Paul O'Connor:

Welcome to the Netwealth Portfolio Construction Podcast and thanks for joining us. I'm Paul O'Connor and I'm head of investments at Netwealth, which includes responsibility for the funds and investment options we make available on our investment menus and the products we issue as a responsible entity, namely being the GSS funds and managed accounts. On today's podcast, we have Nathan Lim from Lonsec Investment Solutions joining us who is an executive director and the chief investment officer for the business. Nathan's responsible for building and managing Lonsec's suite of investment solutions, devising strategies for growth and acting as the liaison with the market. Lonsec Investment Solutions is in the process of launching an alternatives portfolio on net wealth for wholesale investors. And so I thought a general discussion with Nathan today on alternatives and his thoughts on building a standalone alternatives portfolio would be timely and of interest to our listeners.

Lonsec Investment Solutions is now part of the Evidentia Group that focuses on managed account solutions and investment consulting services. Evidentia Group is owned by the Generation Development Group, and Generation effectively has three pillars to its business being the Evidentia Group, the Lonsec Research and Ratings Business and Generation Life, the issuer of investment bonds. The Evidentia Group now has in excess of 25 billion in funds under management and continues to grow very strongly so I would suspect they're the largest investment manager in Australia now in the managed account space. Prior to joining Lonsec, Nathan was with Morgan Stanley Wealth Management from 2016 to 2023 holding senior roles in Sydney and Hong Kong where he developed their multi-asset investment approach. Before Morgan Stanley, he was with Australian Ethical Investments and started his career in 1995. Nathan has extensive experience in asset management research and stock breaking that's taken him really all across the world, including Asia, North America, the Middle East, and Australia, and holds a Bachelor of Commerce from the University of British Columbia.

He's an honorary adjunct professor with the UTS in Sydney Business School and a CFA charter holder, so certainly very well credentialed to join us today and impart his knowledge and wisdom on alternatives. Lonsec have 12 multi-asset managed models on the Netwealth public investment menu covering accumulation, retirement and sustainable strategies that are available to all clients. Alternative strategies available in Australia historically covered hedge fund strategies such as multi-strategy, global macro, equity neutral and equity long-short and merger and arbitrage. However, over the last decade, we've seen a huge growth in private or unlisted asset strategies covering private equity, private credit, and unlisted infrastructure. The growth of these investment options are fundamentally changing capital markets and significantly broadening the investment universe for investors. Private equity for example, offers exposure to many more companies outside listed markets where well over 80% of all companies globally are privately owned.

Private equity strategies include also a broad selection of these companies ranging from higher risk venture capital through to growth capital and buyouts of more established companies. And I think we've seen numerous examples in recent years where publicly listed companies have gone private. They've been purchased by private equity businesses. Private credit strategies also significantly broaden the opportunities in fixed interest markets where specialist lenders are active in property, property development and corporate lending across the entire capital structure of a company. This includes senior lending, secured lending and subordinated lending. So these strategies can vary greatly in terms of risk. So it certainly pays for investors to do their homework and understand what type of private credit strategy, for example, they're getting exposure to. Apart from the broader investment universe, private assets have traditionally offered an illiquidity premium over listed assets obviously due to the low liquidity offered by these strategies.

However, there's also issues such as the lack of transparency, the short track record of many managers and the varying idiosyncratic or very specific risks of each strategy that add additional risks that investors need to consider and analyse and potentially use the services of a group such as Lonsec Investment Solutions. So I'll discuss today with Nathan how investors should think about alternative strategies and building a portfolio of alternatives in 2025, including what are the opportunities and risks investors need to consider. Maybe to begin with, Nathan, can you share with our listeners some comments on your career journey and how you came to now being the chief investment officer of Lonsec Investment Solutions?

