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 earlier this year 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 third course will take place at the Harvard Club in New York City on March 9^th, 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.

Once upon a time, Michael Milken catalyzed the modern private equity industry by financing leveraged buyouts (LBOs) with below-investment-grade bonds. Market participants dubbed the paper “junk bonds” in the heyday of the 1980s. Much like less-marketable financial conventions like “death insurance” and “passive investing,” the moniker “junk bonds” did not resonate with all comers.^[1] The euphemism “high yield bonds” sounded a lot better, as did “private equity” for those afraid of leverage.

At times, “high” was not an apt description for the yield on below-investment-grade bonds. Yield spreads compressed in the run-up to the GFC, when troubled issues without protective covenants revealed many were junky after all. More recently, low interest rates made the “high” in “high yield” true only in relative terms.

Despite a few quirks in terminology, high-yield bonds and their cousin, leveraged loans, supported a surge in private equity activity over the last thirty years. Returns on those deals far surpassed investor needs.

Where’s the L in LBO?

My conversations on our new show, Private Equity Deals, discuss portfolio companies and recent exits. Some of the conversations with mega-cap private equity firms like KKR and Thoma Bravo cover companies purchased and sold at mid-teens to twenties EBITDA multiples. The prices seem high, but private equity firms have found lots of ways to create value and deliver.^[2]

A funny thing happened on the way to launching Private Equity Deals. While I was cognizant of risk coming from high purchase prices and rising interest rates, I missed a significant change in the capital structure of private companies. The LBO has gone away in place of, well, private equity. A glimpse under the covers reveals there’s a lot less L. Leverage has not kept up with rising asset prices in mega cap deals. A similar business that may have sold for 10x EBITDA a decade ago would transact 20x EBITDA today, at least until recently. Lenders extended credit lines from 6 to 7 turns of leverage, but they have not increased debt pro rata with the increase in equity invested by sponsors. What was once an LBO with 40% equity/60% debt now is buyout financed with 60% equity/40% debt.

The middle market has seen a muted version of the same trend. My friends at Fund Evaluation Group shared data showing that middle market purchase multiples rose around 30% over the last decade from 9x to 11.5x EBITDA. Lenders extended from 4.5x to 5.0x, leaving equity sponsors increasing their contributions from 50% of the capital structure to 65%.

As we peer into the abyss of rising rates, inflation, and a potential recession, the increased equitization of privately owned businesses has implications for company fundamentals, valuation, and investment risk.

Operating Fundamentals

Financial leverage works both ways in magnifying operating results. When a business performs, higher leverage enhances returns and conversely, lower leverage decreases returns. In this lower leveraged environment, sponsors will need to rely on continued growth and operational improvement at portfolio companies to meet return hurdles, even in the face of a more challenging macroeconomic headwinds.

On the other hand, in difficult periods, lower leverage mitigates the downside. Companies with a larger equity cushion may have more operational flexibility to weather the storm and play offense. Additionally, for all the noise about lagged private equity marks manufacturing low return volatility, less leverage actually does reduce the volatility of private equity strategies.

Time and again, private equity managers have found different levers to drive operational excellence. KKR increased engagement and productivity through employee ownership at CHI Overhead Doors. Thoma Bravo installed a newly motivated management team at RealPage, and Stone Point opened new sales channels for Bullhorn as the fifth private equity owner of the business. Each succeeded by growing the top line and improving margins without significant financial leverage.

The more subtle dynamic at play is the confluence of a lower leverage ratio with an increase in debt outstanding. No matter how much equity a sponsor invests, the business still must support a higher debt load and rising interest costs with the same cash flow. That hasn’t been an issue for a long time, but it may become one in a downturn.

Business Valuation

Rising purchase prices expose portfolio companies to the risk of multiple compression unlike any the private equity industry has experienced. Valuations over the decades have risen without as much as a blip. Even without an economic downturn, the industry may discover it has resembled a frog in a slowly boiling pot of water.

The public market selloff suggests the pricing environment has changed. In response, the private markets are showing signs of weakness through a slowdown in deal activity, widening of bid-ask spreads, and lack of price discovery. Valuations are on the cusp of a repricing.

Risk

Owners and lenders are assessing risk differently. Private equity managers have sought a return on capital by embracing the impact of technology on growth and profitability to catalyze a step-change increase in business quality. Lenders have sought a return of capital by ensuring the existing cash flows of the business support the interest expense. In the end, only one will have accurately calibrated risk.

Should fundamentals deteriorate, the battle between lenders and sponsors in a restructuring will be one to watch. In the 2008 crisis, many private equity sponsors took advantage of weak debt covenants created by banks to kick the can down the road, preserve the option value of their equity, and avoid defaults. This time around, lenders are primarily sophisticated private credit managers that know sponsors have both a lot to lose and plenty of dry powder to support struggling portfolio companies. The bargaining power in a negotiated restructuring may be more balanced than in the past.

Where do we go from here?

Thirty years ago, junk bonds and corporate raiders embodied by Gordon Gekko inspired a future generation of dealmakers that reshaped companies around the world. Their impressive work inspired a generation of allocators to plow hundreds of billions of dollars into private market strategies. That supply of capital drove an increase in equity check sizes that left the L in LBO behind.

Today, higher purchase multiples, increased financing costs, and slower growth present headwinds for private equity managers to produce similar returns to what investors have enjoyed for decades. If a business can support its debt, returns will be muted by the large amount of equity invested in deals. If not, we’ve got a real problem.

Then again, private equity firms have done a fabulous job improving businesses for a long time. Maybe they can pull yet another rabbit out of their hat. So will private equity managers continue to spin straw into gold, muddle through as companies grow into their valuation, or be left dealing with a pile of junk?

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[1] Catch phrases in investing are an important driver of fund flows. See What’s In A Name? The Problem With ESG for a recent example.

[2] I wrote The Day of Reckoning for Private Equity two years ago predicting the freight train would stop. I was either early or wrong, although the data so far only supports the later.