Financial market participants tend to stretch at the end of a cycle in ways that look silly in retrospect. In 2000, public companies with millions of “clicks” (and minimal revenue) held market caps in the billions of dollars. In 2008, structured products that sliced and diced subprime mortgages professed to spin junk credit straw into AAA gold. After their fall from grace, dot.coms became dot.bombs, and the only sighting of precious metal attached to defaulted mortgages was on the “silver” screen.[1]

The New New Thing in private lending is NAV loans.[2] In its most common form, a private equity sponsor takes on senior debt at the Fund level using its portfolio or a subset of the portfolio as collateral. The portfolio loan differs from the standard practice of borrowing only at the individual company level.

Private credit managers see NAV loans as the latest gold mine. Accustomed to providing leverage to individual companies, lenders can now issue 12-14% senior paper at 10-20% LTV backed by a diversified portfolio of companies. The risk of these loans seems minimal, and the rewards are outstanding.

Private equity managers look at NAV loans as a solution to problems created by today’s difficult environment. For those struggling, NAV loans may help generate distributions to LPs or provide capital for new deals. GPs with stronger hands use NAV loans as a portfolio management tool to access lower-cost debt than otherwise available.

Allocators are raising alarm bells over NAV loans. In her soon-to-be-released book, The Climb to Investment Excellence, Ana Marshall, CIO at the Hewlett Foundation, compares investing to climbing a mountain. At Capital Allocators University, she called NAV loans “an oxygen tank for GPs,” implying that those accepting NAV loans might be running out of air.

The different perspectives across the food chain of capital are an interesting dynamic to unpack.

Case Study – Vista and Finastra

In a recently publicized NAV loan transaction, Vista Equity Partners took a $1 billion NAV loan to complete a $5 billion refinancing for portfolio company Finastra.[3] According to investors familiar with the situation, the Vista fund that owns the business has $10 billion in assets and is performing extremely well. This example has me thinking about the choices Vista faced in refinancing Finastra’s debt.

1. Provide more capital. Vista could have added $1 billion of equity, structured equity, or credit from their different pools of capital.
2. Pay more interest. Vista could have accepted a higher coupon to refinance Finastra’s junior debt. Credit may not have been available at the rates Vista liked, but it still could have refinanced and maintained the independence of collateral.
3. Wait for market conditions to improve. Vista could have waited to see if the recent spike in interest rates settled down before testing the market.
4. Take a NAV loan. Vista could have used the lowest cost of capital available.

By choosing a NAV loan to fund Finastra, Vista decided to not add equity to the deal. It eschewed traditional junior debt financing and consummated a transaction in advance of a debt maturity. In past cycles, Vista would have had to choose among the first three options.

Use Cases for NAV Loans – Private Equity Manager Perspective

Private equity managers use NAV loans for refinancing in a tough environment, distributing capital to its investors, or buying time to continue doing deals.

1. Lower cost debt. By providing a diversified portfolio as collateral, sponsors can access cheaper credit for their companies. Business cash flow projections based on the prior interest rate regime may not hold up in the current environment. But a 12-14% NAV loan allows the model to work if the company exceeds its cost of capital.
2. Refinancing portfolio companies. The purse strings of private lenders are tightening. If a private equity firm cannot access funding for its companies, a NAV loan can fill the funding gap.
3. Return of capital. As dealmaking has slowed, some GPs are using the proceeds from NAV loans to return capital to LPs. The act is especially useful when LPs are overallocated to private equity and need distributions to create capacity for future commitments. Carlyle, HG Capital, and Softbank reportedly used NAV loans to distribute capital this year.[4]
4. Dealmaking. GPs out of dry powder can buy time for the fundraising environment to improve by taking a NAV loan and using the proceeds to add a deal or two to its existing fund.

Problems with NAV Loans – LP Perspective

While private credit managers are enthusiastically offering NAV loans and private equity firms are increasingly accepting them, investors in private equity funds are concerned about the risk and misalignment of interest they create.

1. NAV loans introduce equity risk. A portfolio of options is more valuable than an option on a portfolio. One of the attractive features of private equity is the absence of cross-collateralization of debt across portfolio companies. NAV loans take away that benefit. The risk of a low LTV NAV loan to LPs is low - until it isn’t.
2. Leveraged capital structures. NAV loans allow GPs to apply more leverage to an individual company than lenders deem appropriate. Creditors and sponsors have not seen eye-to-eye on the future cash flows of buyouts for a while. Using the software industry as an example, private equity multiples were a lot less ten or twenty years ago. A deal back then might have transacted at 10x EBITDA with 6x leverage. Today, that same deal might sell for 18x EBITDA, carrying a similar 6x leverage. Private equity managers believe that growing future cash flows will justify higher valuations, but lenders have not been willing to extend a proportional amount of debt.
   If the sponsors are right and their portfolio companies can handle the debt, everyone wins. If the lenders are right and the businesses can’t support more debt through a cycle, problems will surface. Only one of the participants will be correct.

3. Expensive dividend recap. Why does a sponsor think that borrowing at 12% to return capital will help an LP whose cost of capital is 8-10%? If an LP wanted liquidity from its private equity portfolio, most could borrow against their interests more cheaply than a single private equity fund could. A dividend recap of a private equity portfolio seems like a gimmick to juice distributions (DPI) and IRR so the GP can ask for a commitment to its next fund. In fact, NAV lenders are pitching this concept to GPs as part of the value proposition for accepting a loan.
4. Borrowing to do more deals is the ultimate misalignment of interest. If a GP is out of dry powder and unable to raise money, the market has told the GP that it is not supportive of their future deal-making ability. Their response of using more debt to reload is like pulling the goalie at the end of a hockey game or throwing a Hail Mary at the end of a football game. It rarely reverses the outcome.
5. Zero-sum game. The LPs providing capital to private equity funds are the same ones who invest in private credit funds making NAV loans. One investor’s attractive return on a NAV loan is another’s price paid in a private equity fund. In the case where an LP invests in a NAV lending fund that extends a loan to one of their private equity funds, the investor loses by the fees it pays to both sides, just like Jack Bogle’s critique of active management in public equities.
6. Complexity and communications. Private equity managers have the discretion to manage the capital structure of their portfolio companies. In a high-performing fund, the GP is likely to communicate their rationale for a NAV loan in advance. In an act of desperation, the LP may not know about the loan until it’s too late. Further, the structure of every NAV loan is different. Only clear communication in advance by the GP can help ease LP scrutiny.

Canary or Gold?

Gold Mine. I can tell two stories that suggest that NAV loans are a win-win-win for investors, fund managers, and creditors. The first is when incremental leverage carries little risk, creates a better capital structure, and the loan fills a funding gap between lender and sponsor expectations. This dynamic could have played out in the software industry over the last decade; buyouts worked, but they have not been leveraged buyouts. Vista’s NAV loan exemplifies this story.

The second story is that a NAV loan is a new portfolio management tool for a mature portfolio, where the sponsor can replace higher-cost debt in a more difficult borrowing environment. Capitalizing businesses fund-by-fund instead of deal-by-deal resembles a holding company in which the sponsor can efficiently acquire and allocate financing. It’s a bit like Warren Buffett’s centralized capital allocation at Berkshire Hathaway.[5] With long track records of low losses at the portfolio level, maybe all sponsors would generate higher returns by exchanging cross-collateralization for a lower cost of capital.

Canary. While both stories have some merit, they also have flaws. In the first story about funding gaps, the late stage of an economic cycle is a bad time to decide that previously undercapitalized deals can be improved with more leverage. Lightly leveraged loans may not have much risk, but, as Buffett says, what the wise man does in the beginning, the fool does in the end. I’ve already seen presentations from lenders offering NAV loans for up to 50% of a private equity portfolio value. That amount of leverage poses a substantial risk in a downturn.

In the second story about portfolio management, I scratch my head again thinking about why this innovation is taking hold now. Private equity firms could have accessed cheaper debt this way any time in the past, and it’s unlikely the entire industry left easy money on the table. The massive growth of private equity over the last fifteen years coincided with low rates and readily available financing. Maybe now is the first time in the modern era that the titans of industry need to sharpen their pencils.

Other use cases of NAV loans are more pernicious. A GP struggling to maintain its business might take out a NAV loan to make a distribution, thinking that LPs will return the money with a new commitment. The GP boosts its IRR but lowers its MOIC in exchange. Worse, GPs out of dry powder can take NAV loans to conduct additional deals. Both of these pit the interest of the GP against those of its LPs.

We’ve Seen This Before; Let’s Not Again

NAV loans strike me as a canary in the coal mine signaling the end of the private equity boom. According to Preqin, 645 firms have not raised a new vehicle since 2015.[6]  With interest rates higher and the fundraising environment tighter, credit is scarce. NAV loans feel like the “extend and pretend” activity we saw after the GFC. For every Vista NAV loan, there are probably ten used to cure the woes of a GP.

This isn’t the first structural innovation in finance, and most have unintended consequences. In private equity, subscription lines started as a red-headed stepchild, became an expected business practice, and then led to instances of abuse including excessive leverage, inflated IRRs, and opacity.

Continuation funds started as an idea for GPs to hold great businesses longer and LPs to save fees from fewer sponsor-to-sponsor transactions. The pristine concept didn’t last long. Continuation funds are controversial today. Many LPs are concerned about valuation challenges, incentive misalignment, questionable business selection, and zombie fund extensions.

In many ways, NAV loans resemble the AAA tranches of subprime CDOs fifteen years ago. Real estate prices across the U.S. had never previously declined simultaneously, and the super senior portion of securitizations held the same credit rating as U.S. Treasuries. Between portfolio company debt, NAV loans, and credit facilities, potentially three layers of leverage sit above private equity assets. I can’t think of a reason why private equity-owned businesses would default on low LTV portfolio loans, but markets experience hundred-year floods far more than once a century.

No matter how you look at it, NAV loans are a late-cycle response to the higher cost of debt and slowing fund flows that will bring uncompensated risk to LPs. Whenever a GP takes a NAV loan, LPs must assess whether the additional debt is a wise capital allocation decision or an early warning sign of problems at the firm.

Ana suggested that anyone hearing about a NAV loan should shout out a warning from the mountaintop. She is right – you’ve now heard my call.

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[1] The Big Short, based on the 2010 book by Michael Lewis.

[2] Another hat tip to Michael Lewis, The New New Thing: A Silicon Valley Story, 2008.

[3] https://www.ft.com/content/be9e095f-71b8-402f-a404-1172d6df1fb7?shareType=nongift.

[4] https://www.ft.com/content/f23d9cd9-2650-4943-a9ac-eb262414e772.

