Neal Graziano is a director of investments at the W. K. Kellogg Foundation, which manages $3.5 billion in assets. Prior to joining Kellogg in 2007, Graziano was an associate portfolio manager at Mastrapasqua Asset Management and investment analyst at William Blair & Co. Graziano holds a B.A. in finance from Michigan State University and an MBA from the University of Chicago. He holds a chartered financial analyst and chartered alternative investment analyst designations. Graziano was named of Trusted Insight's Top 30 LPs Investing Real Assets, Real Estate.
Trusted Insight's interview with Graziano is split into two parts. The first, today's piece, focuses on the evolution of markets following the 2008-2009 financial crisis and how that spells the likely death of lower tier private equity and hedge funds and the industry standard two-and-twenty fee structure. Part two will focus on W. K. Kellogg's investment office and its recipe for long-term success. The following interview has been edited and condensed for clarity.
Trusted Insight: You joined Kellogg right before the financial crisis. Tell me about your experience of investing through financial crisis. How did it change your approach to investing in this current market?
Neal Graziano: My first challenge was I joined William Blair, which is a growth shop, in January of 2000. The tech meltdown was hard for growth shops. Certainly, there were some value-add strategies that had positive returns, but if you are a growth manager, these were 60% to 70% types of declines across the portfolio. That was my first full foray in some pain.
What was a little bit different about this crisis was how broad it was, and how it was stuck in the actual gear box of the financial institutions.
One of the big takeaways from the financial crisis is spending an extraordinary amount of time understanding what can go wrong and mapping it out before we make the potential investments. Where we see it stick its head up more than ever is leverage. An example is in real estate investments from the use of cross-collateralization, or the act of securing one property with another property. If one goes down, they all hold hands and go down together.
With totally structured CMBS contracts, you have to make sure that there is an alternative manager and they're looking at the docs, they're spending the time and reading the notes. All the way to the basic custodial needs. Keeping an eye on understanding and appreciating securities lending and how the whole machine works. Don't go under the assumption that it worked before so just continue moving along.
Trusted Insight: What did the portfolio look like when you arrived? Where can your individual fingerprints be found on the portfolio?
Neal Graziano: One thing that we were efficient in doing is taking a look at the portfolio in early 2010 coming out of the crisis, then appreciate and understand the level of risk we want to take and where we want to allocate some of the resources.
We took some sizable investments across real estate, and it's something that we significantly increased our commitment to opportunistic real estate managers that invested on the credit side and equity in real estate. We more than doubled our commitments to real estate.
Another one is we found good opportunities across the credit space, whether in a mezzanine or preferred lending. There was also significant dislocations that we took advantage of at that time period.
Trusted Insight: Are your moves into credit a result of the banks being forced to pull back?
Neal Graziano: Exactly. That's something that we've played out up until about a year ago. What is it that the banks were in that they aren’t in anymore.
That thesis we’ve morphed over the past couple of years to our European investments. What we're seeing and what we're continuing to see is that Europe is at least five years behind the States on cleaning up their balance sheets.
Those spaces where banks were the historical players, you can still find some pretty attractive risk-adjusted returns where the banks used to operate. So, we're taking a similar playbook and using it across Europe.
Trusted Insight: What is your strategy for meeting the five percent annual payout requirement while maintaining your long-term capital preservation perspective given the current market climate?
Neal Graziano: If I think about one of the other things that we're extremely fortunate about besides having a close-knit team that's worked together for a significant amount of years is our trustees and our governance.
Our trustees have been able to create a policy or risk benchmark that essentially keeps us in line. They've also given us the flexibility to opportunistically dial up or down the portfolio given the opportunities.
With that five percent payout, we understand and our trustees understand that in order for us to have a five percent real payout, we need to take on equity or equity risks. With that equity risk, there's going to be volatility, and it's essential to have a good governance structure. There are going to be time periods when that five percent does not come in, and there are going to be times when you're going to significantly exceed that five percent.
