~15 min read

In this post I’ll use Partners Group’s recent investor day presentation to frame our key points about the alternative asset management industry. This is our largest portfolio position, with ~10% in KKR and ~30% of the portfolio in BN.

Hopefully this gives good clarity on how Brookfield/KKR’s industry is developing overall. Past, present, future. Yes, we talk about our companies’ performance: fund returns each year, how much new AUM is being raised or not, whether carried interest based income has gone up or down and how much, what new avenues they’re going down, like annuity sales, etc. These but these are smaller, timing-related things compared to what my thesis has always been. They are like waves compared to the tide.

Furthermore, I keep a lot of numbers in my head, usually approximate ones.1 Looking at my posts, I realized that’s probably too rough for some of you, and that you’d benefit from more granular data and clearer logic to show what I think’s going on in this industry.

Partners Group,2 a Europe-centric competitor of Brookfield/KKR, held an investor day conference recently. I flipped through PGHN’s deck and think some of it can help you. The whole Investor Day deck is here, and their ongoing pitch deck is here.3 Sadly there’s no recording, though :(

Slide 7 from the iDay deck helps you frame the industry’s clients overall, as well as the market penetration:

The chart shows the average portfolio allocation to alternative assets (like infrastructure and private credit funds) by client client type (aka: by market segment). The rest of their portfolio will be made up of stocks, bonds, cash, and derivatives.4 I’ve seen other estimates where the institutional market is smaller (e.g., because corporate pensions are excluded) and the private wealth market (wealthy families + individuals including retiree savings) is bigger. But this gives you a good picture.

You can see that many, many investors in the world have little or no allocation to private markets assets. Other investors who have been doing this >25 years now and are more “mature” and farther along this trend — such as the Yale Endowment and the Canada Pension Plan — are >50% allocated to privates.

But many aren’t.

Their portfolios are 70-90% stocks, bonds, and derivatives, with few alternative investments like infrastructure (ports, toll roads, cell towers), real estate (data centers), power (wind & solar farms), private credit (bespoke loans against aircraft equipment and such) etc. None of that stuff’s publicly-traded and you’ve got to have expertise and relationships to originate (find) and underwrite (decide on making) those investments. Either you build out the expertise to do that in-house and pay for it yourself (which Canada Pension Plan did 25 years ago, and is still doing, constantly hiring and changing teams), or you hire a money manager for a fee, like KKR. It’s hard to do this in-house while also finding the best investment people: thousands of institutions would be competing with each other to have thousands of teams; no way can they all be “the best.” So, most institutions hire a few managers like KKR, Blackstone, Partners Group, Brookfield, and Apollo.

That allocation above is trending upward. It used to be nearly 0% 25 years ago. When you survey the clients and prospective clients, they generally say they want to add more of this stuff, implying the above allocation will keep trending up.

It’s very simple why and is in my KKR report:

• Diversification: a portfolio of different asset classes is more robust than a portfolio that only owns 1-2 kinds of assets. Many of these assets are uncorrelated (or even negatively correlated) to each other, meaning they don’t all gain/lose value at the same time — such as during a recession and market sell-off. An oil pipeline held in an infrastructure fund doesn’t really care about a recession: most of the oil volumes will still be sold through the pipe, the toll rates will be the same or increase, and the volumes the oil producers don’t ship during recession, still have to be paid for at a reduced rate under “take-or-pay” contracts, so the cash flows coming from the oil pipeline investment in that fund will continue to do just fine in a recession while stocks are falling 30%. Hence the investors like the idea of having an infrastructure fund that does the same 7-15% returns as stocks, but isn’t correlated to stock prices. It diversifies the portfolio.

• Higher returns: in general, the best money managers like Brookfield are putting out returns far in excess of their competitors and in excess of stock returns and bond returns. The product in this industry is the returns. The money manager’s job is to make money for the clients. If you can make more money for the same risk, you’re going to take “share of wallet” from the clients. They’ll buy less of the crappier-performing stuff, and buy more of the higher-performing stuff. Brookfield’s private equity business has been doing >20% returns for ages. People like Brookfield and want to do more business with Brookfield. They reduce their stock holdings, and give the money to Brookfield. They also buy less of competitors’ products, and give the money to Brookfield.

