Counsel Views – Episode 17: Mikhial Pasic

Stu Morrow:
Welcome to Counsel Views. I’m your host, Stu Morrow, Chief Investment Strategist at RBC PH&N Investment Counsel.

In an ever evolving and increasingly complex market environment, investors are actively seeking out opportunities to diversify their sources of return away from traditional equity and fixed income investments. Alternative investments, which includes private markets, can be key components in portfolios for most investors, providing diversification benefits and reduced volatility, helping investors achieve their goals. Private market investments are defined as an equity or a debt investment in private companies that do not trade in the public markets.

At RBC PH&N Investment Counsel, we are proud to offer our clients a growing sweep of private market investments based on their individual risk tolerance, capacity, and overall portfolio objectives and goals. We have access to the growing suite of RBC Global Asset Management private market solutions, as well as some private market solutions offered outside of RBC.

Just recently, we have launched on a direct access, private equity vehicle offered by Carlyle Group, called the Carlyle Direct Alternative Opportunities Fund II.

With me here today to discuss this investment solution is Mikhial Pasic, Vice President, Alternative Investments with RBC Wealth Management Canada. Mikhial has been with RBC since 2008 and a member of the Portfolio Advisory Group since 2010. In his current role, he works closely with colleagues in global manager research to develop a managed platform of private markets offerings and provides advice and guidance on how to integrate alternative investments into portfolios. He also serves as a co-portfolio manager of tactical managed solution portfolios, and a government bond portfolio, and is a member of a global portfolio advisory committee that provides asset allocation guidance. Mikhial is a CFA charter holder and earned a Bachelor of Science degree in Business Administration with concentration in finance from the University of Detroit Mercy.

Mikhial, welcome to Counsel Views.

Mikhial Pasic:
Thanks a lot, Stu. I appreciate you having me today.

Stu Morrow:
Great having you here. I wonder if you can kick us off and maybe talk a little bit more about your role, about your team, and a little bit more about how your investment process works.

Mikhial Pasic:
Sure. That is definitely probably a great place to start. And so, you did a really good job of capturing it there in the intro. I mean, basically, there’s a group of six of us on a newly formed team in 2021 this year. And essentially, our mandate, there’s kind of two main components of it. Number one is for us to develop a managed platform of private market offerings that are available to RBC Wealth Management Canada clients. And really, number two—and this is very much to support number one in the mandate—is our role is to provide guidance really on how to integrate alternative investments into portfolios broadly.

And so, the team structure that we have in place to try to achieve these goals here, there’s six members of the team. And really there’s kind of three distinct work streams that we’re working within. There’s a strategy and advisor-facing component of what we’re doing, there’s an operational component, and there’s a manager research component. And really, all three of these items here are quite complementary and really essential to make sure that this is done properly and thoroughly here at the firm.

Stu Morrow:
So, Mikhial, picking up on the search function and that process within your team, can you talk about the investment process that you go through with your team in terms of due diligence? And how you come to select individual private market solutions?

Mikhial Pasic:
Yeah. I think that’s really a great way to bring kind of the team dynamic to life and give a sense of how those three distinct work streams kind of all come together to ultimately land a product on the shelf.

And so, basically, where we begin is sort of high-level conversations which are principally between the investment strategy and manager research functions within the team, where we’re collaborating; we want to have multiple eyes kind of scanning the landscape in a category. The investment strategy piece of it is kind of gathering information from advisors and clients on where there might be interest. It’s looking at the market from a relative value analysis and trying to identify opportunity. And then it’s drawing on the expertise of our manager research team to help us get a short list of managers that we’d really be excited to potentially work with in a given space.

And so, that process is very much one that I would call somewhat exploratory in the first phase of the evaluation that we’re doing on a fund. And it’s really about sort of honing down a short list of funds that we want to start to really do a second phase, what I would call maybe more investigative phase, and a deeper dive into a strategy to really underwrite the potential risk return profile.

The initial exploratory phase is all pretty high level, fact sheet-based, maybe introductory call level. But once we drill down to the investigative phase, that’s where manager research really takes the ball and runs with it. There’s a slew of meetings with managers; upwards of 10 meetings. We’re really trying to get in front of anybody we can at one of these investment managers to learn more about the strategy.

