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The Challenges When Assessing OCIO Performance: Applying Global Investment Performance Standards (GIPS) to OCIOs

Posted on July 17, 2026July 17, 2026 by Chris in Briefings, OCIO Search, Uncategorized

Introduction

Assessing OCIO performance is an important part of evaluating OCIOs as candidates for our clients. The task also has many imbedded complexities. The CFA Institute has taken steps to address some of these complexities.

We explain here why we think the CFA Institute is moving in the right direction, but we still believe that GIPS Standards do not provide a complete picture of #OCIO performance. Instead, when we evaluate OCIO performance we assess performance by asset class, looking both at performance relative to client specified asset class benchmarks, and also performance driven by asset class selection.

Background

The CFA Institute and its predecessor AIMR set the foundation for assessing investment performance of individual investment managers. They created the Performance Presentation Standards, which evolved into the Global Investment Performance Standards or “GIPS,” an acronym trademarked by the CFA Institute.

In a world where the foundation for almost all investments were liquid, publicly traded securities, GIPS’s uniform methodology revolutionized the asset management industry. GIPS created standardization in performance reporting and disclosures, which greatly increased transparency and comparability in our industry. The standards allowed allocators to access improved and objective information about the investment performance of their investment managers.[1]

[1] To improve reliability and lessen dependence on investment managers’ own self-reporting, an ecosystem of independent GIPS compliance developed. The audit industry started to provide GIPS attestations which are basically two main levels of independent, third-party attestations. Verification (firm-wide) and Performance Examination (composite-level), These attestations simply assert whether or not the investment manager calculated and presented their performance in compliance with GIPS standards. The auditor verification does not provide assurance on the accuracy, validity, or performance of any specific composite report. A firm cannot claim that a specific composite is “verified”. The GIPS standards merely tell the investor that the performance has been calculated and presented in compliance with GIPS standards.

The Initial Application of GIPS to OCIOs Created Confusion

It is understandable that the CFA Institute would wish to extend GIPS to cover OCIOs, since OCIOs are becoming increasingly important in the institutional asset management marketplace. However, OCIOs seeking to comply with GIPS faced a major challenge: GIPS did not sufficiently allow differentiation of client-types in the OCIO managers’ composite returns. The result was a mixing of low-risk, immunized pension plans with return-seeking foundations into composite returns. Only when an OCIO’s client mix was relatively uniform did the GIPS standards offer any hope of being a meaningful measure of an OCIO’s skill in advising clients.

Another major challenge with computing GIPS returns for OCIOs is the fact that OCIO strategies are not directly comparable across OCIOs. For example, some OCIOs pursue 100% liquid investment strategies into equities and bonds, while others will allocate up to 50% in private strategies. It would be difficult to assess the performance of the liquid OCIO strategy against the OCIO with the 50% private strategy.

Moreover, within equities are sub-asset classes with vastly different risk profiles. Within liquid equity strategies, OCIOs may present choices of value equities versus growth equities. More broadly, OCIOs may offer relatively low-risk consumer staple equity strategies, versus highly illiquid venture capital investments into AI and biotech. Comparing an OCIO that is offering a high proportion of venture strategies with a 10-year commitment, with an OCIO that offers a high proportion of value equity strategies would create complications, since the underlying question is the asset allocation choice and the relative success within those choices. The relative performance comparison only scratches the surface of the OCIO performance analysis.

Challenges from Including Illiquid Private Strategies in GIPS

OCIOs present challenges that stretch the limits of GIPS. At its inception, GIPS primarily addressed investment strategies consisting of liquid securities with transparent pricing. That is not the case for many OCIOs that may have 10% to 50% of the portfolio invested in semiliquid or illiquid strategies. The pricing transparency of those assets can range from high for many hedge funds, to very low for venture capital investments.

So how does GIPS handle this transparency challenge? It does so indirectly, by implicitly relying on valuations provided by the managers of the underlying private strategies. This method is called the “practical expedient” valuation method. With current market conditions, the “practical expedient” tends to have the following attributes:

Understated volatility: Valuation changes are driven by major, infrequent events, like pricing for latest capital raises, or private corporate sales. Thus, the volatility of valuations from the “practical expedient” method are greatly dampened compared to publicly-traded investments.
Overstated valuations: We believe that managers of private strategies have a tendency to be optimistic in the face of distressed market conditions. That appears to be the case for private credit managers, where the private credit funds have de minimis losses over the last year, whereas their publicly-traded analogs are often trading around 25% lower. Older private equity funds also face a similar dynamic in private markets, where investors will trade their 5- to 10-year-old vintages at times with discounts of 25% to 50% off of the values stated by the managers.
Overstated private returns: If the valuations are overstated, so are the returns.

CFA Institute Seeks to Implement Better OCIO GIPS Standards

The most recent proposed GIPS standards present a material improvement over the initial GIPS standards, because they allow for the breaking out of “growth assets” from “capital preservation” or “liability management” assets:

Required OCIO Composites for Total OCIO Portfolios

Required OCIO Composites	Allocation to Liability-Hedging Assets	Allocation to Growth Assets
Liability-Focused Aggressive Liability-Focused Moderately Aggressive Liability-Focused Moderate Liability-Focused Moderately Conservative Liability-Focused Conservative	0–20% 21–30% 31–50% 51–75% 76–100%	80–100% 70–79% 50–69% 25–49% 0–24%
Required OCIO Composites	Allocation to Risk-Mitigating Assets	Allocation to Growth Assets
Total Return Objective Aggressive Total Return Objective Moderately Aggressive Total Return Objective Moderate Total Return Objective Moderately Conservative Total Return Objective Conservative	0–20% 21–30% 31–50% 51–75% 76–100%	80–100% 70–79% 50–69% 25–49% 0–24%

Source: CFA Institute “Exposure Draft of the Guidance Statement for OCIO Strategies” from October 16, 2023

Challenges from Including Heterogeneous Strategies in GIPS Composites

As can be seen from the #CFA Institute’s proposal, #OCIOs will be permitted greater gradation of risk appetite by client type, which is a helpful improvement over the GIPS standards for traditional liquid managers. However, the new standards do not distinguish for:

Volatility dampening and income smoothing of “growth asset” strategies that are private assets, nor the valuation risks assumed by using the “practical expedient” valuation method.
Gradations of risk, primarily in the Growth Asset category, which inappropriately places venture capital and value investing in the same risk bucket.
Differences in liquidity across #OCIO clients.

We note that the Alpha-NASDAQ OCIO benchmark generally accepts these flaws, but provides gradations of 10 risk-appetite buckets of 10% allocation differences between Growth Assets and Capital Preservation assets. Like the CFA Institute OCIO GIPS standard, the #Alpha-NASDAQ OCIO benchmark approach does not correct for illiquidity difference, use of the “practical expedient” accounting practice, volatility dampening or income smoothing.

Conclusions

#GIPS standards for OCIOs are evolving. We believe the CFA Institute is taking a step forward by recognizing that not all OCIO clients are identical, and allowing OCIOs greater ability to distinguish among them by broad bucketing.

Unfortunately for us as #OCIO search consultants, we cannot rely on these standards, nor the AlphaNASDAQ approach, because neither account for the use of “practical expedient” accounting, volatility dampening and income smoothing, or differences in liquidity.

We encourage the CFA Institute to continue to consider evaluation of GIPS practices for OCIOs, while realizing that they may want to consider additional disclosures covering liquidity, asset class performance, and percentage use of “practical expedient” accounting methods in portfolios.

In the meantime, our approach is to gather asset-class level performance, and information on liquidity restrictions and valuation practices, to help us assess performance at a deeper level.

#OCIO Search

#OCIO Evaluation

#Investment Adviser Search

#Investment Consulting

#Investment Consultant Search

PRIVATE EQUITY SECONDARY FUNDS AND THE INVERTED J CURVE

Posted on June 26, 2026June 26, 2026 by Chris in Briefings, Diligence, Family Office, OCIO Search

One of the main challenges institutional investors and OCIOs face today is ensuring longevity of favorable returns from their private equity and venture capital investment programs. Following 2021, both returns and distributions/returns of capital from those investments have fallen sharply. We have written about the return challenges in prior Briefings that are posted on our website www.manageranalysis.com. In the last year, distributions/returns of capital have started to increase which could be seen as favorable. However, we believe that over 1/3^rd of all distributions now come from events where the private equity manager [the GP] retains their control of the companies sold, using continuation vehicles or GP-led secondaries. Adjusting for these GP-led efforts, “true” exits may actually be continuing to decline.