[5] Described in Berkshire Hathaway’s Annual Letter in 2014 commemorating 50-years of Warren Buffett’s tenure. www.berkshirehathaway.com/2014ar/2014ar.pdf, page 30.

[6] https://www.bloomberg.com/news/features/2023-09-24/private-equity-zombie-firms-leave-pension-funds-with-hard-choices?sref=oaOFfGYY.  .

Investors following David Swensen too often miss the mark in their interpretation of his theory. Like children playing the game telephone, they listen to other voices and echo beliefs with shakier foundations than Yale’s.

Anyone adopting the “Yale Model” is well served to revisit David’s writing from time to time. I had a chance to do that and found perspectives on illiquid investments, asset allocation, active management, private equity, and rebalancing that differ from the conventional wisdom that defines the Yale Model.

The Yale Model in David Swensen’s Words

David’s ability to articulate and act on an investment philosophy based on academic research was the foundation of his greatness. Reading the revised edition of Pioneering Portfolio Management reminded me of the clarity of his ideas and depth of his insight.

David put forth a framework for thinking about the investment problem and shared how he applied that framework to managing Yale’s endowment. He wrote about an investment strategy for educational endowments with a perpetual time horizon, articulating a series of first principles. This core of the “Yale Model” in his words are as follows:

1. Equity bias. “Sensible investors approach markets with a strong equity bias, since accepting the risk of owning equities rewards long-term investors with higher returns.”^[1]
2. Diversification. “Significant concentration in a single asset class poses extraordinary risk to portfolio assets. Portfolio diversification provides investors with a “free lunch,” since risk can be reduced without sacrificing expected return.”^[2]
3. Alignment of Interest. “Nearly every aspect of fund management suffers from decisions made in the self-interest of the agents at the expense of the best interest of the principals. By evaluating each participant involved in investment activities with a skeptical attitude, fiduciaries increase the likelihood of avoiding or mitigating the most serious principal-agent conflicts.”^[3]
4. Search for inefficiency. Focus on asset classes with a wide dispersion between top and bottom performers and employ external managers to exploit opportunities.^[4]

David’s Words of Warning

David preached an investment philosophy and a mission-driven purpose. Many others read his words and inferred a prescriptive recipe for investing broadly.

Interpretations of David’s beliefs generally follow his principles, but his philosophy included three obstacles to investment success that most institutions and individuals are unable to overcome. As a result, David warned investors against playing follow the leader.^[5]

1. Rigorous investment framework. David stresses the importance of taking actions within the context of an “analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities.”^[6]
2. Agency Issues. “Agency issues interfere with the successful pursuit of institutional goals. Culprits range from trustees seeking to make an impact during their term on an investment committee to staff members acting to increase job security to portfolio managers pursuing steady fee income at the expense of investment excellence to corporate managers diverting assets for personal gain.”^[7]
3. Active Management Challenges. “Investors hoping to beat the odds by playing the game of active management face daunting obstacles ranging from the efficiency in pricing of most marketable securities to the burden of extraordinary fees in most alternative asset investment vehicles.”^[8] Success also demands substantial staff resources and contrarian behavior not typically practiced by institutions.^[9]

What I also found worth consideration are the contradictions between David’s words and others’ interpretations of his work. It’s where the students fall short of the master.

What David Said

…on Illiquidity

Embracing illiquidity is not a first principle of the Yale Model, despite many misinterpreting David’s beliefs as such.

David discusses his tenets in the first pages of the book. He does not focus on the topic of liquidity until page 82. Illiquidity is neither a feature nor a bug in David’s model; it serves as both necessary for diversification and a potential source of alpha.

Before Pioneering Portfolio Management, institutions typically held only public equity and bonds in their portfolios. In the U.S., asset owners tilted heavily towards domestic stocks and bonds. David believed in diversifying away from U.S. equity market risk. To diversify away from the most liquid equity market in the world, an investor necessarily accepts illiquidity. David described illiquidity as “the inevitable cousin of diversification and high-return investment opportunities.” In that sense, illiquidity is a bug, not a feature.

When David wrote about illiquidity, he saw it as an innovation – an opportunity to go where others did not.

Serious managers who attempt to identify inefficiency frequently gravitate towards relatively illiquid markets, since rewarding investments tend to reside in dark corners, not in the clear of floodlights.^[10]

By moving against the crowd, David saw opportunities to take advantage of mispricings in less efficient markets.

Because market players routinely overpay for liquidity, serious investors benefit by avoiding overpriced liquid securities, and by embracing less liquid alternatives.^[11]

To the extent David tilted towards illiquid assets, it was primarily because others did not. For those like him willing to look in ‘dark corners’, opportunities to add value were plentiful. Investing in illiquid markets requires a long duration and an ability to lock-up capital, which Yale has in spades.

Further, David’s desire to take advantage of market inefficiencies requires attractive prices. Without underpriced assets, illiquid markets would not offer strong risk-adjusted expected returns. The illiquid markets today are far more efficient than they were in 2000 and 2009 when David published his ground-breaking work.

…on Asset Allocation

Investors often cite a landmark study by Gary Brinson, Brian Singer, and Gil Beebower from 1991 to defend asset allocation as the most important driver of returns. Is asset allocation essential to investment success?  Of course.  Is it the driver of returns according to David?  Not at all.

Asset Allocation is not the driver of returns. Investors often treat asset allocation’s central role in determining portfolio returns as a truism. It is not. The…study describes investor behavior, not finance theory.^[12]

Investor behavior causes policy asset allocation to dominate portfolio returns, since institutions tend to hold stable commitments to a broadly diversified portfolio of marketable securities.^[13]

David was a staunch proponent of asset allocation, but he recognized that asset allocation drives returns in the rear-view mirror. If investors choose equities and equities outperform over time, then asset allocation mathematically dominates long-term return attribution. It’s as simple as that.

…on Active Management

While Yale’s approach relies on active management, David believed most should not try.

Investors wishing to beat the market by actively managing portfolios face daunting obstacles…Intelligent investors approach active strategies with a healthy sense of skepticism.^[14]

Active management strategies, whether in public markets or private, generally fail to meet investor expectations.^[15]

While he sought opportunities in private markets, David was fully aware of the massive hurdle to success created by the high cost required to participate.

While illiquid markets provide a much greater range of mispriced assets, private investors fare little better than their marketable security counterparts as the extraordinary fee burden typical of private equity funds almost guarantees delivery of disappointing risk-adjusted results.^[16]

Those following the Yale Model may presume David promoted active management for all. He did not. He believed that the chance of success is low and most who try will fail.

…on Private Equity and Venture Capital

It’s ironic that Pioneering Portfolio Management became ignition fuel for capital flows to private markets. Readers followed an approach of “do what I do, not what I say,” as David essentially begged all but the most well-resourced and sophisticated investors to play a different game.

In the absence of truly superior fund selection skills (or extraordinary luck) investors should stay far, far away from private equity investments.^[17]

David cites data that concludes most private equity and venture capital investors are better off investing in the public markets.

In aggregate buyout investments failed to match public market alternatives. After adjusting for the higher level of risk and the greater degree of illiquidity in buyout transactions, publicly traded equity securities gain a clear advantage.^[18]

Over reasonably long periods of time, aggregate venture returns more or less match marketable equity returns, indicating the providers of capital fail to receive compensation for the substantial risk inherent in start-up investing.^[19]

Importantly, David saw private equity and venture capital as opportunities to generate high returns without corresponding diversification benefits.

Because of the strong fundamental links between private equity investments and marketable equities, private equity provides limited diversification to investors.^[20]

In other words, if just showing up doesn’t add diversification and you can’t play to win, you better be careful playing at all.

…on Rebalancing

David believed rebalancing was an important risk management tool to ensure a faithful adherence to a policy portfolio. However, he saw rebalancing as a cost center, not the return enhancer many believe it to be.

Investors hoping to profit in the short run from rebalancing trades face nearly certain long-run disappointment. Over long periods of time, portfolios allowed to drift with capital market returns tend to contain ever increasing allocations to risky assets, as higher returns cause riskier positions to crowd out other holdings. The fundamental purpose of rebalancing lies in controlling risk, not enhancing return.^[21]

All followers of the Yale Model preach the importance of rebalancing. I suspect those who also understand David’s rationale behind the activity will be better positioned to implement effectively without a goal of return enhancement.

What David Didn’t Say

The well-followed gospel of Swensen changed the face of the investing world. Internalizing and implementing his approach, however, is as difficult as outperforming the markets.

I wish David was here to revise his work again. His revised edition includes valuable applications of his principles to market events in the decade after the original publication. The lessons he could have taught from the financial crisis and the fifteen years since would be worth their weight in gold. I would love to know what he thought about social media, artificial intelligence, ChatGPT, private credit, late-stage venture, and everything else new under the sun.

Sadly, we no longer can benefit from David’s updated wisdom. Throughout Pioneering Portfolio Management, David alternately refers to those who follow his approach as “sensible investors”, “serious investors”, “careful investors”, “thoughtful investors”, and “effective investors.”

Where can we find words of wisdom from practitioners who have demonstrated those adjectives over the test of time? 

There are many who can fill that void, even among guests on the podcast. I’ll suggest two who both learned at David’s feet and have spent decades honing their adaptation of the model – Andy Golden and Seth Alexander. Andy, who will retire next year after thirty years at Princeton, shared his approach on an early Capital Allocators podcast. Seth, whose only two jobs have been at Yale and MIT, commemorated ten years and fifteen years at MIT and recently wrote an introduction to a chapter in the seventh edition of Graham and Dodd’s Security Analysis. Each piece is a brilliant, personalized extension of David’s first principles.

I drafted a follow-up blog reading into David’s words to learn how he might have approached topical issues like inflation, hedge funds, and private credit. My dear friends, former colleagues at Yale, and thoughtful investors Casey Whalen and Paula Volent reviewed the draft and both warned me from making any attempt to channel David from above. They were exactly right; I’ll leave the game of telephone to you.

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[1] David F. Swensen, Pioneering Portfolio Management, Fully Revised and Updated, 2009 edition, page 55.

[2] Ibid, page 59.

[3] Ibid, page 5.

[4] Yale University Investments Office: February 2015. Josh Lerner, Harvard Business School Publishing, page 16.

[5] Swensen, page 5.

[6] Ibid, page 4.

[7] Ibid, page 5.

[8] Swensen, page 296.

[9] Ibid, page 7.

[10] Ibid, page 82.

[11] Ibid, page 54.

[12] Ibid, page 51. Swensen cited Brinson et al in his first edition and a 2000 study by Roger Ibbotson and Paul Kaplan in the second edition.

[13] Ibid, page 97.

[14] Ibid, page 73.