Nathan Lim:

Paul, thanks a lot for having me on the show. I guess to sort of start off my career, I started in Asia actually just before the Asian financial crisis, so I like to describe it as sort of the two best years of my life followed by the three worst years of my life. But that early stage or that early stage of my career really gave me a real appreciation of what is risk and how to actually understand what that means. And so that was a real sort of baptism of fire. Subsequent to that, I ended up moving back to Toronto, Canada and ended up working for arguably one of the most successful hedge funds in the world and I worked for a gentleman by the name of Eric Sprott and worked on Sprott Asset Management and that's where I really started to learn what investing was all about.

So I do credit a lot of my sort of investment knowledge and skill really on that time that I spent with Eric and his crew. Subsequent to that, ended up in Australia about 20 years ago now, and since coming here I've been a manager on an LIC and as you mentioned, introduction was the lead portfolio manager at Australian Ethical and then ultimately at Morgan Stanley. So really my career has really been about risk management, about managing risk, managing portfolios, and more recently in the last 10 years, really more about the wealth channel and dealing with both high net worth individuals and also with advisors directly.

Paul O'Connor:

You make the comment numerous times or use the word risk numerous times in that summary of your career there. And you've obviously seen quite a few crises, namely being the Asian financial crisis and the tech wreck of the early 2000s, the global financial crisis. So you're certainly battle-worn, I would say in extreme market volatility.

Nathan Lim:

Yeah, that'd be a good description. I've been caned a few times, but every time you come through it, you sort of develop another layer of callous so that way when the second one comes around it's not so bad and by the fifth time around you're actually quite numb to the whole thing and just see, for me anyways, whenever I see these sort of crises, there's certain sort of patterns that you sort of pick up and it's not always the obvious stuff. I know people like to look at, oh, the multiples look high, the market's about to crash. That's not really the way that you sort of see these things. So I guess the way I would describe it is that history rhymes and you just got to always be listening to it.

Paul O'Connor:

I made some comments about alternatives in my introduction, but can you provide views on what are alternatives and how does Lonsec actually define alternatives?

Nathan Lim:

At Lonsec Investment Solutions, I'll refer to us as LIS during today's sort of conversation. So at LIS we see alternatives as really being like a broad church that covers many strategies and assets that fall outside of traditional asset classes, and we further break that down in our universe by either defining it as either a defensive or a growth asset. And really practically how we separate between defensive and growth is we observe their volatility over time and that starts to help us bucketing strategies in terms of their suitability for different client risk profiles. Now keep in mind we totally acknowledge that volatility doesn't tell you everything, it just merely tells you the variation of the strategy over time. Volatility doesn't tell you anything about the nature of the strategy, like when in the economic cycle or the market environment you should be using the strategy, how does this strategy correlate with other strategies that you already have and how does this correlation with other strategies, how does it change over different macro regimes?

When it comes to portfolio construction, we believe alternatives are an excellent compliment to a traditional 60-40 portfolio as it brings new dimensions to the portfolio. What we're talking about here is that again, we're not looking for more of the same, so we're not looking for more equity risk or more duration risk or more credit risk. For us, alternatives should bring something new to the portfolio. And so for us, we think of it, you should be looking to get three things from your Alts exposure in your portfolio. Number one, it should provide access to risk premia that is not readily available in other parts of your portfolio. And a good example of this is illiquidity risk premia. This is the reward you would get for taking on illiquid risk that you can get from say, private equity or private infrastructure or private debt. This type of risk premia tends to have a reasonably high correlation to equity markets. So do keep that in mind.

The second thing we'd be looking for are for assets that are uncorrelated to equities or stuff that relies more on manager skill. We call these diversifiers. So global macro, multi-strat funds, strategies that can smooth out returns over time and are less sensitive to changes in macro conditions like strategies that can win in high or low inflation regimes. The third thing that we'd be looking for are our assets that provide risk off diversification. This would be an asset that goes up when the bulk of the risk in your portfolio is under stress conditions. So basically it does well when there's a lot of bad things happening in the market. These assets are typically negatively correlated to equities. There aren't very many of these and you should be thinking of things gold duration or trend following.