Having the trustees on board, to understand and appreciate that there will be the good periods and the challenging periods, really gives us the comfort as a team to be able to make those long-term decisions on what's best for the Kellogg Foundation and the foundations’ guarantors.
Trusted Insight: What trends are shaping how Kellogg invests?
Neal Graziano: What we're seeing change and change dramatically are the structures and the compensation of investment structures. Historically things fit in a nice little box, where there is a hedge fund, there is private equity, there is a long-only mandate. You kind of fill up a nice little box, and you understand what it is.
What we're finding now, and part of it is driven because of this lower return environment, these strategies are crisscrossing across each other. We're finding it in real estate where you have a JV, where you have direct ownership of properties; in hiring hedge funds, where you can start thinking about seeding strategies, having percentage of GP ownership; to being the first investor and getting discounts; to having a cross-strategy to where you're in a private equity vehicle, and you're investing in long-only strategies with long-only companies, as quasi activists, sometimes you take them private and sometimes they remain public investments.
A lot of it is the need to drive returns and understanding that with a two-and-twenty wrap around anything, it’s really tough to generate outsized returns given where our valuations are across asset classes. The thing to think about is what are some of the partnerships, structures and ways to set up structures that you're seeing, whether it's JVs or seeding managers or other things. And how as institutional investors can we not just be "here's some capital and move ahead” to getting a bit more granular on the investments. Then the economics are shared a little bit more evenly.
Trusted Insight: Are we in the age of the death of the two-and-twenty fee structure?
Neal Graziano: There are too many hedge fund managers, and there are too many private equity managers. What that has done is it has bid up assets across the spectrum and across categories to where it's driving down future returns.
There are going to be those individuals that are phenomenal that are going to be able to maintain those superior economics. But that second and third tier is eventually going to go away.
On that second tier, what we're finding, more specifically in our hedge fund space, is that what was alpha is just beta in sheep's clothing. With the advent of technology, we're able to invest in those betas.
The first advent was small cap twenty years ago, then it was value. In the past ten years, all of a sudden you can get value ETF strategies. Now you can go into passive CTA strategies, where you're wrapping what was historically the two-and-twenty model, and you're able to get that same type of return stream for twenty-to-thirty basis points.
With the advent of technology, we are able to map out these returns a lot better and realize that what you thought was alpha was not there, and you can get it a lot cheaper now.
Trusted Insight: After those second- and third-tier hedge funds and private equity firms disappear, what is going to replace them? Some robo-advisor? An artificial intelligence-powered fund?
Neal Graziano: Yes, and I think that you're seeing it in our portfolio. Historically, we would pay somebody for whether it would be a venture strategy or CTA strategy. The majority of that you can get as a passive type of model where you have a manager put it through their system at a marginal cost of what you're used to.
On top of that you can do your two-and-twenty, your alpha strategies, but those strategies are going to be quite a bit fewer than the historical ones. Smith Barney, on their first merger-arb desk, started out when teams realized that they could pick up this alpha stream by buying the acquired company and short the acquirer. Then you just wait, leverage it. You didn't even have to leverage it in the beginning. All of a sudden, you have a fifteen percent IRR.
As time went on, you said, “Okay, now you need to put a couple gearings in it.” You need to leverage it one time because there are more players. Then, okay, now we need to lever it three or four times because there's a lot more players. Then they realized that alpha opportunity was arbitraged away very quickly. So, you had to take an undue amount of risk through leverage to generate the returns that you need.
That story is playing out across CTAs. That story has played across already on what people call value and what people call quality. We think it's going to be played out through more asset classes and through more hedge fund strategies.
Trusted Insight: What advice would you give to someone looking to enter institutional finance right now?
Neal Graziano: Make sure you love it. I can't underemphasize the importance of passion. Whether it's in this field or in any field, because you're never going to know all the answers, and you need to have that insatiable curiosity of understanding and appreciating what's next.