This Briefing continues our exploration of key themes in private equity and venture capital allocations, where Secondaries funds offer an alternative way to invest in privates.

I. Private Equity Secondaries require a closer look

Many investors have now asked us to opine on various fund offerings by Private Equity Secondaries funds. These funds have become incredibly popular investments over the last few years with assets currently invested at $700 billion, “dry powder” of $300 billion in 2025 and fundraises of $120 billion in 2025 according to Pitchbook’s 2025 Global Private Markets Fundraising Report. For asset owners that are new to private equity, secondaries funds may also offer immediate diversification across managers, sectors, and vintages.

A typical pitch to asset owners is that the new fund has a premiere private equity secondaries manager running it with great access to attractive assets for sale. Most compelling, the new fund already has a very high IRR, and prospective investors historically appear to respond to that enticement by subscribing before the fund’s subscription period ends.

Marketing in Private Equity Secondaries frequently contains obfuscations that are important for investors to identify and understand, and we assist investors in that effort. In some cases, we find compelling opportunities, but in most situations, we advise against these investments. One of the most critical hurdles is that the private equity secondaries manager should add more value than their management and carry fees. We usually think of those fees cumulatively costing 8 to 10% of the value of a secondaries fund over their full life, which is a high hurdle to cross but one that good managers have been able to do.

Key facets we like or avoid are:

We believe that, to assess the investment opportunity of a private equity secondaries fund, it is important to understand the dynamics of the “Inverted J Curve.”

II. Explaining the “Inverted J Curve”

The J-Curve occurs in private equity investing, where the private equity manager acquires portfolio companies while typically incurring large upfront diligence and restructuring costs for the acquired companies. Initial returns may be low or even negative for the first few years, but usually rise sharply when the fund is fully invested and portfolio companies’ earnings improve under the private equity manager’s supervision.

Source: Hamilton Lane Knowledge Center

The “Inverted J Curve” for private equity secondaries reflects the awkward and problematic utilization of the “practical expedient” accounting method, which is the most common valuation practice used for private equity secondary funds. It simply accepts the value stated for each underlying fund investment, as provided by each of the fund’s many private equity managers. Thus, if a private equity secondary fund purchases a $10 million fund investment at a 30% discount for $7 million, the accounting practice is to recognize that $3 million discount as an immediate gain. Since most private equity secondaries are purchased at a discount to their stated value, the net result is that new private equity secondaries funds will demonstrate a very high initial IRR. That IRR will usually go down over time, as the private equity secondaries fund becomes fully invested and no longer realizes these instantaneous gains, and as reasons for the initial discount like application of secondaries fund fees and weak performance of holdings manifest themselves.

The real challenge is that the discounted prices often reflect actual weaknesses in the underlying holdings or their managers. Over time, the example of a 30% discount may cause future returns to be, for example, 6% lower than the average private equity fund over roughly 6 years. Adding to this future drag on returns is the second layer of fees that private equity secondaries managers charge investors. The net result can be a substantial under performance compared to other alternatives the investor could achieve elsewhere.

Relying solely on IRR calculations to understand private equity secondaries’ managers’ performance is fraught with hazards, the biggest of which is that funds that use the ”practical expedient” accounting approach. This approach implicitly assumes a full recovery of discounted values, while ignoring potential problems with underlying holdings that caused the discounted valuations in the first place.

Following are some anonymized examples we share from our research on behalf of clients. Of serious concern for investors is that some of the state returns we examined are substantially inflated: when we compared the IRRs investors received with the IRRs stated in the funds’ marketing materials, we found the actual IRRs can be 3% to 5% per annum lower. Treatment of leverage, timing of investment cash flows that do not align with capital call dates, and treatment of refunded capital calls all appear to favor IRR inflation in reported fund performance data without benefiting actual cash returns.

The following graph reflects anonymized, indicative performance, derived from of three private equity secondaries funds we initially examined five years ago:

Fund A performance is derived from a fund managed by one of the very largest private equity secondaries managers in the marketplace. Their use of the “practical expedient” practice is obvious in the first year of Fund A’s performance. Since the fund was then still open to new investors, the manager could seek to impress prospective investors with the very high initial return. After the strong first year return, the average annual return of Fund A was actually close to zero, with the ultimate 11% IRR through 2025 almost entirely reflecting the first-year gain.

Fund B performance is derived from a fund managed by a value-focused boutique manager. Their use of the “practical expedient” accounting is also obvious, but future returns are much better, and they outperformed Fund A by about 7% per annum. Fund B’s manager focuses on cherry-picking to acquire interests in stable, well-capitalized private businesses with strong fundamentals. Their approach is allowing them to miss the SAAS-apocalypse and they continue to perform well.

Fund C’s performance history differs in that Fund C avoids the enticement of the high initial IRR print. Fund C does not use the “practical expedient” accounting method and instead amortizes the discount over an expected life of the holding. They also take a more active role in valuing each holding to override reporting provided to them, if Fund C’s manager’s value is lower. Fund C’s manager is a very large private equity manager that seeks to understand all of the underlying portfolio companies. Before a secondary private equity portfolio is shown to them, they already have performed meaningful diligence on the majority of private companies in the portfolio, and know each of those companies’ management teams. Their approach causes them to pass on many opportunities shown to them, so they can focus on where they are seeing better opportunities. Fund C’s five-year returns are twice the returns of the “asset-gatherer” Fund A, reflecting Fund C’s manager’s prioritization of investment diligence over asset gathering, which is reflected both in their fair valuation approach and excellent investment returns.

III Conclusion

Understanding performance drivers and management philosophy in private equity secondaries markets is just as important as in other alternatives markets. Nonetheless, we continue to be surprised by the dominance of “asset-gatherer” managers in attracting investor assets into private equity secondaries funds, while using the very misleading “practical expedient” accounting practice. We expect many investors to be disappointed by their secondaries allocations, while diligent and skillful investors will achieve satisfactory results.

Should you wish to discuss assistance in due diligence of a secondaries strategy, review of an OCIO, or just want a second opinion, please call us at 917-287-9551 or email us at cutler@manageranalysis.com.

The analysis presented here is the sole opinion of Manager Analysis Services (MAS). Any investment decision should be made with reference to one’s own risk and return objectives and in counsel with one’s advisers.

COMMUNITY FOUNDATION IMPACT INVESTING IN AFFORDABLE HOUSING SECTOR POISED FOR CHANGE

Posted on March 31, 2026March 31, 2026 by Chris in Briefings, OCIO Search

We have seen opportunities for community foundations to improve the effectiveness of their efforts to improve low-income housing availability. The expanding availability of Low-Income Housing Tax Credits [LIHTC] has made low-income housing developments into attractive portfolio investments for taxable institutional investors. Private investments in LIHTC developments have been surging. This trend offers community foundations a transformational opportunity to act as catalysts to facilitate the availability of development properties, rather than as the primary equity investor.

Community foundations should not compete with private investors using LIHTC for several reasons. LIHTCs provide a powerful tax subsidy that is about 30%, or 70%, of the cost of a project to taxable investors, depending on the nature of the housing project. Additional tax-exemption benefits accrue to bond investors in LIHTC properties. Why forego powerful incentives offered to taxable equity investors and taxable bond investors, which tax-exempt community foundations could never realize on their own?

Instead, community foundations could facilitate the creation of zoning and available properties with local officials, accelerating the path for developers to create low-income housing. We could easily see such an approach creating 5x more effectiveness in a community foundation’s impact investing for low cost housing, when compared to making direct investments in properties.

It is also important to understand LIHTC market considerations, participants, and time lines.

Tax credits

Tax treatment is the central driver, both for LIHTC-driven investment strategies and for the broader affordable housing construction market. Any changes in tax treatment either for affordable housing bonds or for municipal bonds more generally could have a material adverse effect on this strategy.

Equity investors receive federal low-income housing tax credits (LIHTC). Also, interest on bonds issued in support of affordable housing construction or rehabilitation is mostly or entirely exempt from federal taxes. Equity investors receive valuable tax credits that they can apply to offset current income elsewhere in their portfolios. These tax credits can be worth more than the remaining equity value of the property being built, and they are the primary economic incentive for equity investors in the affordable housing marketplace.

2. Rent Roll Profile

Renters pay below-market rates to rent affordable housing apartments. Because of this, waitlists tend to be as large as 10x the number of units available. Thus, even if a sharp curtailment in rental assistance payments to some renters were to occur because of changes in fiscal policies, having occupancy rates below 95% is unlikely unless there are very unusual circumstances.

3. Equity investors

While demand from low-income renters is not likely to be in question, the actual cash flows from managing the low-income housing properties can be challenging. Often, these properties are barely breakeven after operating costs and interest expense, and in about 20% of cases they incur modest losses.