So certainly, we want to talk to senior people on the investment team, but that’s by no means the only folks that we’re talking to in this process. We’re having extensive conversations with people across the organization—folks on the operational side at the firm itself, third-party valuation firms that work with the investment fund company—to make sure we understand how valuations are flowing through to a given fund, and all of kinds of things to really make sure that we deeply understand the strategy from a risk-and-return perspective, both what does the upside look like and what does the downside look like, basically.

And then, private markets—this is the high-rent district in some respect, from a fee perspective. And so, really, we want to roll our sleeves up and make sure we have a full understanding of what that picture looks like, and we feel comfortable we’re getting value for those fees.

After we’ve really, through that process, identified a strategy that we think we would like to move forward, the next step from there is, I’d call it a summarization and formalization part of the process where, from an operational element, after we’ve identified a strategy we like from an investment perspective, it’s critical to make sure we can get that strategy into our clients’ hands in a format that is something they would actually want.

I mean, many of these strategies are strategies that come from global managers where they’re not necessarily oriented to the Canadian marketplace and a Canadian client. And there can be things like adverse tax consequences for a Canadian to just go into a Cayman fund or a U.S. fund that’s run by a global manager. And so, there’s a conversation about how would we bring that fund to Canada; what would the structure look like. And that’s really where the operations side of our team plays a really vital role in shaping those conversations and those dialogues with both the fund company and, often, a third party who’s structuring the feeder fund.

And at the same time that that’s going on, the manager research folks are working towards proposing the strategy formally, which takes the form of about a 20-, 25-page internal investment memo that gets presented to an investment committee. And that process—you’re a part of it, Stu. You know this very well, that the way that process works—we’ll work on maybe shrinking them under 20 pages if we can—but as you know, it’s very important to be thorough in that process. And what we’re essentially doing there is, the six of us on the small team have spent a lot of time rolling up our sleeves on something, but we need to present it to folks across the broader organization to get as many different perspectives as we can.

Many people on the committee have heard various things about the strategy by the time it makes its way to them because they’ve been consulted in the process, whether it’s folks in compliance, folks in legal, heads of different investment teams in different parts of the organization. But ultimately, we have an alternative investment committee which has business heads in the Canadian wealth management businesses. It’s got the head of alternatives in the U.S. business. It’s got folks on the legal and compliance side who are the heads of those units in the Canadian business. And we’re really just making sure that everybody’s onside with a fund before it actually makes its way onto a shelf.

And the final thing I’d say maybe on that, Stu, is you might have heard that explanation and said, wow, that sounds like an awful lot of work; is there actually a payoff for this? And once in a while in the process, admittedly, we do ask ourselves that. But the data does back up the fact that there can be a very substantial payoff in private markets for doing that level of due diligence.

And so, a data point I’d leave you with on that front would be, if you look at public markets and you look at top-quartile versus bottom-quartile managers in a category like U.S. equities over a number of different time periods, you’re looking at maybe a 1 percentage-point or 2 percentage-point annual difference in performance. It’s not nothing, and compounded over a long period of time, that can add up.

But compared to private markets, it’s a drop in the bucket. In the private market sphere, if you look at private equity strategies, even in the least volatile, which would be the buyout category, you have over 10 percentage points of dispersion between the top and bottom-quartile managers, and very meaningful dispersion still between second- and third-quartile managers. And as you go out to look at riskier strategies inside private equity, something like venture capital would be 20 percentage points of difference.

And so there really is—in terms of, bad outcomes can be really bad with the wrong manager and good outcomes can potentially be very good. We think the potential for that work to translate into better portfolio outcomes is potentially something that’s a very real possibility inside private markets.

Stu Morrow:
That’s a great overview. I think it’s important for everyone to understand the robustness of the process that goes into—from search to operations to execution—just based on that dispersion that you just mentioned between private and public markets. It’s a very different game in that respect.

So, the investment process that you’ve outlined more recently has given us this new fund, this Carlyle Direct Access Fund II. Can you give us, maybe to start, our clients a little bit of background? Who is Carlyle Group?