Paul O'Connor:

Interesting just thinking as you're talking through your thoughts on alternatives and defining alternatives, and I think a key comment you made there is that a good starting point is to break it up to a view on defensive versus a growth alternative and looking at volatility, but as we know, volatility is only one measure of risk in alternatives there. So they're an area that will certainly require a very specialist and experienced understanding I feel to try and put that broader range lens on what are the risks in each portfolio there, but interesting comments there, Nathan. What are some of the risks advisors should be aware about before investing in alternatives?

Nathan Lim:

What private markets, especially private market managers, they're always sort of really quick to point out the lower volatility of their portfolios. However, when you think about it, everybody is buying similar assets, but the only difference is whether the transaction was done through the public or the private markets and private markets, they're just not priced or traded regularly. So while the lower reported volatility of these assets does provide important benefits in portfolio construction, advisors do need to think about risks that aren't captured in statistical measures such as standard deviation and whether those risks are appropriate for your client. So for example, an advisor should be thinking about the liquidity of the investment, the complexity of the investment, the amount of leverage that is inherent within the investment, and of course the transparency that you're getting of the investment itself. No, but in saying all that, having reliable access to information is key to overcoming these risks that have highlighted above specifically from an advisor's point of view.

Another risk or another consideration that advisor should be thinking about is I'd really be calling out manager selection as another sort of critical risk when considering private assets because the dispersion in returns between the highest and lowest quartile managers is much wider than in public markets. Let me just get into that a bit more. So we recently have seen a study that estimates that the performance between the average top quartile and bottom quartile US private equity manager was nearly 20%. So that means the best manager and the worst manager there was like a 20% difference between the returns that they produced that is about 10 times the dispersion you find with public market global equity fund managers where the difference between the best and worst manager was only about 2%. So I think that's really important that when you're looking at private markets, manager selection is really important. It's very crucial.

Paul O'Connor:

Yeah, I think that also gets back to a comment I made in my opening around the idiosyncratic risks are very specific in a lot of private asset strategies and I think private equity, what you've explained there for the listeners is a great example there, Nathan, that dispersion of return. And I guess it also means to me that there should be a real focus on looking and understanding each private equity strategy and potentially looking at what sort of research and potentially even a Lonsec research rating on a product to give you a better understanding about what actually lies within that product.

Paul O'Connor:

We're seeing at the moment globally I guess inflation starting to moderate in the developed world. We're seeing in interest rates come down as a result. So what do the moving current macroeconomic settings mean for alternative investments in your view?

Nathan Lim:

That's a great question, Paul, and I'm going to channel my Deputy CIO Deanne Baker and she's made some great comments on this before, so I'm kind of paraphrasing the way that she sort of called this out. The current macro environment has shifted dramatically after COVID. The post global financial period was characterised by ultra low cash rates. Remember interest rates got down to like zero, record low volatility and ample liquidity finding its way into markets thanks to unconventional policies such as quantitative easing exercised by central banks around the world. Now that excess liquidity in markets really suppressed volatility as all asset classes rose. I think you'll remember this phenomenon summarised as buy the dip mentality over much of this period. Now the ten-year period or so was a bad time for most liquid alternative strategies, specifically hedge funds that rely on dispersion and volatility to generate returns.

Alternatively, it was a really good time for private equity which enjoyed the benefits of the low cost of capital and strong investor inflows. There has been a significant shift in this environment since COVID. Inflation has clearly re-emerged as all this ample liquidity was supplemented literally with helicopter money from governments worldwide in response to people being locked at home and unable to earn a living. This drove an inflation spike that drove a massive repricing across all major asset classes from cash to bonds and equities. It also brought with a greater uncertainty about the future and how central banks would respond to this increased volatility in some markets and resulted in greater performance dispersion across asset classes, sectors and securities. Now eventually central banks, they finally started to raise interest rates and they did so in a very dramatic fashion leading to materially higher cash rates, higher volatility and tighter liquidity conditions.

And it was that increase in dispersion and volatility that has provided a much more fruitful environment for hedge fund managers to generate returns from the various opportunities that are thrown up by asset and risk pricing. So as a result from 2022 and 2023, these were pretty good times for hedge funds like CTAs and macro strategies. So with liquidity now coming out from markets in the form of quantitative tightening, higher cash rates as well as slowing of economic growth, this period was more challenging for private equity which underwent significant repricing.