Instead of seeking operating profits on these properties, equity investors look to the LIHTCs created to reach their effective equity return targets. Investors with high current income, like banks and insurance companies, often have the highest direct tax benefits from acquiring LIHTCs and are thus the dominant participants in the affordable housing marketplace.

A corollary of the importance of LIHTCs to equity investors is that the market value of low-income properties without these credits is far below the properties’ replacement values. For instance, a new $50 million property that is 50% financed each by equity and debt, may only have a market value of less than $40 million. Even so, the equity owners of these properties could lose their LIHTCs retroactively if adverse events like defaults or severe property degradation occur. This rule incentivizes the equity owners to cover deficits and otherwise to maintain the properties until their LIHTCs expire, usually in 15 years. The equity holders’ backstopping of the performance of low-income housing projects serves to reinforce the creditworthiness of projects to bondholders. Moreover, the cumulative default rates of LIHTC-linked bonds is very low, typically under 1% over the expected life of the bonds, and with high recovery levels.

About $30 billion in new equity investments were made into affordable housing projects in 2025, doubling from $15 billion in 2017. Since the debt/equity ratio of these projects tends to be close to 1:1, it is likely that the annual supply of LIHTC-linked mortgage debt is over $30 billion and growing.

4. Debt investors

Tax treatment is a primary driver for investors purchasing debt issued for low-income housing developments. Interest on these bonds is mostly to entirely treated as exempt from federal income tax.

Spreads on LIHTC-linked bonds can be as high as 3% over comparable municipal bond rates when they are issued. These spreads exist because bondholders incur material risks at the start of the housing construction [or rehabilitation] project, both from construction risks and risks of delays leasing up the apartment properties.

Having a strong partner to manage these risks is an important part of any development, these developments, and they should understand permitting, contracting, construction, leasing, and property management. Skilled development partners effectively convert economic exposures into a manageable operational risk cycle for each new multifamily development. Consequently, the actual risk of LIHTC bonds tends to be less than what would be implied by the observed credit spread, creating opportunity for taxable investors.

Summary

We urge community foundations to redirect as much of their low-income housing investing activities toward cooperation with taxable equity investors and their developers. Momentum from the very large capital base of large, taxable investors can greatly magnify the effectiveness of community foundations’ talents, while allowing community foundations to preserve their resources for their many other worthy causes.

Chris Cutler CFA

Manager Analysis Services, LLC

cutler@manageranalysis.com

917-287-9551

Strait of Hormuz Closed for a Month or a Year? The Case for Hedging

Posted on March 15, 2026March 15, 2026 by Chris in Briefings

While many of you know me as founder of the renowned alternatives diligence and OCIO search firm MAS, my very first job was serving as a country analyst for the Federal Reserve Bank of New York. I have covered economic, policy, and geopolitical risk considerations for countries, and unfortunately my experience in these fields of study is also relevant today.

As an analyst of OCIO performance, I understand that most OCIOs avoid hedging strategies, instead relying on their diligent asset allocation models to build robust portfolios that will carry their long-term performance through market cycles. However, I would also recognize that any modest loss of alpha from hedging in a geopolitical crisis could actually reflect a disciplined approach to managing risk in crisis situations and, should the crisis worsen, the OCIO’s clients would at least be partially protected. The current crisis reflects one such scenario.

The Pessimist’s Case

First, I must say that I applaud the professionalism of our soldiers in dismantling Iran’s military infrastructure. It appears a critical oversight is how the emergence of low-cost drones magnifies the hazards of asymmetric warfare to other countries in the region. What I find most shocking is the extensive lack of preparation to protect these facilities from drone warfare. Sending $1 million missiles to intercept $25,000 drones is unsustainable. Ignoring the help offered eight months ago by the world’s experts in anti-drone warfare—the Ukrainians—is astounding. Moreover, there does not appear to be a strategy to neutralize the ability to attack shipping or respond in a timely manner when it happens, and energy assets are exceptionally vulnerable when attacked. The U.S. Navy may lack the ships to break the blockade, and I understand no U.S. Navy ships are in the Strait of Hormuz at this time. The 550-ship navy of 1990 has whittled down to about 280 today, most of which are committed to protecting aircraft carriers and allies. A big reason for the decline in ship numbers is the tendency of the U.S. Navy to sabotage its own shipbuilding programs with impractical designs and excessive change orders—that’s an entirely different topic of frustration.

I do not think the markets appreciate the extent of damage that has already occurred to critical shipping facilities that support energy and other commodity exports through the Strait of Hormuz, and the Iranian drones continue to attack. More than one-fifth of global oil production ships through the Strait of Hormuz. About a quarter of that can be diverted into a pipeline to the Red Sea, provided that the Iranian drones do not also compromise that facility.

It is difficult for Westerners to comprehend the stubbornness of theocratic and ideological governments. We can hope for a revolution in Iran but it looks like that may require a civil war. Chinese and Russian intelligence will notify Iran every time an aircraft takes off from a carrier or airport. I also see risk that Russia clandestinely supplies Iran both with Russian-made Shahed drones, with Iran claiming they are domestically made, and with antiaircraft equipment. Any ship transversing the Caspian Sea between Russia and Iran should be viewed with great suspicion. Drones will continue to harass shipping until each vessel has a properly-equipped Ukrainian-trained anti-drone crew aboard, and the U.S. Navy finds the resources to make a determined presence in the Persian Gulf.

Possible Exits

To be sure, good things can happen. Iran may agree to stop attacking neighbors. A sudden coup or successful revolution could occur, ending hostilities with the U.S. and neighbors. Iran and the U.S. might reach some sort of a ceasefire. The U.S. Navy may muster enough forces to defend shipping adequately.

Conversely, more bad things can happen. A surprise “operation spiderweb” with drones attacking a U.S. coastal city from a merchant ship is a possibility, according to the recent FBI warning for Los Angeles. Revenge is a powerful motivator, and after massive damage to Iran, expect the Iranian military to cherish launching every Shahid drone they can possibly smuggle in from Russia at their neighbors.

We are hopeful that the scenario we describe does not play out. However, scenario management is what hedges are for. One example of a partial hedge is to look at a 95%/85% put spread on the S&P 500 for six months costs 1.8%. We would be happy to see an OCIO explaining how they lost 1.8% in alpha to help protect against a 10% loss in this adverse scenario, and we think the next six months will determine the path of the war. More complex hedges covering direct and proxy/correlation hedges could offer smarter approaches toward managing global risks.

While the U.S. is an energy net-exporter, high oil prices will impact already-stretched U.S. consumers. Fertilizer prices will also rise globally, since Urea is also a major Persian Gulf export. Some sector effects likely include:

Airlines could suffer acutely and the travel industry will suffer.
Domestic shipping costs will rise sharply;
Auto manufacturing will suffer;
Energy services and energy will benefit further;
The inflation prints will be discouraging;
While technology will be relatively insulated, technology companies linked to U.S. consumers could be impacted.

It’s also important to consider that the United States is economically insulated relative to other countries. India, China, Japan, and South Korea, the biggest engines of Asia, are very dependent upon Mideast commerce. See for example the sharp declines of Indian and South Korean currencies already, down about 3% over the last month. The Global South is in far worse shape. There will be enormous domestic pressure on governments across the globe to get this war to stop. Only political malfeasance would see this conflict last a year, which is exactly the scenario that concerns us the most.

Conclusion

Long term investors typically hold consistent asset allocation policies and are unlikely to engage in hedging directly. For the most part, we support that approach. We do think however that downside risks are highly elevated right now. Buying a put spread could provide partial protection against theocratic-ideological inflexibility, while still allowing investors to capture most of the upside gains the markets would experience if a peace breakthrough occurs.

Important note: While we outline this scenario and identify a possible hedging strategy, we intend to provide education, not investment advice or recommendations, from our Briefings. Every investor should act only with the review and advice from their retained investment advisers and investment consultants.

Chris Cutler CFA

March 14, 2026

Are OCIOs Ready For AI-Driven Volatility?

Posted on January 23, 2026January 23, 2026 by Chris in Briefings, Family Office, OCIO Search, Uncategorized

Epic changes to equity market structure have occurred over the last five years that challenge key tenets followed by OCIOs. The ascension of the Magnificent Seven to market supremacy has been a major theme where OCIOs have struggled, along with other sophisticated asset allocators. Collectively the Magnificent Seven rose 111% from December 31, 2023 to December 31, 2025, compared to 48% for the S&P 500, yet OCIOs were substantially underweight the Magnificent Seven. We will discuss the reasons they missed it.

