Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Beyond 60-40: Rethinking Asset Allocation - Interview with Larry Kochard (S2 E2)
What happens when the traditional safeguards of portfolio diversification unravel? Join me, Edward Finley, with my distinguished guest, Larry Kochard, as we navigate the complexities of a changing financial world where stocks and bonds, once reliable opposites, have lately moved in tandem. We promise you'll walk away with a fresh perspective on the classic 60-40 portfolio and insights into the impact of today's macroeconomic forces. Inflation, interest rates, and the Federal Reserve's moves no longer just affect markets—they reshape investment strategies, pushing investors to rethink their approach to risk and seek alternatives beyond traditional assets.
Larry and I explore the shifting dynamics of equity risk premiums, the allure of credit allocation, and the strategic decisions that come with navigating rising bond yields and expensive U.S. stocks. As portfolio managers adapt to new market conditions, you'll gain a deeper understanding of the opportunities in private equity and private credit, as well as the importance of a flexible bond portfolio during volatile times. We also tackle the evolution of today's corporate giants and the regulatory challenges they face, discussing whether the tech leaders dominating the market can sustain their reign amidst growing scrutiny and the AI investment surge.
Finally, we delve into the ongoing debate of active versus passive strategies, the diminishing small-cap premium, and the contrasting roles of public and private markets in fostering financial discipline and growth. Discover how private equity's alignment of incentives might provide an edge over public markets, especially in an era of fluctuating interest rates and refinancing hurdles. As we wrap up our conversation, Larry and I offer insights into strategic investment approaches that balance short-term challenges with long-term opportunities, helping you navigate the evolving landscape with confidence.
Research links:
- Bessembinder, Which US Stocks Generated the Highest Long-Term Returns
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. Well, today we're really lucky to have with us Larry Kochard. Larry and I have known each other now for a number of years. Both of us have taught finance at the University of Virginia. We both share a passion and a love for teaching finance. Larry is currently the co-CIO for a large investment firm, but over the course of his career he's been the chief investment officer for large endowments, large pension funds and, as I say, has been a professor of finance. Larry got his PhD in economics, as well as being an all-around very interesting and enlightening guy. Larry, thanks for coming on the podcast.
Speaker 2:No, thanks for inviting me, Ed. I really appreciate it. Look forward to it.
Speaker 1:So one of the things I think that's happened of late and that's got a lot of people worried people like you who run portfolios is the relationship between stocks and bonds. As listeners of this podcast understand, over longer periods of time that relationship is either independent or maybe even negative, but at shorter intervals it can be positive and that throws a wrench in gears. What are you seeing in the moment? Have we moved past this problem? Where do things stand? Has the stock-bond relationship broken down in portfolio?
Speaker 2:It doesn't. I mean, we took a regime change, made a regime change shift a few years back, where bonds and stock really are moving in tandem. So many people they're singularly focused on what the Fed does, worried about inflation, worried about the direction of rates, worried about then hence bond yields, and that really has been driving the price of risk assets. So you haven't seen the diversification benefit at all from bonds. That's changed over periods of time. If you go back more than 20 years, you actually saw periods like this before, but then through really most of the 2000s, the next decade, you saw a nice diversification benefit from bonds. You saw a nice diversification benefit from bonds. There seems to be some research that suggests when people are overly concerned about inflation, you tend to see this positive correlation, and when people are overly concerned about economic growth or the risk of recession, that's the periods of time during which bonds really do provide some diversification benefit. And one of the reasons this matters is twofold.
Speaker 2:One is sort of the basic building blocks of a portfolio. Everyone's talked about the 60-40 portfolio 60% equities, 40% bonds. Is this notion of providing a balanced portfolio what we as multi-asset class investors try to build? A portfolio that might have a similar level of volatility, but try to add outperformance over and above that by adding some other asset classes, which I know we're going to talk about. But when the bonds aren't providing any diversification benefit, it really, really changes the equation. You really have to think about what are some of the other asset classes that you could introduce into the portfolio that are going to help you over and above the role that bonds have played.
Speaker 2:And what I've seen now is that today we have the Fed's going to make an announcement and the market's going to move as a result of that. That has been really the biggest catalyst for market moves, as opposed to what's going on with earnings, what's going with earnings at the corporate, individual company level, at the sector level and ideally we get back to this focus on earnings as opposed to kind of every hanging on every word that the Fed releases in their statement and the press conference I mean, when Jay Powell does a press conference, the market could swing a couple hundred basis points in either direction, so we want to get away from that. What?
Speaker 1:do you think causes that? Why are asset prices so responsive to Fed policy changes?
Speaker 2:Well, for one, there's so many investors that, whether they're stated as macro investors but with the proliferation of ETFs, even individual investors have been lured into making macro calls, whether we want to overwrite a country or bonds, or you can kind of apply leverage to it too, and so every there are so many investors now that I'd say, even though they may not say they're macro investors, have become that over time. And we went through this period of time for the 10 years prior to the pandemic and then really into the pandemic, where real yields were negative or zero, and that's an environment where the discount rate on risk assets is really low and so the present value of future cash flows is really high, and that was really driving things Now that we're getting more normalized, so the real yield now is really kind of at historic averages. This higher for longer argument it's really not higher for longer, it's just more higher for longer.