[15] Ibid, page 7.

[16] Ibid, page 7.

[17] Ibid, page 224.

[18] Ibid, page 223.

[19] Ibid, page 235.

[20] Ibid, page 220. David’s definition of private equity included both leveraged buyout and venture capital strategies.

[21] Ibid, page 71.

About twenty years ago, I sat down with a leading long-short hedge fund in Korea. The portfolio manager spent forty minutes offering an articulate bull case for Samsung, in which he had a 20% long position. When he finished his impassioned presentation, I responded with a single question: “That sounds great, but why are you net short Samsung?”

The manager had a long book comprised of individual stocks and a short book comprised of KOSPI index options and futures. Samsung comprised 40% of the KOSPI index. His fund was 100% long and 60% short, so despite the seemingly large 20% long position, he effectively had a 24% short position through the index and was 4% net short his favorite stock. The concentration of the KOSPI index was wreaking havoc on his bottom-up stock approach to security selection and position sizing.

Since the GFC, the underperformance of active managers has been a repeated refrain. Index funds have been the beneficiaries, with Vanguard leading the pack and overseeing $7 trillion in assets. The flow of funds to indexes has also been the correct market call; the S&P 500 compounded at 12.2% for the last five years and 13.8% over the last fourteen, far surpassing most markets around the world and its long-term returns of 10.9% over the last fifty years[1].

The driver of this soaring index performance has been the magnificent seven.[2] These technology-enabled businesses emerged as the winners of the internet, capturing the lion’s share of all the economics created from the technological revolution. Their business success translated into stock performance as well. In an extreme example, in the first half of 2023, the mag seven comprised 95% of the performance of the S&P 500 and 70% of the MSCI ACWI.

After this incredible run, the mag seven comprises 25% of the S&P 500 and 18% of the MSCI ACWI. To put the dominance in perspective, the market cap of Apple today is larger than that of the entire Russell 2000 Index, and the mag seven weighting in the NASDAQ is so high (51%) that the index had to rebalance away from the stocks.[3] The S&P 500 and MSCI ACWI have experienced similar concentrations in the past but never has the concentration been in the hands of stocks with roughly the same risk factors – in this case large cap, high beta, growth, and technology.

As a result, active management today comes down to a single decision – how much do you own of the mag seven.

Many managers have a large position in one or more of the gang, but few have 25% of their portfolio invested. All the work of active managers that goes into creating an investment philosophy, searching for uncovered gems, conducting deep fundamental research, exercising sound decision making, and constructing rigorous portfolios is dwarfed at the end of the day by a single decision.

This setup has me thinking about first principles of an allocation to equities. Stated as a question, what are investors trying to capture by owning U.S. stocks? The purpose of the allocation is to benefit from diversified exposure to the U.S. or global economy, which raises another question: Is such a significant concentration in large, growth-oriented, technology companies achieving that objective?

Jack Bogle said the beauty of a cap-weighted index fund is it provides the purest representation of an economy as measured by the market. The mag seven certainly dominates the U.S. economy today, so he might conclude that it is what it is.

In recent weeks, I’ve had several conversations with CIOs who inquired how others are managing the underperformance of their U.S. equity managers. I don’t think diversified portfolios benefit much from having 25% of their U.S. equity exposure invested in a highly correlated basket of names. Most others agree. These CIOs are shrugging their shoulders and thinking about equal-weighted indexes, recognizing that their desired high active share is synonymous with a significant underweighting in the mag seven in a cap-weighted index. At the same time, that active share is resulting in significant underperformance.

Those seeking analogs to the dilemma can consort with their peers abroad. Raff Arndt from Australia Future Fund and Tom Joy from Church Commissioners Pension Fund in the U.K. both shared on the Capital Allocators podcast that the biggest driver of their returns each year is the decision of how much to hedge their home currency, as their global assets have lots of USD and EU exposure, but their liabilities are denominated in the AUD and GBP, respectively. They know they can’t get this right all the time but recognize that it still has the biggest impact on their results.

Active management in the U.S. today is the same.[4] The winners will make the right call on their allocation to the mag seven, and that’s about it. The entire investment process and the typical importance of behavioral, analytical, informational, or technical edge will be swamped by that one decision when assessing returns for the foreseeable future.

Few profess to have an edge on these types of decisions. Rather than diving in to develop a false sense of security, the lessons from peers abroad and stock pickers in emerging markets with concentrated indexes is one of communication. It’s less about what to do and more about how to educate your constituents on the choices at hand and expected outcomes to come.

Proper communication is necessary because the one decision will in fact determine relative performance in equities. It’s a very different dynamic than any I remember in this country, but it’s the same one that the manager in Korea faced twenty years ago.

One thing is for sure – communication and understanding is what gets us to the other side. The naivete that led that Korean manager to get net short his favorite name was not a good look irrespective of what happened with Samsung stock.

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[1] MSCI ACWI ex-US 5.4% and MSCI EM 4.0% over fourteen years ending 7/31/23. Data: FactSet via AJO Vista.

[2] Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, Meta Platforms

[3] https://www.forbes.com/sites/bethkindig/2023/07/28/nasdaq-rebalance-what-you-need-to-know/

[4] And to a lesser extent globally as well.

Back in 1994, I was overseeing Yale’s boring, internally managed bond portfolio. We benchmarked the portfolio to the Lehman Brothers Government Bond Index and occasionally sought to add value buying securities with the same characteristics as a bond at a discount. [1] One example was the Morgan Stanley Government Income Trust (“GVT”) a closed-end fund comprised of securities backed by the full faith and credit of the U.S. Government that traded around a 10% discount to net asset value (“NAV”).

Closed-end funds are one type of permanent capital vehicle. The manager of the fund does not offer redemption rights to investors.[2] Instead, closed-end funds are publicly listed on an exchange, and investors get liquidity by trading shares. When we found a good manager trading at a discount at Yale, we supplemented our long-only portfolio with closed-end funds investing in domestic equities, international equities, and fixed income. GVT was my first professional involvement with a permanent capital vehicle.

Permanent capital vehicles are a dream for money managers. Whether markets go up or down or investors fall in or out of love with their strategy, the assets can’t leave. Managers can play for the long term without worrying about interim liquidity needs that almost everyone else in the industry faces. Even ten-year private capital strategies end up buying assets with longer durations than the funds can hold.

From an allocator’s perspective, permanent capital vehicles make intuitive sense, aligning the duration of their underlying investments with that of their spending needs. Universities educating scholars for centuries, foundations supporting humanity, sovereign wealth funds supporting citizens for generations, and pension funds doing the same for retirees have an incentive to optimize their return potential by matching the duration of their assets and liabilities. Continuation funds initiated from investors’ desire to hold great assets rather than watch GPs flip companies from sponsor-to-sponsor, incurring frictional costs along the way.

I currently invest in three permanent capital vehicles that offer different, attractive features.[3] Two are public vehicles with the permanent capital label, Bill Ackman’s Pershing Square Holdings (PSH.LN) and Blue Owl Capital (OWL), and one is a private equity strategy, Brent Beshore’s Permanent Equity. PSH offers Ackman’s strategy with a little leverage and trades at a significant discount to NAV. OWL is a public asset manager that oversees $140 billion and collects fees on three permanent capital strategies. Permanent Equity is a twenty-five-year life private equity fund that pays out free cash flow annually and owns businesses with no intention to sell.

The problem with so-called permanent capital vehicles is that most aren’t permanent at all. Closed-end funds tend to trade at discounts to NAV and are subject to pressure from shareholders to narrow or eliminate the discount. For example, Bill Ackman regularly buys back shares of PSH, each time increasing NAV per share but effectively redeeming a small sliver of AUM in the process. Brent Beshore’s funds are effectively permanent capital, but neither he nor I know what will happen at the end of the quarter-century term described in the fund documents.

Another challenge with permanent capital vehicles arises when people are involved, which is always. The media recently reported about strife inside Blue Owl. The leaders of two of its divisions, Owl Rock and Dyal, apparently aren’t getting along and may part ways. I have not read Dyal’s fund documents, but I imagine investors could have a key man provision that triggers a withdrawal right if its founder Michael Rees departs.

The potential for change within an investment organization poses an underwriting challenge for allocators considering a permanent capital strategy. In private equity and venture capital, GPs sign on to manage a fund for a decade even though the average length of a marriage in the U.S. is significantly shorter. Permanent capital vehicles take it even further in assuming individuals driving the investment strategy will be around their seat “until death do us part.”

Let’s not forget that allocators are people too. The organizations they represent may own assets with a perpetual life, but the individuals making investment decisions on behalf of the institutions are anything but eternal. Charles Skorina reports that only about a third of the top one hundred endowment CIOs have held their role for a decade or more, and the average tenure is under six years.[4] As Jeremy Grantham pointed out long ago, job risk is the biggest risk in institutional investing.

Despite the messiness of the concept, permanent capital, or at least longer duration capital than others, provides a competitive advantage that allows a manager to persist through market cycles and organizational challenges in an industry whose time horizons are shorter than everyone believes they should be. And whether a feature or a bug, permanent capital vehicles are one way for allocators to reduce behavioral bias in decision making.

If I recall correctly, GVT held $800 million in assets and its manager, Raj Gupta, ran a multi-billion-dollar open-end fund side-by-side. Through a series of persuasive private letters, David Swensen convinced the Board of the closed-end fund to merge the vehicle into the open-end fund and eliminate the discount.

In the blink of an eye, the permanent capital vehicle was gone.

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[1] Yes, it was a while ago. The index became the Barclays Index after Lehman’s bankruptcy.

[2] This is a simplification. Closed-end funds may have tender offers and other mechanisms for shareholders to redeem at NAV. The prospectus for each one contains the liquidity rights. Not investment advice!

[3] Not investment advice!

[4] Charles Skorina & Company, Endowment Performance Rankings 2020 – Strange Days, 5/1/21.

I ask every guest on the podcast “What is your biggest investment pet peeve?” 

Mine is investors who express absolutes in a world of probabilities. The late Peter Bernstein defined risk as “you don’t know what will happen,” adding “even when you think you do.” There’s a fine line that investors walk between conviction and humility, but those who believe they know the future without a shadow of a doubt fall a notch in my estimation.[1]

At the end of my last blog, Playing for Tomorrow, I shared a series of opportunities and risks that I believe have a greater than 50% chance of occurring. But the truth is I don’t know what the future holds. Of course I don’t; It sounds so obvious when I say it that way. Yet every day we see market participants behaving as if they do. It’s what forms bubbles in markets and what makes for great television on CNBC.