The rise of AI-related businesses presents the next epic change, and the emergence of hierarchies within AI-related industries should be a key focus. OCIOs and institutional investors seem to be missing this important nuance as well, treating AI-related businesses very differently based on their asset class [public equity, private equity, venture, or real estate] without having a strategy of how to discern how these investment opportunities relate to the broader AI theme.

I. How did OCIOs miss the Magnificent Seven opportunity in 2023 and 2024?

1. The Quest to Avoid Concentrated Single-Stock Exposures and an Implicit Value Bias Blinded OCIOs to the Opportunities

Many OCIOs adhere to an asset allocator’s perspective when viewing stock concentrations, and they surrender any role in actually analyzing individual stocks to the equity managers they select. Those equity managers usually wish to prove their excellence with a diversity of ideas, not by concentrating in mega cap stocks that are widely held. Moreover, a very superficial view of Magnificent Seven P/E valuations implied that they were overvalued, which reinforced the conviction of many equity managers to underweight the Magnificent Seven.

By contrast, our February 2024 briefing “You May be in VC but not know it: OCIOs versus “The Magnificent Seven”” showed that the Magnificent Seven were actually undervalued. They have since outperformed the S&P 500 cumulatively by 63% for 2024 and 2025. They now represent an astounding 39% of the S&P 500, but their growth premiums have also risen, as depicted in the charts below:

Sources: data derived from publicly available sources, including financial statements of issuers and finance.yahoo.com

2. Did OCIOs Surrender Responsibilities as Financial Analysts?

We believe that, if there are less than 10 mega cap stocks driving much of the market, conducting some of your own financial statement analyses of these stocks themselves can yield helpful insights in your asset allocation strategy. That’s why we took a contrarian position in our February 2024 review of the Magnificent Seven stocks. Our review found that Magnificent Seven balance sheets were conservatively valued, and earnings materially understated. A big portion of the cost–R&D employee expenses–for developing their main asset–intellectual property–is expensed rather than capitalized. Thus earnings were materially “understated” because GAAP categorizes such investments as expenses, and assets did not reflect the full value committed to product development over time.

These big stock returns were not anomalies. The Seven generate substantial cash flow and profits with substantial growth, and they represent a meaningful part of the U.S. economy. Viewing them as n=7 out of 500 in a diversification framework was a risk manager-driven error.

II. Looking Forward – The Changing Market Narrative and AI-Led Volatility

Massive investments in AI technology and infrastructure are rapidly reshaping investment markets. We no longer hold a view on whether the valuation of the Magnificent Seven is rich or cheap. Instead, the AI activities of the Hyperscalers [Amazon, Microsoft, Alphabet, and Meta] have become the key market narrative. These companies have historically been heavy investors in research and development. Those R&D budgets are now much higher, and together with heavy investments into physical plant for cloud computing sites, total Hyperscaler investments now substantially exceed earnings in many cases.

Why are Hyperscalers investing so heavily in AI? Current AI-related earnings do not appear to justify the investments. If the rapid growth assumptions presented by OpenAI and others come true, the total rate of return on a $1 trillion + investment might make sense, but much can also go awry.

Consider the following perspective: “spending too much on AI is a profitability risk while spending too little on AI is an existential risk.” Falling behind your competitors could lead to being surpassed in a transformational stage of the cloud computing marketplace, thus jeopardizing your immensely valuable cloud computing business. At the same time, it’s hard to imagine a better formula to create an environment for massive overinvestment. In 2025, the Magnificent Seven’s R&D was 35% of their net income, and property, plant and equipment investments represented an astonishing 62% of net income. We’ll return to that topic soon.

III. The Emerging Hierarchy in the AI Industry

I’ll quote the insightful commentary of one of those rare trust portfolio managers that outperforms the S&P 500 by a few percentage points per year, and who prefers to remain anonymous:

“As the hyperscalers (e.g., Amazon, Microsoft, Google) accelerate datacenter growth to support the offerings of first tier AI developers (i.e., OpenAI, Anthropic, Alphabet, Meta) and lesser entrants (e.g., DeepSeek, Mistral, xAI), and as they and others infuse their products with generative AI, they have spurred GDP growth in an otherwise lackluster economy, with consequential impact on a growing set of industries. For example, Caterpillar, typically known for its bulldozers and backhoes (useful for construction) also makes big generators required for datacenter backup power during electrical blackouts. As these companies see increased demand from datacenter builds, it increases costs and reduces availability for other industries including any attempting to reshore to the USA.

More importantly, there is an expanding list of late-to-market and/or unsophisticated money starting “neocloud” companies including CoreWeave, Nebius, and Fermi, which seek to create datacenters campuses to lease to the hyperscalers, finance companies such as Blue Owl Capital providing funding for such endeavors, and then there is Oracle, a once first tier and now second tier tech company which was late to cloud and now late to AI. These late entrants have higher costs and lower margins than the owned capacity of the hyperscalers, and with the exception of Oracle have no end customers and no intellectual property. When there is eventually some correction or reckoning, it will be felt here first and very painfully, so we’re staying well clear. The hyperscalers have end customers, intellectual property, and the revenue to fund their datacenter builds, so while there is risk to profitability, there is as yet no risk to survival of these companies.”

IV. Hyperscalers and AI Developers: Considerations for OCIOs Positioning Portfolios

We see here a hierarchy of AI-related businesses that OCIOs could use to position their investments in the AI ecosystem. We believe the Hyperscalers are the best tier, closest to the ultimate clients and having the most robust business models. They outsource the largest risks and potentially a substantial amount of upside returns to the first tier AI developers that the Hyperscalers partially own. Some of the AI developers [particularly Open AI] are also spending massively on data centers in addition to AI R&D. They have also sourced investor capital from sovereign wealth funds and other large institutions, providing leverage to expand their buildout rapidly. Their success would drive business to the hyperscalers, fortifying the early-investor advantage that Hyperscalers had by investing early in the AI enterprises while providing strong investment returns.[4] Second tier Hyperscalers like Oracle and, much further down the food chain CoreWeave and others, have very high elasticity to the success of the AI business model but would also be most likely to fail in an AI downturn. Venture firms building AI applications for clients also have substantial upside, but they may also find themselves competing with the technology development arms of the Hyperscalers.

We see much value creation coming from building AI applications but we struggle to justify valuations of $50 billion and up for de novo ventures.

Real Estate Data Centers

Farthest away from the true end-customers are the data center-focused real estate investors. We view data centers as having the worst return for risk in the AI industry vertical. We understand that the real estate fund sponsors negotiate long term contracts with the Hyperscalers and others for capacity use, but we suspect that in a downturn the Hyperscalers will find ways to use their own PP&E first, rather than pay real estate investors for use of unneeded capacity. Institutional real estate investors have a strong tendency to overinvest wherever they see opportunities, damaging their track records. We see no reason why datacenter-focused real estate investments will be any smarter this time. If a conservative real estate investor thinks they can achieve better returns allocating to datacenter-focused investments, we would suggest that they instead consider investing directly in the liquid stocks of the Hyperscalers.

2. Venture Capital

Where do venture capital firms stand in this hierarchy? First we note Pitchbook’s 2025 Q4 statistic that 71% of new venture commitments were made into AI-focused ventures. That statistic indicates that diversification benefits from venture investing could also be lower than investors might hope for. Another finding from our Magnificent Seven review was that the Magnificent Seven are the most prominent venture investors, and their R&D budgets overwhelm the size and scope of all venture firms put together. They are also far better venture capital investors than most of the VC industry, because they have better and more comprehensive tech know-how and they are closer to actual customers. Thus, an investor interested in venture should consider the mega cap Magnificent Seven as a liquid substitute for illiquid venture investing.

Venture Capital’s average performance is also not attractive, but if you are a top quartile investor in venture capital, your returns are far better than this:

V) How Investing in AI Could Rapidly Go Horribly Wrong

Management of some Hyperscalers and AI ventures tout rapid growth projections for AI revenues. Alongside revenue growth comes volume growth. As measured by wattage use, “Global electricity generation to supply data centers is projected to grow from 460 TWh in 2024 to over 1 000 TWh in 2030 and 1 300 TWh in 2035 in the Base Case” according to the April 2025 “Energy and AI” report by the International Energy Agency [IEA]. Other reports project even higher growth in energy use.

Such volume growth is a strong justification for high valuations, assuming prices and margins are reliable. But are they reliable?

Financial analysts, not always known for their technological insights, are sometimes unaware of important shifts in the technology landscape. Consider the 2025 AI Index Report by Stanford Institute for Human-Centered AI. This report shows a rapid rate of efficiency improvements, as AI models become better trained and focused on relevant data.