You have to remember that the IPO activity really dried up for private equity and that's when private equity typically captures the last 20%, 10, 20% of the value creation when they take markets public. You now fast-forward to today and the outlook for private equity has improved with central banks having turned from raising interest rates to lowering them again, creating a tailwind for the sector. There are even signs that merger and acquisition activity is starting to recover. So net-net bottom line, what we're trying to call out here is that the macro environment really does play into which strategies do well at a point in time, which kind of echoes back to the comment I made earlier just because private equity was great at one point in time, it doesn't mean it's always going to be great, but look at this point in time, clearly private equity is looking very attractive at current levels

Paul O'Connor:

Over the last probably five years, the products we've added on to our investment menu, there'd be more private credit strategies than any other product. So what trends are you seeing in private credit today, Nathan?

Nathan Lim:

So for this question, I'm going to draw from Ishwin Kaur who is one of our asset consultants. She's done a lot of work in private credit. She and Ron Mehmet really lead our work into fixed income strategies. It's important first to frame why private debt has become so popular amongst investors. Banks globally effectively stepped back from lending to small and mid-sized businesses because of the increased capital requirements associated with this form of lending following those regulatory changes in the aftermath of the GFC. The same time the increased policy rates by central banks means that the absolute yields from this form of lending is becoming really attractive for both lenders and investors. So this combination of regulatory arbitrage and rising policy rates means that private credit and direct lending markets have experienced rapid growth. And in fact, according to the numbers that we've seen from the IMF globally, this market now exceeds 2 trillion US dollars including undeployed capital commitments.

Now the same trend has also occurred in Australia where the private credit market has also seen significant expansion in recent years. Looking at data that we've gathered from various leading financial institutions here in Australia, we estimate that private credit has already passed $200 billion in assets in 2024, and this is up from $33 billion in 2016. All that said, Australia in our opinion remains in the very early stages compared to more established markets like in the US and Europe where they have even larger pools of borrowers. So this means for example, private credit transactions in the US are diversified across industries like healthcare providers, financial service providers, insurance, technology, consumer discretionary. Alternatively, in Australia the private debt market is much more concentrated specifically in the real estate sector. So the rapid growth in private debt, it comes with a lot of complexities and risk and the increasing popularity of private debt investors means that this rapid flow of new capital into the sector is putting more pressure on private credit players to deploy this capital and there are emerging signs of weaker underwriting standards and looser loan covenants.

And so when you circle that back, especially here in Australia where a lot of that origination is coming from one sector, that's not a really healthy combination. And also remember that borrowers in the private credit market generally tend to be small and medium-sized companies with generally higher levels of debt, and that means they have less wherewithal to withstand higher interest rates, inflation and economic downturns. So even recently ASIC has recently echoed these sort of similar global concerns how opaque the private debt markets are here, which gives rise to the potential for systemic risk if there's limited prudential oversight. But this sort of transparency aspect, clearly it is improving in the market.

Paul O'Connor:

And I think that's really what ASIC has some concerns about in the way that they have flagged that they're going to be having a very close look at I guess the whole private assets space. But I think there is a real focus on private credit there, Nathan. So I think very poignant comments that you have made about it.

Nathan Lim:

I don't want to poo poo over the whole sector, right? There are good private debt managers in a Australia.

Paul O'Connor:

Absolutely.

Nathan Lim:

What investors really need to be confident in is the outlook for Australia and for property development in general, but clearly transparency and portfolio disclosure are key markers in trying to identify these great managers.

Paul O'Connor:

So outside of private equity and private credit, are there any other alternative strategies that are interesting to Lonsec presently?