• Eyes closed & agency problems: some people will think this is stupid, and it is, but it’s also extremely real. Stock prices go up and down every day. And they go up and down by a lot over the course of a month. That’s volatility. Volatility makes us scared. Whenever some pension’s stocks go down 30% or whatever, the CIO of that pension has to go into a board meeting with the board of trustees and explain why all this stuff is down 30% and if they haven’t made some huge mistake or something. If the CIO looks like he or she’s screwed up, maybe the trustees fire them and hire another guy to fix it. This happens all the time. It’s really dumb. Welcome to working in the investment business. Buuuuuuuuut… private funds don’t trade every minute of every day. They only get marked to market once a quarter or so. So, “magically” there is “not much” volatility. It’s like Trump said about COVID: if you don’t test for COVID cases then there are no COVID cases! If you don’t value the fund every day, then the price doesn’t change, so nobody has to get fired at board meetings. It’s “lower volatility.” On YouTube somewhere, there’s recording of a guy who runs a really big public pension in the US, and he’s got a PhD in finance and all, and he’s explaining to a board that this stuff is lower volatility. People want to keep their jobs. In a way, it’s also helpful because it does help train people (like pension trustees, who are often not investment professionals; or maybe they are investors but they’re not the steady-hand kind of investors) not to focus on short-term prices, and not to panic. You can see this point in the data on slide 110 of PGHN’s iDay:

Their longer-running evergreen (open-ended) funds’ performance has been similar-to-or-better-than public stocks, but with much lower maximum drawdowns (“Max DD” in the charts) — i.e., they didn’t fall 50% like the S&P 500 did during 2008/09 — and lower volatility. Compared to 50%, a 13% drawdown5 is hardly worth having a board trustee meeting about, isn’t it?

Final point:

• Envy: when a bunch of institutions start performing well, apparently because they’re buying infrastructure and credit funds and such from Brookfield and Friends, then the boards and the trustees of other institutions are going to ask “Everyone else is doing better than us by investing in these funds. Why aren’t we?” Every chief investment officer wants to keep his or her high-paying job. So, there’s pressure to “Keep Up With The Jonses,” as it were. The same phenomenon is happening among high-net-worth and ultra-high-net-worth individuals, as they talk to each other at the golf course. Even financial decisions are not strictly logical, because those decisions are still made by us humans.

So, the investors who are “under-allocated” to alts are overwhelmingly likely to keep giving more money to Brookfield and Friends, and there’s a ways to go.

The industry and its clients have gotten more sophisticated about this in the last 10 years. There used to just be a team or whatever who left a bank and started a private credit fund and then knocked on a bunch of institutions’ doors. They’d pitch how they could make more money than owning bonds, and some investors backed them and allocated to these funds. It was more Wild West. Nowadays, more institutions know more investment managers, there’re better managers to choose from, and stricter criteria on how they choose. At the same time, a few leaders emerged. They’d stitched together all the different kinds of asset classes and investment teams (infrastructure funds & investment teams, real estate teams, credit teams poached from banks, etc.) and then hired a relationship manager to go out and sell this one-stop-shop shelf full of all the different kinds of funds a guy like the National Pension Service of Korea would want. Only a few competitors did this well: it’s pretty hard to put all these teams together, and even harder to make sure all of them are really good so that you have a good investment track record across 10+ different things.

So, we ended up with an industry with thousands of so-so money managers, then a bunch of successful ones who only specialize in one niche, like Andreessen Horowitz in venture capital, and then a handful of only ~10 or so guys worldwide (who emerged out of those thousands), like Brookfield, Apollo, and Partners Group. These ~10 sell basically everything, and are good at all of it, so they cross-sell it seamlessly to clients. The clients don’t want to work with 50 different money managers, they just want a few good ones. So many clients naturally gravitate to Brookfield and Friends, and away from others.