I thought about the important investment phrase – “I don’t know” – when reading a Bain & Company study on the private wealth market. Matt Brown from CAIS shared mind-blowing data about the tidal wave of capital coming to alternatives from the channel on the podcast last year. However, when Bain asked wealth managers for the names of firms that offer alternative investments, here is what they found:

I would have presumed that Blackstone, Ares, KKR, and other alternative asset market leaders were already well-known brands in the democratization of alternatives, but the playing field is either wide open or a firm called I Don’t Know Asset Management is secretly crushing it.

Turning to investing, here’s a set of questions I’ve been thinking about for which “I don’t know” is my best answer:

Are High Levels of Government Debt Sustainable?  I don’t know. In their 2009 book This Time Is Different, Carmen Reinhardt and Ken Rogoff made the case that countries hit an economic slowdown and intractable debt spiral when their debt-to-GDP rises above 90%. Along these lines of thinking, Stanley Druckenmiller recently said, “The debt ceiling is like sitting on the Santa Monica pier and you see a thirty-foot wave and you're worried about it. There's a two-hundred-foot tsunami ten miles out, but all we talk about is the wave.”[2] The interest on the debt consuming the Federal budget down the road sounds like a big problem waiting to happen, but is it really as straightforward as Druckenmiller believes? Setting aside the fact that Reinhardt and Rogoff’s data set and analysis had errors, the debt in the U.S. and many other countries around the world has been well above those 90% levels for a long time.[3] Why hasn’t it come to roost yet when markets generally do such a good job at discounting the future?

Is Asset Allocation the Most Important Driver of Returns? I don’t know. Capital allocators anchor their portfolios on the belief that asset allocation is the most important driver of returns. The famous Brinson study from 1986 stating that asset allocation drives 90% of returns has been interpreted in ways the study never intended. The research used a backward-looking return stream to conduct performance attribution across investment policy, market timing, and security selection.[4] Nothing about the study indicated that asset allocation would determine future returns. In fact, the same proponents of asset allocation as a driver of returns often dismiss anyone’s ability to time markets. If you don’t know which asset class will outperform and can’t time markets, how can asset allocation be useful as the most important driver of future returns?

Some aspects of mean-variable optimization models make sense. For example, stocks need to earn a risk premium over bonds over a long period of time for capitalism to function. Then again, institutional policy portfolios with long-term horizons are regularly adjusted every year, hardly giving credence to the policy set last year as one for the long-term. Asset allocation is a wonderful communication tool and a useful way to describe returns in the rear-view mirror, but I don’t know if it makes sense to put that stake in the ground that asset allocation matters most for institutional portfolio outcomes.

What Happens Across the Food Chain of Capital in a Slowdown?  I don’t know. Last year public markets sold off, particularly in the technology sector. Concurrently, the well ran dry for late-stage venture companies. The combination of the public market decline (denominator effect) and prior private market boom in 2021 (numerator effect) left the allocator community slowing the pace of their commitments to private equity and venture funds and reducing the size of the commitments they do make.

What happens when companies need more capital?  Will the dry powder already in the hands of private market managers fill financing needs or will we see a wave of bankruptcies?  If the latter, what effect will that have on other assets across the food chain of capital?

Where Will the Stock Market Go?  I don’t know. Predicting if the stock market will go up or down in the near term, medium term, or even the next decade is a folly.

Here’s a fun story that brings that to light. When Warren Buffett and I made our ten-year charitable bet pitting hedge funds against the market starting in 2008, we split the future proceeds of the bet and bought a zero-coupon bond that would mature ten years later for $1 million to be awarded to the winner’s chosen charity. The bet became the headliner for longbets.org, a non-profit created to improve long-term thinking. Alongside our respective arguments, anyone could comment on the bet. The consensus from the public at the time was that we were both stupid for putting the proceeds of the bet in a Treasury bond. We were castigated for hurting the charities, who obviously would benefit by having the money in the stock market, Berkshire stock, hedge funds, or anything else that would compound capital over the decade by far more than the risk-free bond in a risk-seeking world.

That’s not how it played out. A year into the wager the financial crisis hit, rates dropped to zero, and the long-duration zero-coupon bond was one of the highest-performing investments available at the time. About halfway through the bet, we sold the bond for close to par and bought Berkshire Hathaway stock, coincidentally a few months before Warren bought back shares for the very first time. By the end of the decade, our intended $1 million had grown to north of $2 million, far surpassing either side of our carefully thought-out investment strategy in the bet. Everyone thought we were stupid, but they were wrong. I didn’t know where the market was heading then, and I don’t know now – up or down, by a little or a lot, with volatility or calm.

Is Private Credit an Opportunity or a Risk? I don’t know. Marc Lasry spoke on the podcast about an attractive opportunity to earn 12-14% making senior secured loans to mid-sized private companies because of a dearth of capital available from banks. That sounds like an amazing risk-reward, but it’s probably not sustainable. The economy can’t function with that cost of capital and would experience a wave of defaults. After taking into account the potential for losses from defaults, is private credit an opportunity or a risk? 

Additionally, I don’t know if liquidity is an asset or a liability in private credit. Tony Yoseloff made a compelling case for the value of opportunistic credit in institutional portfolios based on its steady yield to assist with annual spending needs. On the other hand, when the Fed’s liquidity tap runs dry and capital stops flowing into private credit, I don’t know who holds the bag when companies, money managers, and institutional pools of capital need to get out.

When Does This Get Easier? I don’t know. I like to say, the hardest day to invest is always today and the May 2023 version of today is no different. If there’s one consensus from my conversations with practitioners, it’s that uncertainty is at an apex. It’s a good time to remember that “I don’t know” is a valuable response to almost any investment question.

Before closing this out, I’d like to turn to a personal uncertainty that, at age 52, has been on my mind as of late. In the past year, we lost great investors David Swensen, Danny Offit, Randy Kim, Sam Zell, and many others. These four men were my most cherished mentor, two valued peers and friends, and the most popular guest on the podcast, respectively. It has me thinking about the most existential question of them all.

What Happens to Us When We Die? I used to be afraid of death. While out in the mountains with Michael Mervosh and the Hero’s Journey Foundation several years ago, I looked around and saw that everything in nature regenerates itself when it dies. I asked myself “Why won’t we?” 

I realized my fears of death were based on a belief I held, with certainty, that when we die, we are alone in eternal nothingness. No wonder I was so afraid of death. In that moment in the woods, I realized the flaw in my foolish certainty and replaced the belief with a range of uncertain possibilities, including the polar opposite of my prior belief that we will regenerate in many future lives for eternity. The alternate nodes on the probability tree of life lifted my spirits with optimism and has reduced my fears ever since.

I don’t know where David, Danny, Randy, and Sam are now. I want to believe they are living their best lives with a newfound level of consciousness and wisdom unattainable on Earth. If that is the case, I’d bet Warren again that they’re laughing at how much we think we know.

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[1]It’s not just in investing where my pet peeve runs amok. My wife would happily share her frequent frustration from my oft-repeated response “Maybe” to anything she expresses with certainty.

[2] https://uscmarshallweb.s3-us-west-2.amazonaws.com/assets/uploads/s1/files/keynote_speech_of_stan_druckenmiller_at_the_37th_usc_marshall_center_for_investment_studies_annual_meeting_may_1_2023_hdmqn6eb4m.pdf

[3] https://theconversation.com/the-reinhart-rogoff-error-or-how-not-to-excel-at-economics-13646

[4] Determinants of Portfolio Performance, Gary Brinson, Randolph Hood, and Gilbert Beebower, Financial Analysts Journal, July-August 1986.

What return was available on a 5-Year U.S. Treasury two years ago?

Observing market conditions, you might have said 0.8%. That was the paltry current yield on a 5-Year U.S. Treasury at the time.

Is that the answer? 

Yield-hungry investors like SVB thought so. They scooped up what yield was available and extended duration to earn more, like doubling expected returns to the 1.6% yield on a 10-Year.

They were wrong.

If we held cash in lieu of that tiny yield two years ago, waited for better opportunities, and bought a Treasury today with three years of duration remaining until maturity, we could have earned 2.2% over the five years (0% for 2 years, 3.6% for 3).

Limiting an assessment of returns only to market conditions in the moment fails to consider the wide range of possibilities of what might happen in the future.

The dramatic change in recent market conditions reminded me of a piece I wrote back in 2006 about the potential disappearance of the abundant liquidity available in markets at the time. It proved prescient when the financial crisis froze credit markets two years later. My favorite excerpt from the piece is a quote from Seth Klarman at Baupost, who brilliantly articulated this concept in his annual letter twenty years ago.

One of the biggest challenges in investing is that the opportunity set available today is not the complete opportunity set that should be considered. Limiting your investment opportunity set to only the one immediately at hand would be like being required to choose your spouse from among the students you met in your high school homeroom. Indeed, for almost any time horizon, the opportunity set of tomorrow is a legitimate competitor for today’s investment dollars. It is hard, perhaps impossible, to accurately predict the volume and attractiveness of future opportunities; but it would be foolish to ignore them as if they will not exist.[1]

In absence of good present opportunities, holding cash has enormous option value. That’s easy to say, but not easy for many to do. Accepting low returns in the short term is structurally untenable for many investors. Most answer to clients and feel pressure to deliver relative to their peers. Chuck Prince, the CEO of Citi during the financial crisis, famously said “As long as the music is playing, you’ve got to get up and dance.” He was maligned for the seemingly stupid statement at the time. But in retrospect, Prince underscored a fundamental truth about what it takes to succeed in the asset management business.

I mentioned at the end of Short-Term Gain, Long-Term Pain, Part 2 that things are about to get interesting. Here are five changes in the investment landscape that I believe may happen with a greater than 50% probability and reasonable confidence:[2]

1. Static or higher interest rates increase the appeal of fixed-income investments.
2. The shift away from U.S. dominance as a global hegemon favors international markets over the U.S.
3. Long-short equity hedge funds earn higher returns than expected, fueled in part by a market that has either never experienced or forgotten about short rebates.
4. Contraction in lending from banks increases the volume and speed of start-up failures.
5. Higher corporate default rates hurt returns to existing private credit portfolios, while simultaneously increasing prospective returns on new loans.

And six more where I believe the odds are even more likely to occur, defined as 75% probability:

1. The movement to reduce carbon emissions causes an attractive secular beta in environmental markets (listen to Colin Campbell on Capital Allocators to learn more).
2. U.S. small-cap value stocks outperform.
3. Commercial office real estate prices have a prolonged slow decline, as leases rolling over across the next 5-10 years reflect the post-Covid working world.
4. Private equity-owned businesses have a significant negative re-rating due to softer economic conditions and a higher cost of capital.
5. Less correlated, idiosyncratic assets like sports teams and tax assets catch a strong bid by institutions. (listen to Arctos and Parallaxes on Capital Allocators)
6. Institutional capital gravitates to investments in empty rooms, including opportunities with known risks in unconventional geographies like Venezuela or Africa, out-of-favor sectors like biotech, and misunderstood assets like CLO equity or taxes. (Search for ‘Empty Rooms’ as a Topic on the Capital Allocators search page.)