“Driven by increasingly capable small models, the inference cost for a system performing at the level of GPT-3.5 dropped over 280-fold between November 2022 and October 2024. At the hardware level, costs have declined by 30% annually, while energy efficiency has improved by 40% each year. Open-weight models are also closing the gap with closed models, reducing the performance difference from 8% to just 1.7% on some benchmarks in a single year. Together, these trends are rapidly lowering the barriers to advanced AI.”

The following table from the EIA report shows the additional benefits of targeting AI models on narrower, more pertinent data:

We have seen elsewhere that improvements in AI programming could reduce computational costs by 90 to 99%, so the Stanford report is consistent with that experience.

Let’s consider the scenario where usage rises not just fourfold as implied by IEA, but tenfold, driven by greater client use and launches of increasingly complex top-end AI models.[3] In this same scenario, the amount of wattage actually needed falls by 90% for that volume of usage, driven by use of more-targeted programming and data sets. The result is 10x increase in calculations * 1/10^th the cost, or no incremental volume to the Hyperscalers. That scenario would be a disaster for the real estate investors into datacenter REITs, whose properties we would argue would be first to be idled. But the biggest impact of this scenario is that cloud computing prices and margins would decline sharply over time.

Tremendous uncertainty about volumes, capacity constraints, and costs pervade the AI discussion but one consideration that is not uncertain is that the laws of Economics will

eventually manifest themselves. If investors are seeing a nearly infinite market with strong margins, and hyperscalers think that “spending too much on AI is a profitability risk while spending too little on AI is an existential risk,” we can be sure that investments will continue until these investors feel the damage of a sharp correction.

VI. Has This Happened Before?

AI’s eventual sharp correction would not be a first. Another industry also faced an era of rapid technological development, an apparent infinite demand, and strong investment flows. That industry was the shale gas industry. Consider its productivity improvements alongside the inflation-adjusted price movement of U.S. Natural Gas.

Source: EIA report from Oct 17, 2014 Sources: EIA for price and U.S. BLS for CPI-U

New shale gas rapidly drove down prices from the mid-2000s to the mid-2010s. For shale gas producers, the major hit occurred in 2015, when prices appeared to be falling below production costs and ultimately fell by more than half. Widespread industry distress occurred, and once-leading fracking firms like Chesapeake Energy eventually folded. Only a tepid recovery occurred, and natural gas prices never recovered consistently to the levels of the early 2010s.

Conclusion – How Should OCIOs Think About the AI Market Shift?

Cloud computing and AI are not the same as shale gas. Hyperscalers and AI developers will create moats using intellectual property[1][2], long term contracts, and bespoke applications for individual clients that will help protect against commoditization. Nonetheless, the point will come when overbuilding will create excess capacity. When that happens, investors should be prepared for a sharp pullback. Hyperscalers are best positioned for that scenario. AI developers will be better positioned by developing bespoke solutions for clients. The least protected will be the commoditized real estate developers of data centers.

We hold a positive outlook for Hyperscalers and we see a market-weight allocation as sensible. We do not think we are smarter than the market. Nor do we think this is a time to pull back from market exposure.

We do think OCIOs should be thinking carefully about the AI industry stack. That suggests that OCIO real estate teams should avoid data center REITs, OCIOs’ underlying managers should treat second-tier Hyperscalers as highly speculative, and that venture investing to chase AI opportunities as a theme should be avoided. Instead, OCIOs should focus on venture managers only if the OCIO has strong track records and long-term relationships with the venture managers, or otherwise avoid most venture investing.

We would be pleased to discuss our analysis further.

Chris Cutler CFA

cutler@manageranalysis.com

917-287-9551

[1] OpenAI, Anthropic, and the others are all doing basically the same thing. There are different choices made technically, in terms of training data, and market focus but at present there’s no indication that any one has an insurmountable lead.

[2] Also, historically in tech the companies have many patents but don’t sue each other. The patents are nearly always for defensive purposes. You stay ahead by investing more and wiser in R&D than your competitors.

[4] Did hyperscalers invest in AI ventures because they wanted returns on their investments, or to drive more traffic to their data centers? For the latest on Musk vs. Open AI et al see https://www.geekwire.com/2026/the-microsoft-openai-files-internal-documents-reveal-the-realities-of-ais-defining-alliance/

OCIOs Reassess Private Equity Portfolios amid Slump

Posted on August 25, 2025August 25, 2025 by Chris in News Excerpts

The following is Chris Cutler’s quotation in the June 20th article writtein by Sabiq Shahidullah of FundFire:

“The industry’s thinking is that whenever periods of poor performance occur, there will be a pretty quick and persuasive rebound,” said Chris Cutler, president of OCIO search firm Manager Analysis Services.

However, the current private markets downturn, which began in 2022, has not yet abated, and fundamental changes to the private equity space may make future return assumptions less reliable, Cutler said.

Private Credit Strategies Call For Deeper Diligence on Asset Holdings

Posted on August 25, 2025August 25, 2025 by Chris in Briefings, Uncategorized

On Tuesday July 22nd, I spoke at Opal Group’s Public Funds Summit 2025 on “Private Credit,
Debt, and Direct Lending: A Developed Asset Class For Pension Funds” alongside Reid
Bernstein [Amerin Partners], Mike Fang [Maryland State Retirement and Pension System],
and Molly Whitehouse [Newmarket Capital], moderated by Lindsay Powers [NEPC]. A big
thank you to Opal Group for bringing this very talented panel of private credit experts
together, to speak to the many public pension plan officials attending this Summit.

Assessing credit strategies has always been one of my favorite professional endeavors, and
the variety of private credit strategies now available offers institutional investors many ways
to seek attractive returns. Like many of my peers, I have found some compelling private
credit strategies that I think are relatively insulated from most economic downturns. We
have analyzed many of these strategies for our clients, and they have helped my diligence
clients achieve excellent results.

Knowing what to look for is important for analyzing any alternative investment strategy, and
particularly so for private credit strategies. The laws of economics did not evaporate when
investors started making allocations to private credit: Investors would be misleading
themselves to target returns of 10% to 20% net-of-fees, expenses, and borrowing costs,
while overlooking vexing operational risks, illiquidity premia, credit and leverage exposures,
and structural considerations. Apparently smooth return streams in private credit also belie
its nascent volatility: Publicly traded BDC analogs of private credit strategies [like one of
my favorites, GBDC] often exhibit annualized volatility as high as equity market volatility,
albeit with much more mean reversion. Record-low spreads on high yield bonds are
encouraging institutional investors to allocate more into private credit, helping to compress
returns, so the return outlook presented by managers to investors today may not be what
they can achieve in the future, even if credit performance is strong.

One of the gravest oversights I have seen is investors not fully appreciating that many of the
protections present with other strategies are simply ineffective for private credit strategies.
I will highlight one key consideration: we cannot rely on auditors to assess valuations of
private credit holdings reliably, much less validate that the assets even exist. In many cases,
no clear comparables exist to help value debt of private borrowers, and auditors often rely
disproportionately on the honesty of the private credit manager to mark their holdings
appropriately. While auditors should take an additional step of assessing the
creditworthiness of a private credit fund’s underlying borrowers, this onerous step is often
missed or glossed over. The example of the $2 billion failure of Bridging Finance is
impressive not just for the brazen misuse of investor capital causing losses of about 65%,
but also for the apparent oversight of KPMG and E&Y as auditors to uncover this major
fraud over many years:
https://canadianbusiness.com/ideas/what-happened-to-bridging-finance-david-natashasharpe/.

We always encourage investment consultants and OCIOs to take a deep dive in private credit
fund diligence, and to allocate proportionately more resources to review these managers’
individual investments. Private credit managers should offer, subject to a reasonable NDA,
full access to review their investment memoranda, and means to validate the existence and
performance of their funds’ assets from original, independent sources—including by
conducting verification calls with some borrowers directly. Relying on audit reports is not
su􀆯icient, but using a sensible sampling approach to help validate asset valuations and
existence could be sufficient. If you encounter resistance, then I would advise you not to
pursue an investment with that manager. I’ve had many very successful diligence reviews of
very talented private credit managers, and I’ve also had a small number of opaque private
credit managers terminate my reviews of them because I insisted on reviewing sufficient
information, for which I am very proud.