Hence, Partners Group shows us that in many areas of the industry, the biggest guys are organically taking market share:

The top 20 infrastructure fund managers were 56% of the market. Now they’re 75%. The trend’s similar elsewhere. It should continue for the reasons above, and there’s a lot of share left to take while the underlying market grows ~10% (at the expense of stock and bond money managers). So I think I’m justified in my valuation assumptions that leaders like Brookfield have a good shot at 10-15% AUM growth for a decade.

This is why in one of my first posts on KKR/BN, we quoted the Christian bible:

“Whoever has will be given more, and they will have an abundance. Whoever does not have, even what they have will be taken from them.” — Matthew 13:12

The winners are just winning more of a growing pie.

The steady state for this industry looks like it will be (1) a small number of big behemoths, with (2) a few successful specialists, and then (3) ongoing churn of smaller new entrants who try to succeed in a niche and may or may not succeed long-term. The big behemoths have already emerged, because it was difficult to put together that full shelf product offering. Consider that KKR has hundreds of investment people sourcing investments for funds around the world, sifting through deals to generate good performance. On the other side, it has hundreds of people banging on doors and maintaining client relationships with the world’s largest investors and wealth management firms. That took 20 years to build and is not even done yet. On the investment side, you also can’t replicate a 20-year investment track record out of thin air. It takes 20 years to have a 20-year record. If you are the new guy pitching to a client and you’ve not much of a record, and Brookfield pitches “yeah, well, we have been doing >15%/yr for 20 years, and here’s 10 different funds you can buy to diversify”, who gets the money? There won’t suddenly be another 10 guys competing for the pie Brookfield and Friends are competing for. Just them. We also know this because it was hard to figure out in the first place: Out of thousands of smart finance guys at thousands of competitors, only these ~10 companies figured it out right, a 0.1-1% success rate.

That’s some of the key data and logic behind why I think we picked a couple winners in a good industry, one that won’t see tons of new competition.

A model for industry development

To illustrate this more generally, I made this really ugly chart in Paint:

The horizontal axis is time. The vertical is whatever gauge of size you want, like billions of dollars of revenue (the actual industry size), or the percentage of total industry sales (market penetration) or of customer spending (share of wallet). For the red line, the vertical axis is the number of competitors in the industry.

Now, the puke-green line, you have probably seen many times. It’s just an S-curve for industry growth and market penetration. Maybe you’ve seen the US e-commerce market penetration S-curve that Amazon’s retail business lives within:

Green is that. Green starts at “early adoption.” This was the 1980s-mid 2000s for private equity, where guys like cousins George Roberts and Henry Kravis (some of the letters in KKR) were out there wildcatting and buying businesses and convincing rich people they could make a lot of money investing with them. The belly of the curve is “growth”, where most of the industry penetration increase happens as the products become known by pretty much every client and they start choosing to use it. Long-term, the green line starts to flatten out as growth hits “maturity.” In my opinion, the green line then splits into either the purple or black paths, as shown. For some businesses, you end up with these “forever” companies whose growth continues essentially indefinitely at GDP or less. They don’t decline because they meet some fundamental need that we will always need. That’s stuff like food (production, distribution, and sales), banking, insurance, construction, freight, death services, healthcare treatments, etc. Those industries kind of just grow with the global population and economy and exist indefinitely. Then there’s terminal decline, which happens for industries that ultimately go obsolete, such as by being slowly replaced with a substitute product that does the same thing in a better way. This is industries like cigarettes, cable TV, and hard disk drives today, and typewriters earlier in the 1900s. (I tried to avoid horse carriages, the cliche example.)

The rates of change and market penetration vary massively. Modern banking is 400 years old, but things like internet advertising and many medical devices are only 30 years old. Different industries come and go at very different rates. In the kind of investing I tend toward, you like to find stuff in the earlier part of the S-curve, and preferably where the curve looks like it’ll be drawn out for a long period of time.

Red is important. Red is the number of competitors in the industry. In brand-new industries, you get lots of new potential customers every day. People are discovering the product, figuring out if it’s useful to them and stuff. So every single day, there are more and more sales opportunities. One company can rarely touch every prospective customer and capture the sale. This creates room for competitors to come in and for their sales people to capture some of the customers instead. The number of competitors and the amount of investment dollars financing these new businesses goes up and up. This often ends badly. As we move up the green S-curve, the rate of industry growth slows, and so you have too many guys trying to grow into a pie that is no longer growing fast enough to feed all these mouths. A “shake-out” often happens, often caused by some shock that puts the industry into temporary decline (the S-curve is bumpy in reality), where there’s a price war or an advertising war or something as people struggle to survive, pay for all the investments made, and cover their fixed costs. Some guys will go bankrupt because the whole business was financed with a bank loan and such, and the interest costs are killing them.