Some of these ideas may offer opportunities. Others suggest risk. As always, price matters and from time to time may reveal disparities between what I see and what others do.

The hardest day to invest is always today, and today is no exception.

I am holding a bunch of cash as I watch tomorrow’s opportunity set unfold. Sitting on cash could have been extremely valuable two years ago, and it remains so today. Cracks in the surface are starting to appear, and I suspect deeper ones are coming.

It sure is a lot easier getting paid 4% to wait than accepting a whole lot of nothing.

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[1] Seth Klarman, Baupost Limited Partnerships 2003 Year-End Letter

[2] Tip of the hat to Michael Mauboussin for his recent piece Confidence, which discusses the difference between probability and confidence and the importance of both.

David Swensen lived and breathed long-term investing. From his license plate ENDOW to his aphorism “Don’t be so short-term,” David walked into the office every day with a mindset that embodied Yale’s perpetual time horizon. The issues I raised in Short-Term Gain, Long-Term Pain three weeks ago would have resonated with him.

Since then, the collapse of SVB revealed another example of long-term pain inflicted by short-term gains. The conditions leading to the bank crisis included violations of two of David’s beliefs - invest according to first principles and take risk only when receiving adequate compensation. 

Yale’s Fixed Income Portfolio in 1994

In 1994, part of my job at Yale was managing the bond portfolio. Its purpose was to protect the endowment against periods of deflation. David built a portfolio true to that objective comprised almost entirely of long-duration Treasuries and seasoned agency mortgage-backed securities backed by the full faith and credit of the U.S. Government. The only deviations from that model were security-specific opportunities to get paid for illiquidity without taking any interest rate or duration risk. We owned a stripped Brady bond[1] and a closed-end fund trading at a discount[2] as examples.

My role was paper-intensive and kind of boring, but the capital market environment that year was one for the ages. The Fed hiked interest rates seven times, doubling short-term rates from 3% to 6%. That move led to blowups in mortgage funds (Askin Capital), public pensions (Orange County, CA), and emerging market debt (Tequila crisis). Innovations sprung up that became the predecessor to structured credit - crafty derivatives to dissect mortgages, interest rate swaps to hedge risk, and other funky securities borne out of Wall Street.

David would have none of it. When the fixed-income world got thrown into a tizzy, you wouldn’t have known if you sat on the desk with me. We stayed the course with our approach and made one trade a month to rebalance. We looked for enhancements to the portfolio, didn’t find any, and carried on our merry way.[3] That year, our bond portfolio performed near the top of the charts. Boring was beautiful.

The Opposite of Yale - Smooth Return Fixed Income Management

Last week on a panel discussing the banking crisis, the head of a large private credit shop discussed the repositioning of their portfolio to take less risk for similar returns than recently available by moving up in the capital stack of corporate issuers. The CIO of a mega private bank also on the panel agreed with the moves.

That approach is one David would have thrown up all over. The strategy begins with an output – deliver smooth returns for clients – instead of an input from a first principle. In fact, it’s the opposite of a sound strategy; It’s called “buy high, sell low.”

When markets ignored risk and offered scant compensation, the manager took more risk and stretched for returns by moving down in the capital structure. Now that risk surfaced, the market is scared, and commensurate rewards are higher, he chose to take less risk. This approach may generate smooth returns, but it fails to optimize risk-adjusted return through a cycle. I was afraid to ask what pain the clients realized along the way.

Yale’s Securities Lending Book in 1994

I also oversaw Yale’s equity securities lending book at the time. Securities lending was a nice activity to add a little value to the stock portfolio. For a primer, we lent out stock held by growth managers (a.k.a. short sale candidates desired by hedge funds to borrow) and received cash collateral for the securities. We paid interest on that cash (the “Short Rebate”) of around Fed Funds minus 0.50% and reinvested the proceeds in AAA-rated credit on a short-term basis that matched the duration of the loans. We earned a spread of around 0.75% (AAA yield – Short Rebate), which could be decomposed into the “lending spread” of 0.50% (Fed Funds – Short Rebate) and the AAA-credit risk premium of 0.25% (AAA yield – Fed Funds). We achieved that return with no duration or interest rate risk. It was the kind of small thing David found in markets a hundred different ways that added up to meaningful value-added for Yale above its external manager returns.

During the year, the niche market of securities lending changed. Competition came in from custody banks, whose clients were previously unaware of the opportunity. Custodians conducted securities lending on behalf of their clients and split the proceeds 50/50. The increase in supply of securities available to borrow caused an increase in the short rebate and commensurate reduction in the lending spread from 0.50% to around 0.25%. At the same time, the custodians took more credit risk on the reinvestment of proceeds than we did. Although the true value of their services came from only the lending spread, the clients weren’t sophisticated enough to understand they were also paying a 50% carry on a credit risk premium.

What did David do when the once-lucrative business got less attractive, and others were taking more risk than he felt was prudent?  

He exited the business.

David believed that corporate bonds weren’t worth owning most of the time. In fact, he wrote his PhD thesis on the subject, concluding that corporate bonds failed to offer the safety characteristics of U.S. government bonds or the upside of equities.[4] Our re-investment of securities lending collateral in AAA-rated credit was about as much risk as he would accept. When the return attribution from the program shifted from favoring the lending spread to the reinvestment of proceeds, he said “No, thanks.” If only others running large books of assets and liabilities behaved the same way.

The Opposite of Yale - SVB Balance Sheet Management 

SVB was a beloved bank. They served the venture community, offered terrific client service, made loans that others wouldn’t, supported decades of innovation, and thrived alongside the growing venture ecosystem for 40 years.

They also managed their balance sheet the opposite of how David would have. When reinvestment opportunities dried up in a low-rate environment, SVB didn’t exit the business. On the contrary, they extended duration and assumed unhedged rate risk despite paltry returns available. Like many short-term focused strategies, it worked until it didn’t.

What Would David Do Now?

It’s one thing to point out problems. It’s another to suggest action. As frequent podcast guest and macro strategist James Aitken likes to say, “So what?” and “Now what?”

Times of great stress present opportunities. Warren Buffett says when the tide goes out, we find who is swimming naked. That’s true a little bit, but most of the time we need to look closely just to see if the color of a money manager’s trunks is what we thought it was (for those still clothed).

It’s time to sharpen our pencils on first principles because things are about to get interesting. Re-underwrite a manager’s competitive advantage in sourcing, due diligence, decision-making, portfolio construction, and risk management. When a manager finds an opportunity in the mess and calls for the ball, confirm that their first principles resonate with the opportunity set and be ready to pounce.

That’s what David would do.

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[1] Before the days of CDS, fixed-income managers did not have mechanisms to take single-country risk in emerging markets. The Brady Bond program helped emerging markets raise debt by packaging local country risk on interest payments with a U.S. government guarantee on the principal. We were shown an opportunity to own the principal-only at a discount to the same U.S. government issue because a money manager wanted Philippine country risk and was willing to pay a premium.

[2] The closed-end fund we owned was a plain-vanilla portfolio of fixed income backed by the full faith and credit of the U.S. trading at a 10% discount to NAV run by a manager at Morgan Stanley who had a substantially larger open-end fund side-by-side. We became the largest owner of the closed-end fund and quietly urged the manager to combine it with the open-end fund, removing the discount.

[3] I had a chance to bid on Orange County bonds and got outbid by others who paid up for the novelty value of the issue.

[4] The dissertation is entitled A Model of the Valuation of Corporate Bonds. I never read it, but David shared the thesis liberally. It’s apparently still available in library archives on microfiche.

Morgan Housel became one of the most popular investment writers by telling stories about the psychology of money and markets – the same today as it’s ever been.

Sometimes that knowledge can elicit positive change. Sophisticated institutions can build processes to increase their awareness of behaviors that might comprise optimal decisions. More often, we repeat the same patterns of behavior, which is why Morgan has so many stories to share.

Short-termism and self-interest are two behaviors that can combine to create long-term problems. The unwillingness to accept short-term pain for long-term gain alongside systems set up to reward short-term wins have contributed to some of the most significant challenges we face. In an homage to Morgan, I’ll share some stories using this lens that got me thinking about retirement benefits, obesity, and climate change.

Retirement Benefits

Social Security shortfalls in the U.S. are beginning to make headlines. As Roger Lowenstein describes in Everyone Wants to Save Social Security, the Social Security Trust is nearly depleted. A demographic shift over the last seventy-five years created a math problem that needs to be solved. At its core is a change in employee demographics without a commensurate change in promised benefits. Lowenstein points out that “in 1950, 16 workers were contributing to the system for every beneficiary. Today…the ratio is 2.8 workers for each beneficiary.” A system designed for many current workers to support fewer retirees doesn’t work when the country’s demographic profile shifts so dramatically.

Public pensions are also underfunded.[1] For many years, politicians have favored other spending and entitlements over funding to support retirement schemes. Rather than make hard current tradeoffs necessary to support long-term retirement benefits, governments engaged in accounting trickery to pretend pension funding was sufficient.

The self-interest of politicians to stay in office and avoid short-term pain created this mess. No politician wants to raise taxes or cut benefits to address retirement funding gaps. Even admitting an intractable future problem exists is politically unpalatable.

The amount of retirement benefit reduction and budgetary spending cuts required to right these ships has grown too large to solve in one fell swoop. Each year that goes by, the deficit expands. So what will happen when retirement funding runs out? 

Sadly, I think I know. Inertia is a powerful force, and one body in motion since the financial crisis is our familiarity and comfort with borrowing money to avoid pain. Not enough money to fund Social Security – no problem, we’ll borrow more.  Not enough for the retirement of teachers and civil servants – no problem, we’ll borrow for that too.

Before the last fifteen years, it would have been unthinkable to borrow money from the future to support today’s retirees. Today, it’s not only imaginable but likely to happen absent a significant change in behavior from our political leaders.

Obesity

My wife Vanessa recently returned from a vacation in Mexico. In the airport on the way home, she walked into a convenience store with snacks for passengers that she described as “Mexico’s Hudson News.”

Vanessa texted me from the store in shock at what she saw. The top half of the label on every food product in the store contained government-mandated warnings about excess sugar, calories, sweeteners, and caffeine on any applicable product sold. Here’s an example:

Unlike Hudson News at JFK, Vanessa balked at buying food with an in-your-face reminder of its health risks. That deterrent covered nearly the entire inventory in the store. She settled on unsalted nuts for the flight home.