Mikhial Pasic:
Sure. Even the reason that’s so important, as it relates to this fund—and we’ll get into the fund specifics later—but I think, just to really frame this answer, this is important. We like this fund because it basically gets us access to their entire private equity platform but with some features such as, your money gets invested a little bit quicker and there’s a lower minimum, that we think are very desirable. And so that’s why what I’m about to say about Carlyle Group is really so relevant because, in many ways, this fund that we’re launching gets you access to their entire platform.

And basically, Carlyle is one of the largest private asset managers in the world. Private equity is their specialty. From an assets-under-management perspective, they’re nearing $300 billion in AUM. They’ve been at this for over 30 years. They’re one of the early adopters in the private equity space. If you look at their asset breakdown, over half of it is in private equity strategies. So for an asset-weighted basis, it’s certainly their specialty.

And it’s not just asset-weighted; it’s from a performance track record perspective too, that this is their specialty. I mean, what really drew us to The Carlyle Group is this is a manager with a very strong track record. If you look at their mature funds that have been in the market for an extended period, and you can see the full picture of returns kind of on them, they’re, generally speaking, first- and second-quartile funds in the respective categories.

The thing we also really like about Carlyle is when we look at the return pattern across those funds, there’s a very clear pattern of consistent returns that they’ve been able to generate. And when we look at markets today, I mean, there’s other people who can opine on exactly where we are from a valuation perspective and what that might mean, but I think the one comment that is probably fair and doesn’t need to be vetted by anybody is, valuations are not low right now. And to the extent to which they’re high can maybe be debated, but to the extent of somebody arguing that they’re low right now, that’s a very tough debate, unless it’s maybe on a relative value [comment] compared to something else.

And so, in this kind of market environment, if you think about a distribution in terms of the left tail being the bad outcomes and the right tail being the good outcomes, we’ve placed a lot of focus as a group on thinking about, if we do get a tougher market moving forward, who’s a manager that’s got the capability to withstand that? And Carlyle’s track record really speaks to their conservatism and their approach in the sense that, if you look at their worst-performing, [immature] fund, it’s almost doubled investors’ money. Now, that’s over a period of around 10 years, and the worst-performing funds can take double-digit years to return you your capital. And so from the percentage return, that might be not exactly what you’re looking for, but that is still, we would argue, an acceptable outcome in a bad situation or an adverse situation.

And so, we thought that was something that was very compelling, and we feel like we really understand why that’s the case after having kind of got to know them pretty well over the last number of months here. And if you look at their process, they’ve got this great investment team that sources deals and is really good at identifying great opportunities. But I mean, a lot of private equity firms have very good investment teams that source very interesting opportunities.

But we thought there’s a few unique aspects of what Carlyle does that were very compelling. I mean, number one, they’ve really put a lot of investment and resources into developing some internal capabilities to really help advance companies on the operational front. They hired a new chief digital officer, who we actually sat down with. We have a recorded call that’s available internally for our advisors to listen to, to learn more about his process and what he contributes.

But we really like the fact that there’s a clear path to adding value through the digital channel operationally, through businesses that they’ve developed internally. They have a network of operating executives. So these are former CEOs, retired executives, who Carlyle essentially has on retainer on almost a consulting basis to work with companies inside of their portfolio to help drive some operational improvements.

I mean, just to give you an example of who these folks would be—former CEO of Pfizer, former CEO of Domino’s Pizza. Those are some of the people that Carlyle has at their disposal. And what this all ultimately leads towards at the high level in the portfolio is the ability to generate these consistent returns. And why the returns are able to be so consistent is, with the focus on operating results rather than financial engineering or trying to pick a hot sector and ride multiple expansion, is the fact that they’ve generated roughly 80%, 75% of their returns in the last almost decade from improvements in cash flow and earnings, rather than sort of those other items that I talked about, which we think makes a lot of sense.

And then just the final point, Stu, and I think this is a very important one. We always want to think about alignment with the firm we’re partnering with. And it’s undoubtedly been a tremendous environment for fundraising in recent years, where there’s been lots of money moving into different private market solutions, and it’s been a bit of a bonanza from a fundraising perspective. And Carlyle’s definitely participated, and they’re raising large funds. They’re in the middle of raising—their large buyout fund is over a $25 billion fund.

