marketing or any kind of things, even for the clients who might qualify. It is only available once we entertain a client in an RFP, and that they're already an advised client.

What I am allowed to say on the fees is that--and I kind of commented on some of this earlier is--there's a management fee and then there's also a performance fee. The performance fee does not kick in, and we mentioned what is a hurdle rate--meaning the performance fee does not kick in until the returns on the fund are at over 8%. We find that to be very attractive. Most people's outlook on the public markets--and you can pick a number 5, 6, 7, 8--so, we think the performance fee will kick in in the vast majority of circumstances when the offering has beaten the public space.

And then, lastly, and I can't get into the details, but we've negotiated fees that when we have looked at fees in the space--and we've actually shown this to other investors and consultants in the space who are actually potential clients--are very surprised of what we've been able to generate. And it's all about … We were not going to enter the space like, one thing--a precondition of us being in the space is that we believe that it would be net outcomes to clients. And so, one is, do we believe in the asset class, the illiquidity premium? Answer is yes. Do we believe we could find a world-class manager that could slightly get us in the top quartile? So, the answer is yes, through HarbourVest.

And the third thing is, how much would be coming out in fees, because all we really care about is how much the investor gets to keep. And so, we believe that when we add in a negotiated fee that we have, that our investors will be well served in the asset class. They will not be able to replicate this anywhere on their own, that's for sure. And the fees will be quite competitive with some of the largest asset pools out there.

Ptak: I guess I have one last question, which is on potential liquidity mismatch, which is something to your credit, you've mentioned as we've had a conversation here, is you look to broaden availability of this capability to other parts of your audience. Granted, they'd have to meet the qualification requirements, but it still seems like there's a potential liquidity mismatch, or at least an increase, as you broaden availability. So, how do you plan to manage that?

Kinniry: Yeah, our hope would be that we are very, very transparent and clear. The way this asset works, if you put in, let's just say, $1 million. On average, you're getting your $1 million back in four to six years. But that is not the total because your return on $1 million, let's say, of the $1 million investment, let's say you got a 2.5% return. So, you get $2.5 million back. While you will get your first million back in four to six years, the other $1.5 million of return of capital will be between year six and 15. So, we will say loud and clear, as loud as we can, that investors should expect not to get their last penny out for 15 years. Their initial investment out, four to six. The discount that one would pay if they decided they needed to break out of this would be significant. That we do know. So, you really want to go into this eyes wide open, and we'll make sure that our investors know that. Are we going to get some investors in there who did not understand it? We hope not. Our hope is that the vast majority of these clients are advised. But we do also want to offer this out to our direct investors that are qualified. And if we explain this all very clearly …

I think it's also why you wouldn't just want to use a mean variance or other type of portfolio construction, even if it said, put 40% or 50% in there, and I want to have a return target of 6% and the only way I can do that is through private. We would want to make sure we have a real long conversation of, can you handle the liquidity? And so, if investors, let's say, on average have 20% to 30% here, that means that 80% to 70% of their portfolio is highly liquid. And we're hoping that that liquidity is able to meet their liquidity needs. But it is a valid concern, Jeff, and we'll make sure that we say it loud and clear, because we do not want people redeeming early because we know what the discounts will be.

Ptak: Well, Fran, this has been great. Thank you so much. It's been a really interesting conversation on a very timely topic. Thanks for taking the time to share your insights and perspectives with our listeners.

Kinniry: Well, thank you, Jeff, so much for everything. And thank you, Christine. It's been a pleasure talking with you all, and I appreciate all you do for investors.

Ptak: Thanks again.

Kinniry: OK. Bye-bye.

Benz: Thanks, Fran. Bye-bye. Thank you.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at Until next time, thanks for joining us.

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