Obesity is one of the most significant health issues in America. It would seem obvious to improve our collective wellness by enforcing health warnings on consumables. But can you imagine such measures getting past powerful corporations and lobbyists in the U.S.?

Once again, self-interest overpowers the greater good. Short-term gain, long-term pain.

Climate Change

Carbon emissions have been warming the planet for a long time. Weather patterns and factual research got brushed aside because intangible externalities in the distant future are a difficult concept to grasp and fund.

For some reason during the pandemic, climate risk reached a tipping point in the public discourse. What was once dismissed as a serious issue in the U.S. and elsewhere outside of Europe rose to the forefront of consciousness. The desire for action is a revolutionary change from just a few years ago; not even Malcolm Gladwell could have predicted when this would have happened. [2]

The call to action to address a long-term problem with short-term solutions is messy. ESG mashed together three different objectives and pervaded the investment landscape without consistent or clear benchmarks.[3] The movement took a pause once the war in Ukraine reminded many that fossil fuels are necessary to affect a transition to net zero emissions.

Despite the bumpy road, investment efforts to address the climate continue apace. It’s the focus of a new mini-series on the Capital Allocators podcast that starts next week. We sought out investment practitioners focused on climate solutions, including legend Tom Steyer, longstanding veteran Capricorn Group, and the most knowledgeable investors in an essential short-term solution (environmental markets) and a long-term one (nuclear energy). Taken together, these conversations share a conviction about the necessity to address the climate and opportunities to deploy capital productively.

Forces of Change

Herb Stein famously said, “If something cannot go on forever, it will stop.”

Retirement benefits, obesity, and the climate cannot survive at their current trajectory. Jeremy Grantham often cites research from GMO that every quantitatively defined bubble in market history, every single one, has eventually burst and reverted to trend. The gravitational mean-reversion of markets implies that the longer we move away from trend, the steeper and more painful the fall will be when we reach a tipping point.

I don’t know how to solve the important problems we face, but when I see three different examples of longstanding poor behavior creating serious risk, I feel compelled to share what Morgan would say, with a caveat. 

“It’s the same as ever” until it’s not.

Let’s do something about it.

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[1] https://equable.org/unfunded-liabilities-for-state-pension-plans-2022/

[2] Gladwell, The Tipping Point.

[3] See What’s in a Name? The Problem with ESG.

“Our community already knows most of what matters within the field. It’s the interdisciplinary education outside of investing that allows us to identify new sources of return.”

The hardest day to invest is always today. That investment truth seems particularly apropos today – a time managers competition has intensified and allocators are more sophisticated than ever before. In order to meet client needs, institutions will need to identify the next frontier, which I believe will come from inside organizations rather than from the external market environment. We’re here to help at Capital Allocators University.

Let’s set the table on the environment. First, assets seem priced to generate returns that fall short of spending needs. As Jeremy Grantham said on a past episode of Manager Meetings with Capital Allocators, “the market doesn’t care that you don’t have any easy or safe investments to make.” Sometimes the truth hurts.

Additionally, managers battle Michael Mauboussin’s paradox of skill. They are more knowledgeable, better resourced, and have access to more information than ever before. However, the improvement in skill level across asset management is offset by the narrowing of skill relative to other participants. Although absolute skill has dramatically increased, its dispersion has narrowed and made outperforming others more difficult as a result.

Lastly, the allocator community has blossomed in breadth and sophistication since my early days working for David Swensen at Yale. A playbook that once commonly resulted in beating return hurdles - a thoughtful investment policy, diversification beyond traditional asset classes, rigorous rebalancing, manager selection in less efficient markets, and an alignment of interest with managers - is now little more than table stakes.

Without a tailwind of beta, investment leaders need to identify sources of value-add to drive returns above spending needs. The margin of safety within portfolios appears thin, and fine-tuning elements of the investment process has become essential to minimize mistakes and squeeze out every basis point of return.

So, what can we do to reach our investment objectives?

Across over 400 podcast conversations, I have learned more from experts outside the investment field than I have from my many discussions with CIOs. I always pick up a nugget or two discussing the investment process, but in truth, our community already knows most of what matters within the field. It’s the interdisciplinary education outside of investing that allows us to identify new sources of return.

After publishing a book in 2021 to share some of these concepts, I heard repeatedly from leaders in asset management that there’s a gap in training investment professionals on the skills necessary to lead and deliver incremental returns.

So, we decided to do something about it.

We created Capital Allocators University to bring the book to life through in-person training with some of the best in the business. We learned that this training is most effective among only allocators, so we have prohibited managers and service providers from participating. We will build a community of institutional allocators and share the non-investment disciplines that strengthen their organizations and drive investment results.

Our fourth course will take place at the Harvard Club in New York City on September 14th, 2023. We will teach frameworks across four different subjects with pre-recorded interviews from an all-star roster of past guests on the show. Most important, we have created opportunities to connect and learn from each other. Learning in the company of others can be far more powerful than figuring things out on your own. We built Capital Allocators University as a community of like-minded peers. Our class cohort will engage throughout the course and stay connected once it’s completed.

We welcome you to reserve your seat in our cohort today. 

In the fall of 1998, I sat down with famed value investor Michael Price and asked what he learned from having invested in the accounting fraud perpetrated by “Chainsaw” Al Dunlap at Sunbeam Corporation. He responded, “Absolutely nothing!” [1]

Michael went on to explain a principle about frauds. When you conduct analysis on an investment, you spend 99% of your time assessing the merits of the opportunity and 1% thinking about whether what you see is real. The fraudster spends 100% of their time staying two steps ahead of you. Fraud is a risk you bear in every investment and sometimes you can’t avoid it. As he put it, “fraud is fraud.”

I thought about this when my wife and I watched Madoff: The Monster of Wall Street on Netflix last week. Bernie Madoff did not make any trades. He literally spent 100% of his time taking actions to stay a few steps ahead of everyone who got too close to the truth. Madoff exemplified Michael’s principle.

SBF committed the latest high-profile fraud at FTX. A who’s who of respected venture capitalists and entrepreneurs backed the truck to invest in a toll taker on the superhighway of crypto led by a visionary who became the pied piper in the space. The investment thesis would have played out had SBF not fraudulently removed customer funds. No one saw it coming.

Michael’s principle means that flagging a fraud in advance is rare. [2] Madoff features Harry Markopolos, the whistleblower who the SEC ignored. The filmmakers paint the SEC as stumbling badly; my wife agreed as she heard the story for the first time. However, I had watched the Ponzi scheme unravel when it happened and contend Markopolos was an anomaly. He was a former derivatives trader at the right place and the right time who happened to have the time to do the work. Follow the incentives; it won’t happen often. [3]

What the Wise Man Does in the Beginning…

Another complicating factor in detecting fraud is the most heinous acts do not always start out that way. Both Madoff and SBF began as legitimate enterprises that went awry to cover up a loss. Early backers of funds and companies often buy into an entrepreneur’s vision that includes plans for formal processes and procedures not yet put in place. Start-up money managers often do not have the resources to hire the most expensive, brand-name service providers on day one. What looks like a yellow flag in the rear-view mirror may be acceptable in the early stages of the game.

As such, diligence failures in large-scale frauds tend to come later in the game. By the time Madoff’s Ponzi scheme collapsed, a standard operational due diligence review should have picked up Madoff’s friendly local accountant, manufactured bank statements, and opacity. Venture capitalists in the early rounds of FTX bet on SBF and his vision for the business. That turned into a loser, but not because of poor due diligence. Investors in the last billion-dollar round are more culpable. Accurate financial statements and proper governance failed to keep up with FTX’s growth trajectory, and later stage investors could have scrutinized that.

Despite the difference in due diligence expectations at different stages, the industry tends to paint inappropriate, systemic black marks on diligence processes in the wake of frauds. The Madoff fraud crushed the entire institutional hedge fund of funds industry. As a participant in it, I saw a clear distinction between the lack of professionalism across Madoff’s client base and the extreme care in diligence conducted by other funds of funds that passed on or ignored the firm. Similarly, all investors on FTX’s cap table found themselves under scrutiny and issuing a mea culpa for their diligence process. Sequoia Capital’s highly publicized internal chat messages expressing their excitement about SBF is exactly the type of judgment employed by experienced, early-stage VCs. Anthony Scaramucci offers his apology on the Capital Allocators podcast next week for receiving money from SBF. I suspect that most, including Sequoia and Anthony, did not suffer from a faulty diligence process. Fraud is fraud.

It's Not Just You – I Didn’t Detect Frauds Either

What we can learn from Michael’s principle or the wise man becoming a fool is that as smart as you are, or as thorough as your due diligence process may be, you will not detect the next fraud. I should know - I had the benefit of training from the greatest mentor in the business in David Swensen and invested for two decades taking pride in my work. Despite that, I watched two people I thought I knew get on the wrong side of the law.

Sam Barai was convicted of insider trading amidst the expert network crackdown in 2011. He was the first deaf investment banking analyst, the first deaf graduate of Harvard Business School, an early employee at Ziff Brothers Investments, and a lifelong tech geek. His track record indicated he was the antithesis of someone who cut corners. And yet, he blatantly cheated. At the time, my firm was a seed investor in Barai’s hedge fund and had access to his trading records. We could see exactly what he was doing but had no idea how he was doing it. When the SEC raided his office, he told us the SEC came in for a routine review. His 99%; our 1%.

Ifty Ahmed was a section mate of mine from Harvard Business School. He was hard-working, smart, a Baker Scholar, and came from a storied family in India. In 2015, Ifty got accused by federal regulators of insider trading and his partners at venture capital firm Oak Investment Partners soon learned he had conned them as well. In essence, he would receive investment committee approval to invest $5 million in a company, tell the company Oak was investing $3 million, and pocket $2 million for himself. Shortly after, Ifty left his family behind and fled the US for India. If you had asked the eighty people in our section to force rank each other by integrity before this occurred, my hunch is Ifty would have landed in the top 10%. Turns out he was dead last.

Both Sam and Ifty were legitimately successful until they pivoted to something nefarious. Both men had stellar academic pedigrees and strong early career trajectories that were not based solely on bad behavior. At some tipping point, whatever pathology sat deep inside them surfaced and reared its ugly head.

Caveat Emptor

If you’re around the business long enough, you will inevitably observe Michael’s principle. When people you think you know do something you never imagined possible, you trace your steps and wonder what you really knew in the first place. That questioning will eventually turn to what you know about yourself. Humans are complex beings with blind spots. We can spend a lifetime uncovering our own without knowing all the answers. Is it feasible to think we can uncover the rationale for someone else’s behavior? Frauds remind us that we can never understand professional relationships with 100% certainty.