Doing that extra layer of due diligence, understanding and appreciating the different classes and geographies. It's a puzzle that never gets answered. If you don't go in with that original passion or intellectual curiosity, you're going to be frustrated because there's not going to be room for advancement.
Stay tuned for part two of Trusted Insight's interview with Graziano. In the meantime, check out our full collection of exclusive interviews.
Trusted Insight's interview with Graziano is split into two parts. The first, today's piece, focuses on the evolution of markets following the 2008-2009 financial crisis and how that spells the likely death of lower tier private equity and hedge funds and the industry standard two-and-twenty fee structure. Part two will focus on W. K. Kellogg's investment office and its recipe for long-term success. The following interview has been edited and condensed for clarity.
Trusted Insight: You joined Kellogg right before the financial crisis. Tell me about your experience of investing through financial crisis. How did it change your approach to investing in this current market?
Neal Graziano: My first challenge was I joined William Blair, which is a growth shop, in January of 2000. The tech meltdown was hard for growth shops. Certainly, there were some value-add strategies that had positive returns, but if you are a growth manager, these were 60% to 70% types of declines across the portfolio. That was my first full foray in some pain.
What was a little bit different about this crisis was how broad it was, and how it was stuck in the actual gear box of the financial institutions.
One of the big takeaways from the financial crisis is spending an extraordinary amount of time understanding what can go wrong and mapping it out before we make the potential investments. Where we see it stick its head up more than ever is leverage. An example is in real estate investments from the use of cross-collateralization, or the act of securing one property with another property. If one goes down, they all hold hands and go down together.
With totally structured CMBS contracts, you have to make sure that there is an alternative manager and they're looking at the docs, they're spending the time and reading the notes. All the way to the basic custodial needs. Keeping an eye on understanding and appreciating securities lending and how the whole machine works. Don't go under the assumption that it worked before so just continue moving along.
Trusted Insight: What did the portfolio look like when you arrived? Where can your individual fingerprints be found on the portfolio?
Neal Graziano: One thing that we were efficient in doing is taking a look at the portfolio in early 2010 coming out of the crisis, then appreciate and understand the level of risk we want to take and where we want to allocate some of the resources.
We took some sizable investments across real estate, and it's something that we significantly increased our commitment to opportunistic real estate managers that invested on the credit side and equity in real estate. We more than doubled our commitments to real estate.
Another one is we found good opportunities across the credit space, whether in a mezzanine or preferred lending. There was also significant dislocations that we took advantage of at that time period.
Trusted Insight: Are your moves into credit a result of the banks being forced to pull back?
Neal Graziano: Exactly. That's something that we've played out up until about a year ago. What is it that the banks were in that they aren’t in anymore.
That thesis we’ve morphed over the past couple of years to our European investments. What we're seeing and what we're continuing to see is that Europe is at least five years behind the States on cleaning up their balance sheets.
Those spaces where banks were the historical players, you can still find some pretty attractive risk-adjusted returns where the banks used to operate. So, we're taking a similar playbook and using it across Europe.
Trusted Insight: What is your strategy for meeting the five percent annual payout requirement while maintaining your long-term capital preservation perspective given the current market climate?
Neal Graziano: If I think about one of the other things that we're extremely fortunate about besides having a close-knit team that's worked together for a significant amount of years is our trustees and our governance.
Our trustees have been able to create a policy or risk benchmark that essentially keeps us in line. They've also given us the flexibility to opportunistically dial up or down the portfolio given the opportunities.
With that five percent payout, we understand and our trustees understand that in order for us to have a five percent real payout, we need to take on equity or equity risks. With that equity risk, there's going to be volatility, and it's essential to have a good governance structure. There are going to be time periods when that five percent does not come in, and there are going to be times when you're going to significantly exceed that five percent.
Having the trustees on board, to understand and appreciate that there will be the good periods and the challenging periods, really gives us the comfort as a team to be able to make those long-term decisions on what's best for the Kellogg Foundation and the foundations’ guarantors.
Trusted Insight: What trends are shaping how Kellogg invests?