When we evaluate investment consultants and OCIOs, we are particularly focused on
whether these advisers have committed sufficient talent and resources to evaluate the
private credit strategies they recommend to their clients. If your analysts recommend SRT
[structured risk transfer] strategies, we expect that they’ll have a firm understanding of
correlation trading models and that they at least review the SRT reference credit portfolios,
steps we often have seen investors skip. If you invest in trade credits, bridge loans, or
litigation financing, we want to know that you understand enough about those businesses to
ensure that the loan terms make sense for them, as well as validating the existence of these
assets.

While we are very pleased with the development of private credit markets, we do raise
concerns about the rapid growth in private credit allocations. Mistakes in making private
credit investments can be very unforgiving: a portfolio of ten private credit managers
earning 10% net of fees could easily see several years of alpha vaporized by one
meaningful blowout. We would like to see institutional investors take steps to avoid
unpleasant surprises. We would also like investors to develop more rigorous opinions of the
performance of the underlying borrowers and industries selected by their managers. U.S.
middle market companies have yet to recover to their pre-COVID performance. Higher
interest rates, slower private equity exits, weaker earnings and sales growth outside of the
technology sector are harbingers of future performance challenges for private equity
investments.

What do we like? We have helped our clients to source and invest in several interesting
private credit strategies. Right now, we see a few excellent private credit managers lending
to sponsor-backed companies focused on “growth equity” companies, mostly in technology.
We expect that they will earn 10% to 15% per year, with one turn of leverage, provided that
they continue to uphold their underwriting standards. We are concerned about
compromising of credit underwriting standards at the very large “asset gatherers” in
private credit; we avoid them. Conversely, we are interested in seeing upcoming private
credit fund launches by very large insurance companies, which have decades of experience
in this market.

We also like some private credit strategies focused on securitization markets in residential
and commercial real estate markets, but we strongly advise that any investors have
resources to understand securitization markets before approaching this sector. We see
returns there ranging from 10% net with very little leverage, to 15% tax-free for one very
unusual but highly leveraged strategy. On the more conservative end of the markets, we
have seen AA-equivalent consumer securitization strategy that earns well over 2% above
SOFR.

Sophisticated investors have been embracing private credit markets for many reasons. We
encourage all participants to maintain exceptional standards of diligence when examining
private credit strategies. Doing so will help ensure that your institution is getting what they
think they are getting, while also reinforcing good conduct in this important market.

Chris Cutler CFA
President
Manager Analysis Services, LLC
cutler@manageranalysis.com
August 4, 2025

The Future of Private Wealth Management

Posted on June 20, 2025June 20, 2025 by Chris in Uncategorized

On Wednesday I spoke on the CFA Institute’s panel “The Future of Private Wealth Management,” which is part of the CFA Institute’s “Navigating Wealth & Private Markets” series. At Manager Analysis we have been helping wealthy families navigate offerings of private banks, wealth advisers, and Outsourced Chief Investment Officer firms, all of which are now competing against each other in the HNW markets. We are also seeing sophisticated family offices becoming more discriminating in assessing the quality of investment ideas that their advisers bring.

Helena Eaton, CFA from Bedrock Advisers, Peter Went CFA of the CFA Institute, and I spoke on this panel about the rapidly evolving landscape of private wealth management globally. The rise of new sources of wealth from crypto and venture create new dynamics between these new clients and their private wealth managers, who should exercise adaptability and recognize that this “new money” may have entrepreneurial desires that deviate from more traditional portfolio construction. AI tools will materially improve wealth advisers’ internal processes and better prepare advisers for client meetings. Increasing availability of asset allocation and quantitative models, and alternative investment platforms, to smaller wealth advisers narrows the gap in investment capabilities between smaller and larger firms. Challenging private equity market conditions help private wealth managers distinguish themselves for their diligence and skill in selecting investments.

Despite these many changes, the private wealth adviser’s primary goal is unchanged: developing long-term relationships with clients. Having a comprehensive understanding of their goals and desires, and then aligning the client’s portfolio with those goals and desires remains the central role for successful private wealth managers.

Navigating wealth & private markets series — The future of private wealth management

cfainstitute.org

Why Have Private Equity Markets Struggled? Is Your OCIO Adapting to Private Equity Market Changes?

Posted on June 3, 2025June 3, 2025 by Chris in Briefings

Our position as both an OCIO search consulting firm and an alternative investments due diligence provider at Manager Analysis offers an interesting vantage point: while we see how OCIOs allocate into alternative investments, we also see a decent sampling of the quality of alternative investment opportunities that the OCIOs are assessing. We observe that, while compelling opportunities continue to present themselves, average return prospects have also greatly diminished, evidenced by greatly reduced IRRs and very slow distribution rates now persisting for the last three years.

Nonetheless, many OCIOs hope for a recovery in PE performance and liquidity. They continue to advocate for building out PE portfolios, diversified by class year and strategy grouping. We have not yet seen OCIOs accept a prospect for diminished privates returns. Rather they observe that PE markets have recovered very quickly from past down-cycles in subsequent years, so they believe it is critical to sustain the pace of allocations during times of weak performance.

Have return prospects actually changed for private markets? Should OCIO behavior be a concern for OCIO clients? What would we want OCIOs to do in the current PE market?

After Adjusting For Sector Selection, Has Private Equity Really Outperformed?

The existence of widely dispersed investment returns among private equity and venture managers makes these markets a compelling choice for any allocator that believes they have skill in manager selection. We meet few allocators who don’t believe they have such a skill, but nonetheless even without exceptional manager selection skills, hitting the average was still a success over the long term. Allocators for private equity have typically sought excess returns of 3% to 5% over comparable public market returns, and private equity’s long-term returns have, until at least 2022, supported that premise.

But is that outperformance a reflection of private equity managers making skillful selections of enterprises for investments, or something else? For instance, PE managers have had a strong bias toward information technology-related businesses over other sectors. The Russell Technology Index earned an average of 19.7% over the last 10 years to May 30, 2025; compared to 11.0% for the S&P 500 and 5.1% for the Russell 2000. When we consider that the typical private equity fund has a 36.6% allocation to information technology [IT], compared to 14.0% for the Russell 2000 [figures are from Cambridge Associates https://www.cambridgeassociates.com/insight/us-pe-vc-benchmark-commentary-first-half-2024/], the typical PE Fund should outperform public markets. For example, using public market equivalents [PMEs], the higher return from the higher IT weighting creates an alpha versus the Russell 2000 of 5.8%. The IT sector weight in the S&P 500 is about 27.5%; the extra tech weight there adds only about 0.9% alpha versus this large and megacap index over those 10 years.

Looking at performance through June 30, 2024[1] we see that Cambridge’s PE index outperformed the Russell 2000 by 8% and the S&P 500 by 2% over 10 years through June 30, 2024.[2] In fact, our sector-adjusted PME estimates for PE explain much of the actual performance: about half of the outperformance versus the poorly-performing Russell 2000, and 1 percentage point of the 2% outperformance versus the S&P 500.

[1] Performance may appear stale but this data was released in March 2025 and does not overly rely on interim estimates.

[2] Our PME adjusted alphas for the 10 years through June 30, 2024 are close to those through May 30, 2025: 3.65% versus the Russell 2000 and 0.87% versus the S&P 500.

Have Private Markets Fundamentally Changed?

From our diligence work, we observe that investing in Private Equity markets has become more difficult. For private equity, we see the following challenges:

Middle Market Company Underperformance Also Impacts Private Equity Investing

PE performance has been set back because the earnings of America’s middle-market companies have vastly underperformed the experience of America’s publicly traded companies. In a study prepared jointly between Marblegate Asset Management, a distressed private debt investor, and RapidRatings, a credit assessment firm, the authors found severe financial deterioration among middle-market companies with sales between $100 million and $750 million per year—prime hunting grounds for private equity managers. Their 2024 update paper is “Dragged Out to Sea: The Ongoing Stress and Distress in the U.S. Middle Market – an Update to 2023’s “Riptide: The New Era of Acute Financial and Operating Stress in the U.S. Middle Market”” [see FundFire article https://www.fundfire.com/c/4852394/660564/middle_market_train_wreck_marblegate_warns?referrer_module=sideBarHeadlines&module_order=0], and they expect to release an update showing similar results shortly. The authors incorporate full year 2023 financials from RapidRatings data for over 1200 private non-financial middle market companies and a cohort of public companies from the Russell 3000, to show the ongoing deterioration in the financial performance of the middle market companies as predicted in their original paper. A few tables from their paper highlighting this deterioration are quite revealing:

The study shows a surprising amount of distress among middle market companies. Net Profit After Taxes [NPAT] fell almost 80% from 2019 to 2022, and showed net losses in 2023. EBITDA fell almost 40% over four years to 2023 while borrowing increased 45% and leverage 1.4x. Servicing debt alone is very difficult, with interest coverage falling 73%. Marblegate concludes that “This dramatic decline for middle-market companies likely reflects a combination of higher input costs, increased debt service expense and limited pricing power.”