But they’re growing at a reasonable pace in the context of their overall business. And in the last 5 years, in this great environment, Carlyle’s actually distributed more money back to investors than it has raised from them. And we think that that speaks to a firm that is thinking about investment outcomes and not just thinking about growing as fast as they possibly can.

Stu Morrow:
Well-aligned with RBC. And the Direct Access Fund II, our clients who are listenin, when they have more questions, of course, we ask them to contact their investment counsellor or their investment counselling team for more information.

But, at a high level, some of the key features of this particular Carlyle strategy that we have access to, maybe you can touch on that.

Mikhial Pasic:
Yeah. Absolutely. And so, the reason I really wanted to just spend the time on developing a full picture for people of what that platform looks like is, as I said, this product gives you access to the entire Carlyle platform where basically what it is, is it’s a closed-end fund, that’s a private equity fund. And what they’re going to do is they’re going to invest in a portfolio of somewhere between kind of 25 and 30 different portfolio companies.

And the way this fund is going to work is it has a capital call structure. So basically, a client whose going into this fund is committing capital today, and that capital will be drawn down over a commitment period, as Carlyle’s deal teams source investments.

The one distinguishing factor from this fund versus sort of a standard fund is, because this is a platform access fund, and the way they source those investments is they get a predetermined allocation to investments made in other Carlyle funds. So across their entire platform, Carlyle has a buyout fund and a growth fund. The buyout fund is targeting larger transactions in more established companies; the growth fund is targeting somewhat smaller transactions of companies growing more rapidly. And these funds exist in the U.S., Europe, and Asia, and the Carlyle Direct Access II fund ports into any investment that those funds enter, and you get a predetermined allocation to any given deal.

And the beauty of that structure is they’re able to accelerate the investment period without compromising the underwriting standards on the deals that they will be placing in the fund. If you want to get money invested quickly, that’s not hard to do, if that’s your sole goal. But if you want to do it thoughtfully, you can really kind of only accomplish that in a strategy like this and get that investment exposure being diversified, if you have access to these individual pools. And that’s what you’re getting at Carlyle.

So basically, what that means is, that investment period, which can often be five years in a standard private equity fund, they’re able to shrink it to two years because of the fact that they’re sourcing deals from those six funds. And the reason they can actually do this structurally is the Direct Access II fund is only a $400 million fund size.

I mentioned the Carlyle Partners VIII, which is their current buyout fund that’s raising, that is a $22 billion raise. So essentially, what you’re getting is like a 1% allocation to a deal that’s done across these participating funds. For some, it’s a little bigger; for some, it’s a little smaller in terms of the allocation. By virtue of having an allocation to six different funds, the money is able to get invested quicker, but to get invested quicker in a thoughtful manner still.

And the beauty of the money getting invested quicker is basically, anytime you have a closed-end fund, you’re giving up liquidity for a period of time. And generally speaking, you’d rather give up liquidity for a shorter period of time than a longer period of time.

Stu Morrow:
For sure. Maybe talk about the term directly, Mikhial, if you can mention that on the Direct Access II fund.

Mikhial Pasic:
Yeah. For sure, Stu. And so basically, that two-year investment period, that helps shrink the term because you get a two-year investment period. So, the typical investment’s five years. That’s shaving three years off of the full fund life. Carlyle, compared to some other firms in the private equity space, tends to have slightly shorter holds on their investment. Their average holding period on investment is kind of between four years and five years.

And so what that means is, Carlyle’s guiding investors in this fund that they can expect this fund to have an eight-year life. So a two-year investment period, if the average holding period is four or five years, they think there’s a good chance all investments have been exited by eight. They’ve reserved themselves the right to extend it by a year on two separate instances if necessary.

But the important point here, it’s potentially an eight-year fund life with the extensions, but they’re shortening the investment period, which helps shrink the overall time period. And the holds that Carlyle has compared to a lot of other private equity managers tend to be a bit shorter. And so it’s a very real possibility that investors are going to have a meaningful amount of their capital that’s starting to be returned to them by year five, year six, and year seven, which is something that we think is very interesting.