Neal Graziano: What we're seeing change and change dramatically are the structures and the compensation of investment structures. Historically things fit in a nice little box, where there is a hedge fund, there is private equity, there is a long-only mandate. You kind of fill up a nice little box, and you understand what it is.
What we're finding now, and part of it is driven because of this lower return environment, these strategies are crisscrossing across each other. We're finding it in real estate where you have a JV, where you have direct ownership of properties; in hiring hedge funds, where you can start thinking about seeding strategies, having percentage of GP ownership; to being the first investor and getting discounts; to having a cross-strategy to where you're in a private equity vehicle, and you're investing in long-only strategies with long-only companies, as quasi activists, sometimes you take them private and sometimes they remain public investments.
A lot of it is the need to drive returns and understanding that with a two-and-twenty wrap around anything, it’s really tough to generate outsized returns given where our valuations are across asset classes. The thing to think about is what are some of the partnerships, structures and ways to set up structures that you're seeing, whether it's JVs or seeding managers or other things. And how as institutional investors can we not just be "here's some capital and move ahead” to getting a bit more granular on the investments. Then the economics are shared a little bit more evenly.
Trusted Insight: Are we in the age of the death of the two-and-twenty fee structure?
Neal Graziano: There are too many hedge fund managers, and there are too many private equity managers. What that has done is it has bid up assets across the spectrum and across categories to where it's driving down future returns.
There are going to be those individuals that are phenomenal that are going to be able to maintain those superior economics. But that second and third tier is eventually going to go away.
On that second tier, what we're finding, more specifically in our hedge fund space, is that what was alpha is just beta in sheep's clothing. With the advent of technology, we're able to invest in those betas.
The first advent was small cap twenty years ago, then it was value. In the past ten years, all of a sudden you can get value ETF strategies. Now you can go into passive CTA strategies, where you're wrapping what was historically the two-and-twenty model, and you're able to get that same type of return stream for twenty-to-thirty basis points.
With the advent of technology, we are able to map out these returns a lot better and realize that what you thought was alpha was not there, and you can get it a lot cheaper now.
Trusted Insight: After those second- and third-tier hedge funds and private equity firms disappear, what is going to replace them? Some robo-advisor? An artificial intelligence-powered fund?
Neal Graziano: Yes, and I think that you're seeing it in our portfolio. Historically, we would pay somebody for whether it would be a venture strategy or CTA strategy. The majority of that you can get as a passive type of model where you have a manager put it through their system at a marginal cost of what you're used to.
On top of that you can do your two-and-twenty, your alpha strategies, but those strategies are going to be quite a bit fewer than the historical ones. Smith Barney, on their first merger-arb desk, started out when teams realized that they could pick up this alpha stream by buying the acquired company and short the acquirer. Then you just wait, leverage it. You didn't even have to leverage it in the beginning. All of a sudden, you have a fifteen percent IRR.
As time went on, you said, “Okay, now you need to put a couple gearings in it.” You need to leverage it one time because there are more players. Then, okay, now we need to lever it three or four times because there's a lot more players. Then they realized that alpha opportunity was arbitraged away very quickly. So, you had to take an undue amount of risk through leverage to generate the returns that you need.
That story is playing out across CTAs. That story has played across already on what people call value and what people call quality. We think it's going to be played out through more asset classes and through more hedge fund strategies.
Trusted Insight: What advice would you give to someone looking to enter institutional finance right now?
Neal Graziano: Make sure you love it. I can't underemphasize the importance of passion. Whether it's in this field or in any field, because you're never going to know all the answers, and you need to have that insatiable curiosity of understanding and appreciating what's next.
Doing that extra layer of due diligence, understanding and appreciating the different classes and geographies. It's a puzzle that never gets answered. If you don't go in with that original passion or intellectual curiosity, you're going to be frustrated because there's not going to be room for advancement.
Stay tuned for part two of Trusted Insight's interview with Graziano. In the meantime, check out our full collection of exclusive interviews.