Unsurprisingly, the struggles of middle market companies seem to be reflected in public market equivalents. It is helpful to observe graphically the performance over the last 10 years, with the S&P 500 [middle line] having vastly outperformed the smallcap Russell 2000 [bottom line], and IT stocks [top line] achieving the highest returns:

Given the more recent challenges of the middle market, should we care more about shorter-term performance than longer-term performance as an indication of PE market’s return profile? Looking again at Cambridge’s PE performance table, PE has vastly underperformed the S&P 500 from June 2021 to June 2024 [6.9% vs 10.9%], while outperforming the abysmal performance of smallcaps [6.9% vs -1.4%]. So from this viewpoint, PE does appear to be adding value versus smallcaps, likely reflecting a mix of skill in avoiding the more problematic middle market companies, selecting and managing sound businesses, and a bias toward investing in IT businesses.

The net result is that PE returns reflect the successes and struggles of the broader middle market, with a bias toward IT businesses. PE might be characterized as a competing allocation for small and microcap stocks, with similar return and diversification benefits. The approach of using PE to build an asset allocation model with a small/microcap framework might be more suitable than assuming PE returns of “market plus 3%” with unbelievably low volatility.

This public-markets equivalent viewpoint on PE modeling mirrors my previous look at venture capital markets, albeit from the other end of the market capitalization spectrum. See “Venture Capital Versus the Magnificent Seven” which we published in January 2024. In this paper we assert that the large R&D budgets of megacap firms, which are collectively larger than capital deployed annually in venture capital, means that investors in these firms are already meaningfully allocated to the more successful part of venture investment activities. Conversely, the Cambridge venture capital return data does not show, on average, compelling venture performance versus public market equivalents. Nonethless, truly exceptional investors in venture capital can still experience truly exceptional results.

Ramifications of Lower PE Returns on PE Investment Strategies

At Manager Analysis Services we believe that investors’ frustrations with their recent PE returns reflect the dynamics of companies in America’s corporate middle market. We are seeing PE managers respond to the environment by trying to protect their businesses’ earnings potential. With PE funds’ underlying portfolio companies performing far below expectations, we believe that PE managers are holding investments in these companies longer, hoping for a recovery so they can meet their hurdle rates and potentially earn some carry.

The consequence of this “hold for longer” dynamic is that exit rates for PE funds have slowed dramatically over the last three years, leaving markets to find alternative sources of liquidity. The rise of secondary funds reflects market demand for liquidity. PE managers themselves are also embracing new investment structures that allow their funds to hold investments for longer, and in some cases, reset their carry terms through continuation vehicles and other structures. Purchases of captive investors like insurance companies, creation of interval funds, and efforts to access retail sales channels represent a combination of aggressive distribution strategies and a repositioning for future illiquidity.

These strategies indicate a likelihood that investors must be extra vigilant that the PE managers for their future investments have both the will and the capability to execute a PE strategy that is consistent with the investors’ expectations for timing of return of capital. They also indicate a stress upon the reliability of the historical experience, that buyout and growth PE funds would typically be able to return capital on average every 4 to 7 years. We believe that investors in PE today should be prepared for the prospect of much longer effective commitment horizons for new PE investments.

Is Your OCIO Smarter than the Ivy League Endowments?

While the endowment and foundation world has historically looked to the Ivy League endowments for ideas and inspiration, their more recent performance has reflected the challenges we discuss in this Briefing. Illiquidity is a huge problem. The following chart shows the extent to which Ivy League endowments have overextended their commitments to private markets, with unfunded commitments consuming on average 45.6% of their liquid assets, according to a study by Markov Processes:

https://www.markovprocesses.com/blog/a-private-equity-liquidity-squeeze

The combination of any future recession alongside material cuts in government grants for these schools could create major challenges for these institutions.

https://www.markovprocesses.com/blog/elite-u-s-endowments-government-funding-and-liquidity-pressure

While these very respected endowments remain committed to keeping large PE allocations, some are clearly responding to being overextended. Both Harvard and Yale have announced curtailments or sales for portions of their private holdings. They will likely be disappointed with the secondary market values for their holdings.

What We Are Thinking About OCIO Allocations to PE

We do believe that PE markets have achieved maturity and that on average PE managers will struggle to outperform public market equivalents. We question the historic assumption that PE markets will rebound simply following the historic pattern of rebounds. Instead, we think PE markets will reflect the subsectors into which the PE funds have allocated, and the fate of America’s middle market. If the middle market recovers, so will PE; if they continue to struggle, so will PE.

We believe that past use of public market equivalents made faulty comparisons to large cap markets, and that the small and microcap markets are more suitable benchmarks. We question how PE is classified as a separate class within equities, and we think that OCIOs should pay closer attention to the underlying sector allocations of their PE fund holdings. OCIOs should ensure that the sum of their PE funds’ sector exposures are in line with the OCIO’s overall desired market sector exposure.

Despite these observations, we do believe that PE markets continue to offer very attractive investment opportunities for sophisticated investors. The very high dispersion in returns across PE managers and their funds offers evidence that having exceptional manager-picking skills in PE markets is imperative. Moreover, we caution embracing the skeptic’s view, that PE markets just don’t add value after adjusting for sectors. Rather, the PE managers’ embrace of entrepreneurialism is exactly what caused them to concentrate in the best-performing investment sector, information technology, over the last ten years, creating substantial value for investors.

OCIOs should focus their PE investment efforts on areas where they have the strongest quality-sourcing capabilities for private investment opportunities. If the OCIOs believe, as do we, that PE funds tend to track the performance of the middle market and its underlying business sectors, then it is somewhat less important to have a truly diversified PE portfolio, because public market equivalents are available. Instead, OCIOs can maintain higher liquidity for clients while targeting scarce resources on sourcing the best managers in sectors they find compelling for their clients. What we have seen working best is a sort of barbell by PE manager type: investing in already-established relationships with a small set of capacity-constrained, highly performing premiere PE managers; sourcing boutiques and sector pros who avoid “auction markets” and who can find their own management talent to run their portfolio companies; and avoiding the “asset gatherers” who will struggle to add value compared to relevant public market equivalents.

Information about us is on our website www.manageranalysis.com, and we would welcome a conversation with you about this Briefing.

Sincerely,

Chris Cutler, CFA

President

Manager Analysis Services, LLC

917-287-9551

OCIOs vs The Magnificent Seven

Posted on February 5, 2024February 5, 2024 by Chris in Briefings

You May be in VC but not know it: OCIOs versus “The Magnificent Seven”

While OCIOs performed well in 2023 overall, within their public equity allocations few OCIOs successfully positioned themselves to take advantage of key equity market dynamics of 2023. This briefing examines the reasons why that was the case. In particular, we look at the impact that the “Magnificent Seven” performance phenomenon had on OCIO performance, and the stealth “megacap venture” allocations that have been growing in institutional portfolios.

The Year of “Negative Alpha” In Public Equities

Across the 50+ OCIOs that we monitor, we have seen many cases of strong alternatives performance, yet we have not found an OCIO that exhibited meaningfully positive alpha in their public equity allocations in 2023. Several OCIOs described the 2023 experience, where gains from the top seven market cap companies [the “Magnificent Seven”] exceeded the gains for the entirety of the rest of the S&P 500, as a “more than three standard deviation event.” They believe equity markets are primed to mean-revert, that is, returns on the rest of the stock market will catch up to the Magnificent Seven returns, or that Magnificent Seven valuations will fall back in line with market norms.

We approach this “mean reversion” line of thinking with a note of caution. It sounds similar to other mean-reversion themes over the last 10 years: for value stock performance to catch up to growth stock performance, or for European equities performance to catch up with U.S. equities performance. In both instances, there has yet to result in a meaningful catch-up of value or performance relative to U.S. growth and U.S. broad market index performance.

The Magnificent Seven

The impact of the performance of the Magnificent Seven on OCIOs’ 2023 equity performance should not be overlooked. You have probably seen this performance data for 2023 but it is worth revisiting:

Magnificent Seven Average: up 111%

S&P 500 Capitalization Weighted: up 24%

S&P 500 Equal Weighted: up 11%

MSCI ACWI: up 20%

The very large difference between the capitalization weighted and equal weighted gains reflects both the large Magnificent Seven returns, and the now-29% share of the S&P 500 that the Magnificent Seven represent. The 13% gap between the equal weighted and capitalization weighted returns means that your experience seeking alpha in public equity markets depended almost entirely on the extent of your allocation in the seven largest megacap stocks last year. If your OCIO’s strategy is to find talented public equity managers who pursue unusual sources of alpha in overlooked investment themes, your OCIO has probably significantly underweighted the Magnificent Seven megacap stocks. Thus, your public equity return might be somewhere closer to the 11% equal-weighted gain than the 24% market cap-weighted gain. If your OCIO mostly allocated public equities to indexes, or was careful to align your underlying stockholdings’ weights with the market capitalization weights, your public equity returns were probably closer to the 24% return.