And you combine that with the fact that you’ve got a platform access fund; it’s not a fund of funds; you’re getting co-investment rights alongside those other funds without any additional layer of fee. We thought, for all those reasons, this was something that—to the extent a closed-end fund does require a greater commitment, we thought that this was pretty compelling in terms of how it was structured.

Stu Morrow:
And who would qualify for a purchase for this fund specifically? Is there a heightened scrutiny in terms of an accredited investor, or we call it a qualified purchaser? Who qualifies for this?

Mikhial Pasic:
Yeah. Definitely, Stu. I mean this deal has a higher qualification standard on the basis for the fact that, A, if it’s a closed-end fund with a fairly long life compared to a lot of investments that you’re committing to; and number two, it’s private equity that there’s complexity in the investment strategy compared to many more vanilla things you could do with your money.

And so, accordingly, this has a fairly high investor qualification standard where you need to be what’s defined as a qualified purchaser. And that’s a U.S. standard. And the simplest version of that standard is you need to have USD$5 million of investable assets to be an investor in this.

Now that also checks off, clearly, if you qualify for that, you’re an accredited investor and a permitted investor as well in Canada to meet that standard. But that’s really the high standard that you need to qualify for to be eligible.

The other two pieces I think that are critical here is, you must be a Canadian resident to qualify to purchase this, and it’s not eligible for purchase in registered accounts. And so definitely, the funnel on this is a bit narrow, but we think for those it makes sense for, it’s a pretty compelling opportunity.

Stu Morrow:
So, Mikhial, maybe before we go, can you touch on how this solution would fit into a client’s portfolio, maybe in terms of sort of the longer-term portfolio performance and what could be expected?

Mikhial Pasic:
Absolutely. I think what somebody should be looking for here in terms of placing it in a portfolio, this would belong in kind of a long-term growth part of someone’s asset mix. Really, this probably should be thought of as exposure that’s kind of complementary to equity exposure; in particular, large-cap equity exposure because the deal sizes in here are likely going to be smaller than what somebody would have in an equity portfolio, certainly on an average position size in terms of the enterprise values of companies.

And then in terms of what exactly that can translate to in terms of portfolio outcomes and the performance part of your question, Stu, really, private equity is in there for return enhancements. I mean, you’re taking a few additional sources of risk. You’ve got liquidity risk; you’ve got leverage risk. I won’t turn this into a drug commercial and go through all of them. But in exchange for those risks, there’s a return enhancement element that an investor’s getting or should be looking to receive, if the outcome is a good outcome here.

And what we think that looks like, really, we don’t know, but we can use history as a bit of a guide. And so, historically, private equity has outperformed public equity by kind of anywhere from 200 to 400 basis points, depending on your start point and your endpoint. Admittedly, those numbers are compressing increasingly as private equity is getting more competitive, more efficient, but there is still a liquidity premium that can be gained in private equities versus public markets.

And really, where that return enhancement can potentially really be bolstered is the manager research part of the conversation we had earlier, where the difference between top- and bottom-quartile managers, even the difference between second- and third-quartile managers, to the extent you can grab some additional alpha on your manager’s selection and really use that as a way to further augment the return bump you can get in private markets, that’s sort of the way we would think about this here.

And so you’ve got a general level of return enhancement you can get in private markets in general, specifically in private equity versus public equity. And then hopefully, to the extent that we’ve done our job from a manager research selection perspective, you can augment that even a little bit further.

Stu Morrow:
Definitely. And for those clients who are listening and who are interested in learning more, please reach out to your investment counsellor or your investment counselling team with any direct questions about the Carlyle Direct Access Fund II and they can always direct them to myself and to Mikhial.

Mikhail, always nice spending time with you. I’ve really enjoyed working on this project with you. And hopefully, you can come back again to join me to talk about this and some other things that your team is also working on.

Mikhial Pasic:
That would be great, Stu. Thanks a lot for having me. Great to chat with you. And as I joked, [you’d have to] go through the memo. There’s a lot of time in meetings. And we’ve spent a lot of time to decide this was the right opportunity, and we definitely spent quite a bit of time together along that way in a part of that process. But I think that the end result is one that we’re both pretty happy with here in terms of the product we’re able to deliver to clients.

Stu Morrow:
Definitely. Thanks again. Take care, everyone.