Frauds will happen again, and we won’t learn much from them. It would be convenient to think that fraud is something that will happen to someone else and can be avoided with sound due diligence, but it could just as easily happen to you and your organization.

I offer a few suggestions for how to mitigate the damage:

1. Recognize that fraud is fraud.
2. Stay vigilant. What ends up as fraud may start as a legitimate business.
3. When in doubt, stay out.
4. Diversify prudently anyway.

Of course, you can choose to turn up your dial on fraud detection from 1% to 5%, as tends to happen shortly after the revelation of a big one. That would be a mistake. It will cost you time better spent assessing the relative merits of legitimate investment opportunities, and the 5% probably won’t make a difference anyway.

Michael Price was right. Focus on what you can control and stop throwing stones at those caught on the wrong side of the left tail.

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[1] Those who remember Michael would not be surprised to learn that he added an expletive between “abso” and “lutely.”

[2] Markopolos wasn’t the only one I came across who suspected foul play. Cliff Asness told me that AQR’s hedge fund replication strategies were effective for every hedge fund index category except for “Market Neutral.” They could not model the category because they could not replicate Madoff’s returns.

[3] In public companies, short sellers have an incentive to dive in and unearth bad behavior. In funds and private businesses, no one outside of poorly compensated regulators have the motivation.

Dear Stakeholders,

“May you live in interesting times.”

– Ancient Chinese curse

I’m excited to share our third annual letter. To set the table, I’ll start with our Why.

Our mission is to Learn, Share, and Implement the Process of Premier Investors. We carry out that mission through a set of six shared values summarized by the motto Compounding Knowledge and Relationships. You can read about our values on our website, capitalallocators.com, under the subheader About.

My 9^th grade English teacher, Ms. Willner, advised to never use the words “interesting” or “nice” in composition when better descriptors are available. I thought of her when describing 2022 as an “interesting” year. It’s one of the few times I think she would find it appropriate. Across the volatility and uncertainty created by a hot war, a Cold War, and a shifting global macroeconomic regime, we had plenty to discuss, digest, and learn.

Hank, Morgan, and I alongside our partner Rahul experimented with new ideas, leaned into the ones that gained traction, and moved on from others.

With a tip of the cap to my mom, who always reads the last page of a book before the first, I’d like to start with our goals for the coming year, turn to the exciting new things we have in store, and then review our activities from this year. Let’s begin with our traditional closing phrase.

Onwards!

Internally, I refer to our activities as a series of experiments. We think of potentially productive ways to spend our time in line with our mission and take on each as an entrepreneurial venture.

As you’ll read, we experienced the lows of a failure to launch an asset management business and a rough market environment alongside the highs of growth in the podcast and new initiatives with Storytelling and Summits. In the coming year, we will aspire to achieve the following goals:

1. Make the Podcast better than ever and share valuable content with the institutional community.
2. Create Summits and CAU experiences that leave attendees thirsting for more
3. Engage deeply in the community with ideas and investments

I’ll walk you through these developments organized by our activities: events, advisory, investing, podcast, and thought leadership.

Events (Capital Allocators University and Capital Allocators Summits)

Capital allocation requires many skills beyond investing. Capital Allocators University holistically brings all these topics together to make you a more effective allocator in an environment where you can practice your new skills and grow your network.

• Carlos Rangel, CIO, W.K. Kellogg Foundation

Last year, after the release of my second book, Capital Allocators: How the world’s elite money managers lead and invest, we created a course to help allocators learn non-investment frameworks required to succeed at senior levels of investment organizations. We conducted our second virtual cohort of Capital Allocators University (CAU) this year and have now shared these lessons with 100 investors.

CAU attendees expressed a strong desire to get together in-person coming out of the pandemic. For our next cohort, we are transitioning CAU from a virtual series to a one-day seminar. CAU3 will take place for allocators only at the Harvard Club in New York City on March 9, 2023. We welcome allocators to join the cohort by registering at University.

This clear desire for high quality, in-person, peer-to-peer interactions led us to reinvigorate Capital Allocators Summits. Rahul and I conceived of the idea to bring together small groups of allocators and managers three years ago, but the pandemic curtailed those plans.

My experience attending investment conferences for a quarter century is a common one among allocators. Events are comprised of either capital introduction speed dating or high-profile speakers. Capital introduction events serve a great purpose in the industry, directly connecting buyers and sellers. That need is well covered by our friend and advisee Ron Biscardi at iConnections, whose flagship Miami event, charitable annual Funds4 virtual event, and best-in-class technology are powering the industry. Alongside iConnections, Wall Street Prime Brokerage cap intro events for hedge funds, ILPA’s gatherings for private equity, and West and East Coast industry matchmaking gatherings for venture capital do an outstanding job serving managers and investors. We see little additional value in creating a cap intro event in competition with these well-run gatherings.

On the later, I get excited ahead of time about attending an event with a great lineup of presenters, only to find my enthusiasm wanes after about an hour. No matter how good the quality of the roster, I find it hard to sit for hours, listen attentively, and learn much of value.

Covid also accelerated the availability of leading investors on-demand through videos and podcasts. It’s no longer imperative to attend a conference to hear what is on the minds of great investors. As a result, the value proposition of thought leadership events has deceased, perhaps permanently. The only true value added of these events may be the conversations that take place during coffee breaks.

When conceiving of Capital Allocators Summits, we thought of putting together an event where all the attendees participate in the room where it happens from start to finish. We set a mission of fostering great conversations and connections that emphasize learning, sharing, and implementing to compound knowledge and relationships in line with our vision statement. Our concept is to thread the needle between passive thought leadership events and one-on-one capital introduction speed dating by gathering peers to actively participate in small group discussions.

We are excited to host the inaugural Capital Allocators CIO Summit in April. The event will gather 100 senior decision-makers from allocator and manager organizations to discuss topics of interest to them. Rahul and I extended invitations to allocator CIOs and were thrilled by the response. Neither of us recalls seeing a comparable All-Star list of CIOs coming together in this way. We quickly ran out of CIO slots and started a waitlist for future Summits. Working off recommendations from the CIO attendees, we have been inviting managers to join us and are nearly sold out of those seats as well.

We are looking forward to putting on a first-rate event in April and are excited to organize more events going forward. Please reach out if you have an interest in attending one of our future Summits.

Advisory

            Since leaving day-to-day asset management, I have advised a small number of allocators on their investment strategy and managers on their business and communications strategy. A list of my advisees is available at Advisory. Each relationship has been in place for several years with people I have known for as short as a few years, with Jonathan Tepper at Prevatt Capital, to as long as over a quarter-century, with Richard Lawrence and his team at Overlook Investments. This year, I started new engagements with Fund Evaluation Group (FEG), 10 East, and Marblegate Asset Management.

FEG is a former client from my Protégé days and the most thoughtful, investment-driven, independent consultant I encountered from that time. I was tickled when Greg Dowling invited me to join their advisory board alongside highly regarded CIOs. 10 East is a start-up investment platform that arose out of Michael Leffell’s family office. Michael was a partner at Davidson Kempner for many years who retired a while back. He has been investing his capital and sharing ideas with a club of similarly experienced investors ever since. The 10 East platform shares co-investment ideas more broadly than Michael’s existing inner circle. Lastly, my longtime friend, Andrew Milgram, welcomed me to sit in Marblegate’s Connecticut office space, and I agreed to advise them in exchange.[1]

Investing

Annie Duke published Quit in October. It is a phenomenal expose on the value of learning when to quit a direction that no longer has positive expected value. In last year’s annual letter, I hinted at a new venture to start an investment fund. In January, I sent out a letter to the many of you who checked the box as an accredited investor that described a flexible vehicle to expand my personal investing.

Shortly after sending out the letter, I woke up with an empty feeling in my stomach. I anticipated that the reception to the fund would be binary – either sufficient capital would come in to allow us to build a small investment team or we would face a slog to get to critical mass. My gut told me that our non-institutional investment approach and structure did not have a natural audience in the institutional community, and we would not easily gather assets from individuals either. More importantly, I lacked the time and desire to push that boulder up the steep hill required to make it work. The activities around the podcast, events, advising, and thought leadership give me great energy. Investing does as well. Raising capital? Not so much.

I made a quick decision to set aside raising capital and see what happened. It became readily apparent that creating a fund wasn’t in the cards this time around. I considered a single strategy SPV, but again, my heart wasn’t in it enough to dedicate the time and resources required to extend my investing beyond what I do personally. So, as Annie would say, I quit.

The decision-making lessons from quitting the pursuit of an investment fund come right out of Annie’s book. First, I made an unforced error in building a pedestal before tackling the monkey. (See Chapter 6 of Quit, Monkeys and Pedestals). I spent time and resources putting together an institutional infrastructure for the fund (the pedestal) without gathering sufficient information about the receptivity of capital (the monkey). Second, and fortunately in retrospect, I quit before it was apparent to anyone else that the project would not be successful (see Chapter 2, Quitting On Time Usually Feels Like Quitting Too Early). I can’t know for sure that fund raising wouldn’t have been successful, which is the problem with quitting ‘on time,’ but I do know that shifting my focus away from the fund led to the ideas for Private Equity Deals, Summits, and LPTV (see Section 4, Opportunity Cost).

Additionally, the more time I had to focus elsewhere, the more I heard about the resonance the podcast is having in the community. It struck me that the podcast creates far more value than what I could deliver in incremental investment returns. If my sense wasn’t enough, in October I received With Intelligence’s Citizen of the Year award at its inaugural Allocator Prizes. I imagine that unexpected honor would not have happened had I spent most of my time managing a fund.

After quitting the fund launch, I put the two most important intrinsic aspects of the fund into practice in other ways. Underneath my interest in launching a fund laid my desire to stay engaged as an investor and to share my investment ideas so I could benefit my managers and like-minded allocators. On the former, I added the new advisory relationships with FEG, 10 East, and Marblegate, each of which provides active engagement with investing. On the later, our quarterly transparency report for Premium members gets the ball rolling, and our CIO Summit and future events will supercharge connecting industry leaders and investment ideas.

Podcast

The hub of our ecosystem is the Capital Allocators podcast, which passed its fifth anniversary in April. We shared 80 conversations this year that canvassed CIOs, managers across asset classes, and interdisciplinary thought leaders and included two mini-series, ten Manager Meetings, and season one of Private Equity Deals.

Private Equity Deals is a new show where leading managers in private capital strategies describe a portfolio company or recent exit. The conversations resemble those GPs typically hold with LPs behind closed doors. Each episode describes a company and deal, revealing how each GP practices their craft. If you haven’t already subscribed, search for Private Equity Deals on your favorite podcast player to listen and learn.