Nathan Lim:

There's a few things that sort of come to mind. The first one for us is of course, private real estate. This is a sector that's really been beaten up and clearly opportunities are emerging there. Now keep in mind that commercial office buildings, they make up a very small portion of the investment universe, but they capture kind of all the oxygen in the air. What people are missing is that there's really strong positive trends in digital infrastructure like data centres and fulfilment centres, aged care, even malls have seen a resurgence as things like click and collect and a greater focus on malls becoming a destination, not just a place to buy clothes means that there are opportunities abound for skilled managers. The old game of borrowing cheap and riding cap rates lower just doesn't work anymore. So you really need an active manager. Something else we like is distress debt and special situations.

We see opportunities to invest in good companies that have bad balance sheets, which can offer compelling risk return profile. What we are looking for here are managers that can offer flexible capital solutions to allow these sort of companies to restructure their poor balance sheets to help them manage through a higher interest rate environment while simultaneously earning a solid return for investors. And if there was sort of a third one, we kind of like to call, it's asset-based finance and this is actually a growing part of the private debt market, also driven by regulatory changes where small and regional banks in the US were required to de-lever and reduce the risk on their balance sheets. These are loans backed by assets like student loans, equipment finance, music royalties, even aviation leasing. It's even larger than the direct lending market and benefits from exposure to both fixed and floating rates. So it can benefit from a falling interest rate environment. Asset-based lending can be a nice complement to a private direct lending exposure.

Paul O'Connor:

Yeah, I think I've noticed over the years that there historically has not been a lot of opportunity for Australian investors to invest in asset-backed securities or ABS securities, but the US market's been I guess had a lot of... Well, US investors have had a lot of scope to invest in varying types of these strategies. So I think it's pleasing that we are seeing a more diversified range of private credit strategies including asset-backed strategies coming to market. What do you think investors should consider when they're looking at making an allocation to alternatives in a diversified portfolio? Nathan?

Nathan Lim:

I think the most important thing I always want to call out is that alternatives are generally illiquid, and I always want to remind investors that your Alts allocation will be the last place you reach into if you need liquidity. So it really should be reserved for your long-term capital. Now that said, there are daily liquid hedge funds that you can redeem like any other sort of managed fund or ETF if you do need ready cash, but it just is a general rule, allocate your long-term capital to alternatives. Specifically for private debt, while they can offer attractive yields, it is important to recognise that these strategies are not substitutes for cash, term deposits or fixed income bond funds as they generally carry far more credit risk, which I think a lot of people forget. You should be asking yourself, what are you trying to achieve with your alternative exposure as you're trying to... Are you trying to boost the returns or are you trying to take some of that equity market risk out of your portfolio?

It's these decisions that will be informed by the investment objective of the strategy or even just sort of thinking about where are we in the economic cycle. I think these are the sort of things you should be thinking about when you're sort of putting your Alts portfolio together. Related to your objectives of the strategy and also of the client is to of course go back to what I said earlier, consider the correlation of the assets with existing risk in your portfolio. An alternative could amplify an existing exposure or it could help to diversify overall portfolio risk. Make sure you understand the difference before you put these tilts into your portfolio. And lastly, regardless of what you put into your portfolio, like any investment, sizing is a very important determinant in how the investment will impact your portfolio. Remember to keep your portfolio diversified across strategies and managers and keep individual investments relatively small within the portfolio. Basically that old adage, "Don't put all your eggs in one basket" applies to alternatives as well.

Paul O'Connor:

From that, if an investor's considering putting together an actual alternatives portfolio, what are the key considerations that you believe need to be considered in constructing the portfolio?

Nathan Lim:

In terms of construction of the portfolio, I just touched on those sort of objectives, but if I can go one step lower in terms of selecting the manager and the framework that we have for considering a manager that you want to be allocating to, we have a framework that sort of picks up on five factors. The first one of course is the manager's track record. Do they have proven capability? It's just one of the five, but it's important. Scale, private markets, this is a game for the big, you have to be big to do well given the sort of financial and commitments involved. Just as an example, a private equity fund, if they're taking an investment in a company, typically they're putting 50, a 100, $200 million of capital at work instantly. So you have to be big to be able to deploy capital like that. You also want to be thinking about the manager's operating platform regardless of whether they are a private equity manager or a private debt manager.