(There’s this thing Nassim Taleb calls the “graveyard of silent evidence”, which is akin to survivorship bias. Consider for example that there have been tens of airline companies in the US alone over the last 100 years, yet you only see four major ones now. It’s a very concentrated industry, you might think. Yeah, no. Same for the car industry, where there were over 100 car companies that have come and gone as a result of the slowing growth and the industry cycles. You are now witnessing the same shake-out in the Chinese car industry as many of the ~100 new competitors begin to die off and consolidate because of a Chinese and global slowdown.)

You want to be wary of starting a business when the number of competitors is growing or could easily grow, and you also want to be wary of investing in such a business. You usually don’t want to get into an industry where the red line is going up. You want the red line to be going down or flat, so that the industry competitiveness is actually in decline and there’s not a lot of new external investment capital pouring into the industry. You also want to be in a place where the green line has a lot of room to go up, so that the existing guys have a good shot at becoming much bigger businesses. So usually, you often find good long-term investments in places where you are kind of in the first third or the middle of this chart, but not at the beginning. That’s usually a place where the industry can sustain its returns on capital and profitability (because competition is not increasing) but there is a lot of room to still become bigger, reinvest capital at good rates of return on capital, and grow profitability.

Keep in mind, the red line has no specific shape, either. The industry might settle into a large number of competitors for various reasons, and their returns on capital might be decent or poor for various reasons, and the returns might vary a lot from competitor to competitor. You could also have more than one bump in the red line. E.g., even though the number of cars sold in the US is flat and the car sales green line would be flat, you had a bunch of new entrants into the car market when electric powertrains became a thing. Now most of them except Tesla are dying, and the incumbents have come up with their own electric cars.

If you think about the alt. asset management industry’s history, growth today and room tomorrow, and overall competitive structure, I think we are somewhere around the arrow that I put on the chart. I think the red line will forever be elevated, but that there is a clear class of “superbrands” (as some of them say) that emerged in the 2010s, and they are going to capture most of the future increase in the green line. A few years ago, I found data from Bain that showed by the 2010s, the number of private equity money managers has been about flat and slowly decreasing, whereas it had been growing sharply in the 90s and 00s. We got to a point of maturation in the industry. With growing client sophistication and clear winners/losers defined by their long-term investment track records and product breadth, smart clients are increasingly working with the best money managers. I don’t have as much data anymore, but the data and the facts/narratives from people in the industry I do have, point to this kind of competitive maturation. At the same time, the facts point to us being somewhere in the belly of the S-curve. So I think this industry will (a) keep earning good returns on capital for quite some time, and (b) the leaders can keep doing 10-15% growth for 5-10 years as clients preferentially select them to manage more of their portfolios (and sell down stocks and bonds in favor of these better-performing alt. assets). That growth will slow as the industry matures: the leaders can’t keep taking market share forever, they can only get to 100% (which they won’t), and the industry can’t take more than 100% (which they won’t) of a client’s portfolio allocation or “share of wallet” either. So once the industry matures, we will get to a place where the allocations and market share have matured, and the industry will just grow with overall wealth in the world. That’ll go on until something better is invented (though money management has existed for a very long time; it kind of just changes form).

That’s the most basic piece of how I think about the industry today and where it’s going.

Clearly, we don’t have perfect predictive power, so we just follow the ongoing evidence you see above. Is every still telling us the clients’ portfolio allocations to alts are increasing? Is it increasing for the reason we thought it would? Are the leading competitors still in charge and capturing the growth for the reasons we thought they should? Etc. We sit here and do our “maintenance due diligence” to fact-check ourselves. We are in the boring part of long-term investing, which is that you just sit around and fact-check yourself as you own the stock.

Chris

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