SCS Financial: Taking Advantage of Tolerance for IlliquiditySCS Financial: Taking Advantage of Tolerance for Illiquidity
CIO Lane MacDonald discusses why private markets drive so much of the firm’s active management strategy.
SCS Financial, Focus Partners’ family office and OCIO, might have a bit more leeway to invest in high-risk, high-reward strategies than some other RIAs. The Boston-based firm has $33 billion in assets under management, and most of its 212 clients have $100 million or more in net worth. As such, they have a higher tolerance for private market exposure and for waiting a bit to get their money back.
WealthManagement.com recently spoke to Lane MacDonald, CIO of SCS Financial, about how the firm structures its model portfolios, why it prefers to work with emerging asset managers rather than the big names and where in private markets it anticipates the greatest opportunities for investment.
This Q&A has been edited for length, style and clarity.
WealthManagement.com: What tends to be included in your model portfolios?
Lane MacDonald: We have a number of model portfolios, but in terms of where most of our clients sit, our average client is over $100 million, and therefore they have the benefit of duration in their portfolio. They can take advantage of that. So, with those clients, they lean a little bit more on the growth side, the aggressive side. To us, that means taking advantage of the illiquidity. In our growth model, we would have a 10% allocation to core fixed income, 16% to independent return, we have 10% in the private opportunistic bucket. And that’s real estate, natural resources and other private strategies. Public equities is 35% and then private equity is a very healthy 28%. In total, 38% of that portfolio is focused on private strategies, where many of our clients really want to lean in and take advantage of their duration.
WM: How often do you tend to change your allocations?
LM: We don’t change our allocations a lot. We are always macro-aware and market-aware. We believe that the most important things are discipline, focus and patience in markets.
A couple of years ago, the firm looked at broad asset allocations, which led to some tweaks, particularly in the hedge fund portfolio and reworking that around return. Most recently, it’s been much more around the margins in terms of the tweaks we make and trying to capture a little bit more alpha for our clients with small tweaks in various asset classes. We haven’t made major changes, nor do we want to be or trying to be tactical. We want to be in a position where we can think very long-term for our clients and we feel we have portfolios that are in place that will benefit clients over longer periods of time.
WM: You mentioned that you did some rebalancing around the margins to capture more alpha. Can you tell me what those changes were?
LM: We were looking at reevaluating the hedge fund portfolio and what we really want it to be. My background is I was at Harvard Management Company for six years, where I ran private equity also the public equity bucket. And I also oversaw the oil/gas/renewables platform within private equity when I worked for the Johnson family, which owns Fidelity. With all of that background, I’ve been in the best of endowments and the best of family offices. From a hedge fund standpoint, you need to be very thoughtful about how you use your budget and your client’s budget from a fee standpoint, from a carry standpoint and from an illiquidity standpoint. So, we took a step back and evaluated that and we ended up now having a portfolio that’s much less correlated than many strategies out there. And that’s what we are trying to accomplish with that portfolio: to generate an uncorrelated return stream. We also reduced the exposure of that hedge fund independent return bucket and reallocated some of those dollars to other areas of the portfolio, including an area like private equity, where we felt the return premium is there for those clients who can handle the illiquidity.
WM: What differentiates your portfolio from your competitors?
LM: I think it’s really the expression of the privates within our portfolio. This platform and what we do and the focus really being on the mid-cap, small-cap, micro-cap managers within buyout, growth equity and even venture and layering in the most talented emerging managers is really the differentiation. I have been a believer since my days at HMC that the alpha in privates really exists at the lower end of the market. There are going to be some great larger managers, but you are not really going to get a lot of alpha there. You hope they end up being top quartile, so that’s going to be 2x net and 18% to 20%.
But with these smaller emerging managers, where it’s someone who has a $500 million fund or a $300 million fund, if they are really talented and are domain experts, they can have 3x to 5x funds and really generate performance.
So, I think what really differentiates us is our exposure to that part of the market and our networking connectivity to the leading players in that part of the market. I’ll give you a couple of examples: Josh Kushner at Thrive [Capital]. Now everybody knows who he is and about Thrive, but luckily, our private equity team was there very early with Josh, believed in him as he was launching, and benefited from that relationship throughout its history.
Justin Ishbia at Shore [Capital] is another one where we were there very early with Justin as he was building Shore. Shore is very much a micro-cap strategy. We have really benefited from our partnerships with those firms. But then we are also looking for some new emerging managers who we do believe will be the next great managers, who are raising those first funds that are $200 million, $300 million. That is where you can really find meaningful outperformance.
The other thing that goes lockstep with that is our ability to execute on co-investments. Many people talk about it, but given the size of our portfolio with over $10 billion in privates across this platform, we write big enough checks, and we have great relationships so that we are an early first call for many of our GPs from a co-invest standpoint. When your top GPs are leaning into deals, but it’s something that’s a little bit out of size for their fund, and they bring it to their LPs and you can invest in that on a no-fee, no-carry basis in many cases, that’s highly accretive and additive.
WM: Can you tell me what your due diligence process is like when you are deciding which asset managers you are willing to work with?
LM: There can be more risk. Our view is as opposed to once again working with the large managers, where you are getting some flavor of private equity beta and large size, you revert to the mean, full stop. But for us, to find those emerging managers and do it really thoughtfully is the key.
In our due diligence process, number one is the network and sourcing. The best source for us are existing managers. Some of our top managers know where the top talent is spinning out. We end up getting those introductions very early on to engage with folks. The people we are backing are people who are spinning out of different places, who want to be independent, but have a track record, a history and in many cases, true domain expertise and a real edge. That’s what you are underwriting.