Their ability to source deals and opportunities is paramount to their success because as the name suggests, all these deals, they're not available on a public market for everyone to see. So their ability to source deals and the resources to support it absolutely must be considered. The sort of fourth thing in our framework is of course risk. You just want to see the systems in place and the governance that they have in place to manage that risk. And the last thing we'd like to see is the judicious, and I'd like to use that word, judicious use of high quality external resources like third party valuations and again, strong external governance.

Paul O'Connor:

So we've spoken about the opportunities in the whole alternative space and issues that investors need to consider when they're making an allocation. And we've also mentioned numerous risks along the way, but do you have any concerns in relation to the huge growth of investment in private credit and private equity strategies in recent years?

Nathan Lim:

So a recent trend that we've observed is the growth of evergreen structures. Now until recently, if you wanted to invest in private asset deals, it typically meant you had to wait until a manager was ready to accept your investment and then they'd lock up your capital for several years as they then went about deploying that capital in the market. Now in more recent years, managers have adopted open structures where investors could generally invest and redeem far more frequently than what was done previously. And this is what the market now refers to a semi-liquid vehicles. Now generally, these are very general comments. We like evergreen vehicles as it does provide an avenue for some liquidity if you ever needed it. But that said, it is crucial for investors to understand that private asset investments are generally illiquid. Unlike publicly traded assets, private assets cannot be easily sold or converted to cash without the potential loss in value.

And generally if you try to force a sale like a fire sale, it can be a pretty material loss. So what this means is that investors need to understand, really need to understand the redemption details of an evergreen vehicle or any vehicle that they go into, including the frequency of redemption, the notice periods, lockup periods, gating, and any associated exit fees. For example, a fund may offer monthly redemption, but these are often limited to a low percentage of the overall assets of the fund. So we prefer managers who have extensive experience in managing liquidity for these semi-liquid structures. It's actually not an easy thing to do. And so you kind of want to have a manager who's done it several years and has a history of managing the liquidity needs in a semi-liquid structure. What we're basically saying here is that with semi-liquid structures, even though you are able to redeem technically, if everybody goes at the same time because of those caps that a manager may place on a fund at a point in time, you may still not be able to redeem.

So this goes back to my original comment, yes, you have some liquidity with an Evergreen, but these are fundamentally illiquid assets. It's like that strong growth that we've seen in that private credit space. It is sort of been sort of creating a lot of pressure on managers to then deploy that capital. And so I mentioned it earlier that we are starting to observe looser loan covenants and weaker underwriting standards. So they're kind of creeping in. I wouldn't say use that as a blanket statement, but they're definitely creeping in. And so you, as an investor, it's really important to take the time to carefully review strategies and the managers and we definitely would always focus on managers, what we would describe as higher quality managers, higher quality deals.

Paul O'Connor:

Yeah, I must admit, I do think back on the comments you're making there on private credit, whether the flood of money going into the strategies is in some instances reducing the liquidity premium as well. So look, it's been a very interesting discussion with you this morning there, Nathan, and hopefully very educating for our listeners there. So thank you very much for joining us on today's instalment of the Netwealth Portfolio Construction Podcast series. To the listener, thank you again for joining us. I hope you've appreciated the discussion and the comments that Nathan has made in relation to Alts. And I think a couple of key takeouts for me is just, it very much is a broad church of investments in the alternative space and they do very much require specialist skill and knowledge. So I would highly encourage the listener to consider using external research and assistance in appropriately allocating and using Alts in your client's portfolios.

But I also think that the growing investment opportunity and the ability to act as a diversifier in an overall diversified portfolio certainly needs strong consideration there. But on the reverse there, I think too, we need to be careful about the lack of transparency. We need to understand the gearing and the leverage inherent in a lot of these strategies. We need to try and get our head around the complexity of these strategies and obviously appreciate the illiquid nature of these investments. But yeah, look, Nathan, thank you again for joining us on today's Portfolio Construction Podcast series. To the listener, have a great day and I'll look forward to you joining us on the next instalment of the podcast series.