Investors fall in and out of love with specific assets over time and you likely have heard of the nifty fifty, Tech Bubble, etc. over the years. The Magnificent Seven are viewed as a group much like the old FAANG stocks of only a few years ago. (Facebook (now Meta), Apple, Amazon, Netflix, Google (now Alphabet).) The change from FAANG to the Magnificent Seven is the addition of Microsoft, Nvidia and Tesla, and dropping of Netflix. The incessant AI chatter and hopes are tempting investors that the megacap outperformance will continue.

So are the Magnificent Seven a fad that will mean-revert, or is something else going on?

An Alternative View: Are the Magnificent Seven the Premiere Venture Investors?

While we are familiar with macroeconomic debates about monetary policy, a key interest of macroeconomists has been identifying the reasons for economic growth. Technological advancement is viewed as a major driver in macroeconomic models, and the United States’ private sector has been a major contributor to economic growth by investing heavily in research and development (R&D). As investors, we think of venture capital as a major area of technological evolution, but since we are more aligned with allocators, not stock analysts, we can easily overlook the extent of technology investing derived from publicly-held companies. Let the data do the talking:

Sources: market cap and 2023 % Gain are from multiple market data sources; R&D figures are from annualization of third quarter R&D spending from third quarter financial disclosures of each company, total commitments to venture capital funds by year provided by Pitchbook.

Notes: Amazon does not break out research and development (R&D) expenses from spending on all technology and infrastructure.

Clearly we are equating venture investing with R&D investing, yet we accept this linkage as being very close, since almost all R&D spending by these companies will be invested either in developing new technologies or finding new applications for existing technologies. That’s pretty much what almost all venture capital managers seek to do.

From the data, we can see that the Magnificent Seven’s R&D budgets far outstrip the R&D budgets of the venture capital industry in 2023. Recognizing that 2023 was a weak year for venture fundraising, we thought it important to compare as well to venture’s peak fundraising year of 2021. Even then, the entirety of the venture capital industry likely just barely kept up with the R&D spending of the Magnificent Seven.

Are Magnificent Seven Investors Unknowingly the Biggest Venture Investors?

So the Magnificent Seven are big R&D spenders, but how much of an investment in these companies is really a venture-like investment? Each firm already has a well-defined source of cash generation from their ongoing businesses, after all. A quick look at their financials shows that R&D spending represents about 10 to 25% of these companies’ revenues, and 25% to 100% of their profits, in the third quarter of 2023. Those are big commitments!

We would argue that the outstanding returns of the Magnificent Seven represent the result of many years, even decades, of venture program-like investing. Most recently, cloud computing and storage have brought major new business lines to Microsoft and Amazon, with others trying to catch up. In fact, cloud computing, a business that barely existing 10 years ago, represents the majority Amazon’s revenues now. AI opens the potential for vast new markets and could stimulate more technological advancements in sciences, law, education, medicine, and other areas, though it is possible that the value from AI accrues almost entirely to clients rather than the producers.

The net result is that investing in the Magnificent Seven may be like investing in a blend of mature businesses alongside well-established and successful venture investing programs. While determining the mix between the two may be beyond the scope of this discussion, such considerations haven’t stopped us from positing a rule of thumb: if company management is spending 25% to 50% of profits on R&D, then what is the venture mix of an investment in that firm? Is it close to that profit share (we’ll just refer to this as “megacap venture”). Moreover, since the Magnificent Seven represent about 29% of the S&P 500, does that mean that institutional investors’ indexed U.S. public equity allocations are implicitly 7 to 15% invested in venture? After adjusting for non-U.S. holdings in equities, that would be an “average” global equity investor is 5 to 10% invested in “megacap venture.”

You may already be a substantial venture investor through your indirect “megacap venture” allocation, even if you do not have a formal venture allocation.

Venture Investing and Volatility

Experienced alternatives allocators have many stories to share about volatility in their investment strategies, and no major group of alternatives investments is riskier than venture investing. Some of that riskiness clearly shows up in the volatility of the megacap stocks. However, the operational aspects of R&D investing in a corporate framework are quite different from within a venture-backed startup’s framework. Incentives to venture founders are exceptionally strong. Conversely, oversight by talented project managers in a proper corporate setting may allow for a more efficient allocation of resources among R&D efforts, both to deploy capital and to cease investments in less promising ventures.

Reconciling the Megacap Venture Experience with our OCIO’s Allocations

Here we face the crux of the problem. If an alpha-seeking allocator will look for equity managers with an “edge” for investing in or trading stocks that will inevitably scan the universe broadly for best ideas, the result for 2023 will be greatly reduced allocations to the top-performers, the Magnificent Seven. That allocator will likely see a substantially negative alpha in their liquid equities allocations, despite the talents of their underlying equity managers.

However, looking at a partial picture can be misleading. Many OCIOs are keenly aware that private equity, growth equity, and venture capital investment programs are inherently turbocharged growth equity allocations over the long term, so they tend to hold value biases in their liquid equity portfolios to create a more balanced growth/value portfolio. In other words, if your OCIO has been investing in venture and growth equity strategies, it is likely that you will have positive experiences in your private holdings offsetting the lagging performance in the public equity portfolio over the long term.

Conclusion #1: Don’t Expect Mean Reversion, Megacap Venture-Like Investments Have Succeeded

We see a permanent change in the U.S. public equities market structure. Technological innovation appears to favor very large companies, rather than large numbers of small companies. Now we are projecting outside our core expertise by pretending we are stock analysts, but we’ll share our perspective on the seven companies. Unlike in prior “tech bubbles,” the tech giants [MSFT, AAPL, GOOG, AMZN, FB] possess true “know how” that is difficult to replicate, defended by myriad patents, and fortified by continuing research. We see an oligopolistic market structure, with wide profit margins and stable to expanding market share, as a long-term structural change in the public equity market that will continue to flummox the talented alpha seekers. We also see these vast businesses as exceptionally difficult ones for equity managers to understand at a level where they have a material “edge” over the market. The net result is that about 25% of the public equity market represented by these five stocks is both critical to asset allocators and opaque to alpha-seekers.

We also believe that TSLA and NVDA, both excellent firms, face greater risks in their more-concentrated business models; TSLA because they face rising competition from auto manufacturers entering the EV market and waning EV market growth, and NVDA simply because their already-high valuation implicitly depends on programmers failing to increase the efficiency of large language models and other AI programs by 90%+ [which is believed possible], and the failure of meaningful competition to arise over the next few years. The great stock pickers can hopefully discern better than we can how material these risks are to TSLA and NVDA.

The net result: generating alpha from large and megacap public equity allocations is harder than ever, and under allocating to megacaps likely means under allocating to some of the U.S. economy’s greatest economic growth engines.

Conclusion #2: What We Would Like Every OCIO to Consider

As search and evaluation consultants, we are pleased that the impressive array of OCIO managers we recommend continues to produce returns for their clients meaningfully above OCIO market benchmarks. These OCIOs have created a culture of excellence that extends throughout their investment process, and they often achieve their greatest alpha-generating successes with their alternative investment programs.

While OCIOs also strive to generate alpha with their selection of public equity managers, now may finally be a time of reckoning. Finding alpha investing in large cap equities is exceedingly difficult, and we rarely see active managers [or hedge funds, for that matter] who have truly demonstrated an edge in analyzing megacap stocks. Conversely, equity managers that focus on stocks that they can analyze with some edge will likely be underallocating your capital to megacap stocks, leaving you underweighted to that critical growth engine, “megacap venture.”

We ask our talented OCIO managers to consider [again] the possibility that increased use of indexing in the large and megacap parts of the public equity markets may actually be desirable, unless the OCIO has rare capacity with the very short list of alpha-generators in large cap markets. OCIOs need not prove they produce alpha everywhere, and it is better to concentrate efforts where they have demonstrated a meaningful advantage.

We would be pleased to discuss this topic further, and to hear any feedback or experiences you may wish to share with us. We can be reached at 917-287-9551 or at info@manageranalysis.com.

Manager Analysis Services LLC

February 1, 2024