When some of those gifted folks spin out, we want to be an early/first call. Our history of doing this allows us to have credibility when we’ve been great partners and early anchor investors. We can help them with construction and introduce them to other LPs. It’s more than just showing up with a check; it’s really about having relationships and a history. But the important part is doing due diligence.
WM: What investment vehicles do you use?
LM: We generally go into primary vehicles. There are certain cases where we will have SMAs. What we do try to do with the capital base that we have and the checks that we can write, we try to leverage that into some sort of preferred relationship. It’s not always possible, but if we are there early, we can drive terms. There is one manager that we ended up supporting very early in their lifecycle, really compelling on the return side, who spun out of one of the top hedge funds in the U.S. but focused a similar strategy on small caps and mid-caps. In that structure, we are paying one in 10 economics as opposed to 1.5 in 20 that most investors pay.
So, we try to use our access and scale to drive those terms. It’s not always possible in every situation, but we certainly try to do that.
WM: You’ve talked about the firm’s commitment to private markets, including private equity, private debt and real estate. If you can go a bit more in-depth about which sub-sectors in the private market you are invested in?
LM: Obviously, 35% of our portfolio is in private equity. I think it’s important to frame that. We are believers in having exposure to public equities. For us though, given the challenges from an alpha standpoint, the fees you are paying, sometimes the carry for some of those strategies, 65% of our public equity portfolio is actually tax-managed passive. Our view is in markets where it’s hard to find alpha, finding that passive tax-managed alpha, where you can earn 100 basis points a year of tax alpha with some of these structures, is effectively a really compelling way for our clients to get exposure to public equities, particularly the most efficient ones, which is the S&P 500 U.S. markets. Then we reserve 30% to 35% of our portfolio within the more active, where we focus on areas of the market—think small caps in parts of Europe, in parts of Asia—where we will have active management exposure.
But we do lean passive [in public equities]. Therefore, we reserve our fee/carry/illiquidity bucket largely for the private side. In that, we feel like private equity is really in spring right now in terms of it’s coming out of a couple of challenging years from a reported performance standpoint. We continue to believe that private equity will outperform public equities over a longer period of time. Over any 10-year cycle, historically, it has. This last couple of years is not an anomaly. But, once again, you need to have the patience, the discipline and the duration to play the hand out.
I am also very much leaning in right now into natural resources. I think there are pockets of real estate where there is real value, certainly some distress on the commercial office space side where there could be some opportunities there. We really try to find sharpshooters within distinct strategies in the real estate sector. On the natural resources side—and not all of our clients want carbon exposure—but in the oil and gas sector, there continue to be some really interesting opportunities. In parts of the market where it’s very capital-intensive, which oil and gas is, but where there is a shortage of capital, that presents a really interesting opportunity. The risk-adjusted returns in those sectors right now are really compelling. So, we’ve done some things on the renewables side, but we’ve also leaned a lot into things on the more traditional oil and gas side.
WM: Do you invest in any cryptocurrency?
LM: We have cryptocurrency exposure, but that’s generally through our venture managers. Within our venture portfolio, we have a handful of managers who are focused on crypto. Through that, we end up having exposure in the 2% range within client portfolios, but we feel that’s a more elegant way to get that exposure than buying crypto and playing that game with the fall that’s embedded there.
WM: Do you hold any cash?
LM: Very modest amount of cash. Certainly, some clients will. But in our growth portfolio, there is usually a 1% cash or short-term bonds as a liquidity buffer. Even in that portfolio profile, where we lean heavily into privates, that portfolio is still 46% liquid, 16% semi-liquid and then 38% illiquid. Therefore, between cash and core fixed income, we are in places where there is liquidity for our clients when they need it, but history has proven that it’s a meaningful drag from a performance standpoint.
WM: Do you use any direct indexing?
LM: The exposure that we have is really more tax-managed passive. That is effectively passive index exposure in a flavor where we feel there is tax alpha, so we really don’t use much traditional direct indexing. There will be a little bit of it within our portfolio in certain asset classes, but we generally find that there is a more elegant way to express that.
WM: Are you incorporating any ESG strategies into your portfolios on a firm level or for clients who ask for it?
LM: On the former part, it’s part of our process with all of our managers. Because we are investing primarily through managers, it has become part of our process and certainly one of which we are more aware.
We don’t include many specific ESG strategies within our core portfolio. We look for that expression from managers who are very ESG aware. But for those clients who do want to lean in a bit more, we will have strategies and managers and relationships that we can recommend. But just from a risk-adjusted return standpoint and what most clients are hiring us for, ESG is important, but it’s not necessarily a sufficient driver [of decisions].
WM: In broad terms, where do you see risk rising right now, and where do you see opportunities?
LM: As a CIO I see risks everywhere. Clearly, the macro seems pretty good. I think there are risks in U.S. large caps. There is a bit of price perfection. That doesn’t mean that we are tactically moving away from it, but just having been in this business for a long time, we are aware of the concentration that exists, the multiples that exist, and the growth earnings that are forecast. And we’ve seen the volatility—when something is priced to perfection, there is some room to fall, and I do think that continues to be a risk. I think the AI trade has been a risk because it has been priced to perfection, and everyone is chasing it. Anytime people are chasing—1999/2000, 2007—once again, discipline and patience are incredibly important.
I think from a presidential standpoint, the tariff piece is very real. But it’s important to be very measured about anything you are trying to do because the talk about tariffs can oftentimes be very different from the reality of tariffs.
The geopolitical risks and those ongoing challenges will continue to be the case. Obviously, we continue to hope that cooler heads always prevail, but we end up being very aware and talk a lot about all of those things.
Outside of the macro, which is always kind of there, I do think the U.S. large caps and the valuations that exist there. History says that these types of markets don’t go on forever. There will be a correction. It’s just a question of when.
We are aware of these risks and are trying to be thoughtful about them, but we are also not trying to time markets here.
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