Podcast engagement continues to accelerate. Capital Allocators reached 13.5 million downloads at year-end, of which 5.5 million came in 2022. Our library receives approximately 100,000 downloads each week, an increase of 50% from a year ago. Apple created a new metric this year called Followers, and our show counts 47,000 at year-end. Apple’s platform comprises approximately 75% of our downloads, so we extrapolate that our community is 60,000 strong. According to Spotify, Capital Allocators spans 98 countries and is in the top 1% of podcasts followed and shared globally.

Sponsors

The podcast business is a media asset supported by both sides of the platform – sponsors and listeners. Sponsors share their message at a scale unmatched in the institutional investing industry. We believe the value proposition of building brands through affiliation with Capital Allocators is second to none. Eleven sponsors advertised on the show this year led by anchors Northern Trust and Janus Henderson Investors.

We changed the way we deliver sponsor messages in Q4. Previously when a sponsor advertised on an episode, their spot remained with that recording indefinitely. Our conversations have unusually long shelf lives. For example, the very first conversations we released five years ago still receive a few hundred downloads each month. In fact, new shows receive only 15% of total weekly downloads. As a result, we previously offered new sponsors a fraction of the listening audience’s attention. Using dynamic ad insertion, we now put new ads in the entire historical library, allowing five times the number of listeners to hear our sponsor’s message.[2]

Listeners

Listeners support the podcast through Individual and Corporate Premium membership. For the price of a cup of coffee a week (or less after inflation), Individual Premium members can access transcripts, our weekly email, previews of my blog, and an assortment of other goodies.

Our latest addition to Premium content is a quarterly report of my personal fund investments and advisory relationships. Most are with niche funds or direct investments in asset management-related businesses. We encourage our Premium members to reach out, stir conversation, and connect with managers in my portfolio.

Individual membership was roughly flat in 2022 from the prior year. Our data shows that 6% of listeners become Premium members, so we are experimenting with ways to expand the top of the funnel. Our latest initiative is a fun segment of the show called “Spread the Word” in between the introduction and interview. We hope you get a chuckle from our suggestions about how to tell others about the show.

We are especially appreciative of our fifteen Corporate Premium members. The list of these investment organizations is available at Corporate Members. This group quietly and generously supports the show without asking for much in return beyond sharing the benefits of individual membership with their team. They deserve our deepest gratitude.

Manager Storytelling

We continue to iterate on ways to help managers share their insights with the community. We receive incredible feedback on the value created for managers who appear on the show and allocators who find them. Many managers reach out to be guests on the show, but we have a limited number of slots, and I source all guests internally.

We conducted five sponsored episodes this year among those inbound requests. In each case, I prescreened and interviewed a manager that paid to appear on the show. Average downloads for sponsored episodes exceeded average downloads of non-sponsored episodes, confirming our belief that a good conversation would not suffer audience dilution solely because of sponsorship. We will expand that offering next year, focusing on maintaining a high bar for inclusion.

Our latest foray in manager storytelling is a joint venture with Jen Prosek’s Prosek Partners and Ron Biscardi’s iConnections. The three of us came together to create LPTV, a forum where I conduct video interviews with managers about their strategies and topical insights, and we distribute the video across the iConnections platform, our website, and each of our social media channels. Our first session was a conversation with Robert F. Smith, Monti Saroya, and Michael Fosnaugh from Vista Equity Partners about the dealmaking and operating environment for private enterprise software companies after the significant public market drawdown in the sector. We are excited to bring together our respective networks to share great conversations with the community next year. Interested managers can reach out to any of us to learn more.

Thought Leadership - Writing and Speaking

I poked my head out of the office this year as the world re-opened. Engaging in-person with great allocators and managers provides a rich source of topical investment insights. At times, a light bulb goes off in my head, and I put pen to paper[3] to write a blog post. I wrote seven posts this year, with my takes on Melvin Capital, ESG, and LBOs getting a lot of attention and positive, unexpected responses.[4] The posts are available at Blog.

I increasingly have been asked to speak at industry events, sometimes as an interviewer and other times as a keynote on the other side of the microphone. I’ve found both energizing and am looking forward to speaking more in the coming year.

Onwards! (Revisited)

None of this would be possible without the support of an unparalleled community of listeners, fans, and supporters. We have you to thank for our continued pursuit of compounding knowledge and relationships.

I hope to see you in the coming year.

Ted

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[1] My office is above our garage, which my wife and I affectionately call Rapunzel’s Castle from my tendency to hole up for extended periods of time. Marblegate’s office provides a wonderful local option for me to descend from the castle on occasion.

[2] New ad spots remain on the platform for three months.

[3] Technically, fingers to keyboard.

[4] Including a long conversation with Gabe Plotkin while in the mix of his dilemma, a promotion of the ESG paper by the Washington Speaker’s Bureau, and an email from a private equity legend agreeing with the LBO thesis.

The financial world is ablaze with the collapse of FTX. Not since the Bernie Madoff debacle have players in the investment profession been so exposed for failures in due diligence after a frothy market environment. Back then, hedge fund of funds awash in inflows got chastised for glossing over details in the pursuit of steady, uncorrelated returns. This time, a high-profile set of venture capitalists and entrepreneurs are taking it on the chin for having more capital than time in the pursuit of exponential gains.

When Bernie Madoff’s Ponzi scheme unraveled in 2008, we never really learned what happened. Bernie gave a few post-incarceration rants, but he went silent about the actual story. Sam Bankman-Fried (SBF) is taking a different approach and making himself available. He has posted on Twitter and sat down for several interviews last week. These interviews reveal a lot about how we gather and interpret information.

Before discussing the interviews, I think it’s important to share my perspective on SBF. I try to follow Don Miguel Ruiz’s The Four Agreements in the pursuit of happiness. The third agreement reads “Don’t Make Assumptions.” The opinions I have swing back and forth based on my assumptions, which come from what I read and hear. Without making assumptions, I believe it remains to be seen whether SBF had malicious intent from the onset or created a legitimate business that derailed due to his naivete, arrogance, or a combination of both. At this point, it appears that SBF either committed gross negligence or purposefully stole customer funds. Yet one of the most logical explanations I read for what may have happened doesn’t fit neatly into either camp and is wildly different from what is in the public eye.[1]

In forming my views, I was fascinated by my reactions to SBF’s two marquee television interviews with Andrew Ross Sorkin and George Stephanopoulos.[2] When I listened to Sorkin’s interview, I thought Sam may have been telling the truth and just screwed up. Sorkin asked poignant, direct questions, and Sam gave prompt, reasonable answers.

I had the opposite reaction to Stephanopoulos’ interview on Good Morning America. Some of the questions and answers were the same, but SBF hesitated to answer direct questions and gave the impression that he was dodging key issues. When Stephanopoulos asked about the misappropriation of customer funds, Sam stumbled and answered indirectly. Stephanopoulos repeated the question even more succinctly, seeking a yes or no answer, and SBF fumbled again. Stephanopoulos nailed two of my favorite interview techniques in that moment – asking brief questions and deploying ‘The Five Whys’ made famous by Toyota in the 1980s.

My opposite reactions to these interviews say more about the power of an interview than my verdict on SBF. As I described in Capital Allocators (the book), journalist interviews are quite different from those that I conduct on the podcast. A journalist might talk to a subject for hours attempting to pick up a single soundbite that will drive audience attention.

These interviews gave very different public presentations. Sorkin’s was an hour-long live conversation. We heard every question and every response. In contrast, Stephanopoulos’ interview was two hours long, but GMA only released ten minutes of it.

While I came away from the Stephanopoulos interview feeling that SBF was guilty as sin, I am all too aware of the power of an interview to frame thoughts. First, the interviewers’ backgrounds influenced opinions about SBF’s answers. Sorkin asked questions as a knowledgeable financial expert, and Sam answered appropriately. Stephanopoulos professed to be a crypto neophyte, causing SBF’s technical responses to sound obfuscating.

More importantly, the editing of the GMA interview to the sauciest ten minutes removed our ability to put context around what we saw. An investment analyst who sits through a day of training in truth detection learns that setting a baseline of behavior is a prerequisite for assessing the likelihood that a subject is being up-front with answers. Through its significant edits, GMA catalyzed a rapid judgement of SBF without calibration of a baseline rapport between Stephanopoulos and SBF. Sure, SBF may have purposefully dodged Stephanopoulos’ questions, but it’s also possible that SBF was uncomfortable with Stephanopoulos from the get-go and stumbled before every question Stephanopoulos asked.

The media reported that Sorkin conducted a softball interview and Stephanopoulos a hard-hitting one. What I see is the degree to which editing and seeking headlines can shape our views. In the end, SBF comes out far from innocent. My friends at AJO Vista and their partners at BIA conducted behavioral analysis on the two interviews and drew the conclusion that SBF likely wasn’t sharing everything he knows.[3] I’m left wondering what SBF chose not to disclose and why.

We spend our days conducting interviews with money managers and corporate executives. Tuning into the nuances of asking questions allows us to gather better information and make better decisions. It’s something we all can focus on and improve. It’s a framework we teach at Capital Allocators University.

As we watch more information unfold in the SBF/FTX saga, spend some time observing the meta level of how information is presented and how it influences our views. Interviews are powerful in forming our thoughts and beliefs, which we need to get right to make great investment decisions.

Another event down the road will shine another unwelcome light on due diligence failures. It’s incumbent upon us as professionals and fiduciaries to do everything we can to stay out of the dark.

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[1] Doug Colkitt, founder of Crocswap tweeted that Alameda became the patsy at the poker table among increasingly sophisticated crypto traders but nevertheless needed to keep trading and losing money to provide the liquidity on FTX that would preserve its massive enterprise value.

[2] Andrew Ross Sorkin is a demigod among financial journalists. He’s an entrepreneur, a brilliant writer, a thoughtful commentator on CNBC, and an outstanding interviewer. I am in awe of his talent and output. He conducted interviews at his DealBook conference with wide-ranging guests, each of whom is world-renowned. Imagine the breadth of his knowledge and depth of research required to pull off interviews on the same day with leading corporate executives (Mark Zuckerberg, Reed Hastings, Andy Jassy, and Shou Chew), global political leaders (Benjamin Netanyahu, Mike Pence, and Volodymyr Zelensky, economic powerhouses (Janet Yellen and Larry Fink), an actor (Ben Affleck), and then SBF to top it off.

[3] Meg Devin and Liz O’Connor, SBF Under the Microscope (Behavioral Interpretation of DealBook and Good Morning America Interviews), December 1, 2022.