Speaker 2:It's just more normal for longer, but it's going to create, I think, a healthier market where bad companies can't just survive. By refinancing their debt at historically low yields, access to capital is really easy. I think we're going to come into an environment. Potentially, if you see yields stabilize real yields in particular, stabilize at this level, it's going to be good. But if they just could stabilize, as opposed to everyone thinking about what's going to happen with the Fed are they going to come down, are they going to go up? And I think if you just see lower volatility within the bond market, that will be a good market for just active management in general and bad companies won't survive and good companies will not only survive but thrive because they take market share from the bad companies.
Speaker 1:Yeah, I mean, what I'm hearing you say, and it sort of makes sense, is, if you just read the headlines, all of the headlines point to macro stories over and over again, and so it doesn't surprise me too much that retail investors might just follow the headlines when making investment decisions. But it sounds to me like you're adding something to that statement by suggesting maybe professional investors investors who ought to know better are being pulled a little too far in the direction of making macro calls. Is that fair to say?
Speaker 2:Yeah, you've always seen this. I mean, whether it was during and soon thereafter of the GFC, that's the global financial crisis, the global sorry to use acronyms the global financial crisis Again, that really drove big moves in asset prices. And so then everyone was trying to predict, okay, what's going to be the next shoot of drop in terms of it's? You know that one was due to, you know, excess of housing and mortgages and leverage. What's going to be the next one? So everyone was looking for what country, what sector was kind of on the precipice of a big fall, just like that. And then you kind of a half-life. Eventually that goes away.
Speaker 2:But you know, we went through this pandemic, which had major impact, both negative. Certainly, it was a negative from a health standpoint, but certain industries were affected either negatively or positively, and we've finally gotten through that. And so we've gotten through that, what that meant for the Fed, the stimulus that they provided, fiscal stimulus We've finally gotten through that. We're now to more normal yields and I think it's just going to be the basic blocking and tackling going forward of which are good companies, which are bad companies, public companies, private companies, and so I think that will be healthier if we can just get away from those kind of big impacts on the economy, from an exogenous fact like the pandemic COVID virus or what was kind of self-inflicted by the excess of leverage that you saw, and then too much capital rushing into housing and real estate.
Speaker 1:Yeah, I mean. You point to an interesting identity, I think, which is that when you have regime changes, it takes a bit of time for us humans to realign our thinking.
Speaker 2:And everyone's always fighting the last battle too. You know, I even think about early in my career I started right on the heels of, you know, bond yields being in the mid-teens, inflation being in the mid-teens, and you know, everyone from that point for a while was worried about inflation. We then went through a period of disinflation for a variety of reasons, but then people forgot about that as a risk and they just relearned that the last couple of years, yeah, I mean there's a whole class of professional investors who don't have any living memory of inflation and what that might mean in terms of investing.
Speaker 1:You mentioned the level of base interest rates. I want to peel that back a little, if I can. To what extent do you think some of what we're seeing in equity markets broadly, and maybe some of what we see in risk-taking around things like private credit, is really the result of a higher base rate?
Speaker 2:in interest. Something that we look closely at I've looked for years is and it's hard to measure and there are different ways of measuring it but the equity risk premium of do you get compensated, or how much do you get compensated by owning equities versus bonds? Just again, at the simplest level again breaking the world into stocks and bonds, and right now we're at a period of time with bond yields going up, stocks, at least in the US, being very pricey relative to their current earning stream, there's not much of an equity risk premium. You're not getting compensated that much for owning equities In other countries. It's a little different. Owning equities In other countries it's a little different.
Speaker 2:But so that's something that you know has certainly attracted capital to the credit asset class broadly, of whether do you just want bonds, low-risk bonds like treasury bonds, or do you want to take go out the risk curve in terms of owning corporate bonds, and then you know the extreme high-yield bonds, or even you know lower quality high-yield bonds, or even lower-quality high-yield bonds, but that's certainly something that is now more compelling than it was for much of the 2010 decade, when bond yields were low, and so now it's, and so I think you really need to take a look at. Ok, if you own equities, are you being compensated for it relative to bonds? And so, if you are going to own it, what is the best geography in which to own them and what is the best form? Should it be public or should it be private?
Speaker 1:So are the credit spreads right now on risk at historic, typical historic levels, or are they maybe wider?
Speaker 2:Very tight. And so again there's this notion that you're not getting compensated for the credit risk you're taking. So one of the arguments is saying okay, I'd rather own high quality equities, equities that are going to be more impervious to the next economic downturn. So you have the economic downturn, certainly the stocks will trade off a little, but the quality of the company will allow them to survive. And then again this notion that they could take market share and actually do very well coming out the back end, versus if you own credit, where you're just getting a fixed coupon and you're taking all the downside risk.
Speaker 1:And if you're getting, if credit risk spreads were wider, I think you could, I suppose, argue well, I'm also getting paid for that risk, but it sounds like what you're describing is you're really just interested because of the higher base rate.
Speaker 2:In my at least, certainly the last nearly 20 years is the credit opportunity, where those spreads really do blow out does correspond certainly with equity selling off.
Speaker 2:So equities all of a sudden become more attractive as well, and my observation has been that opportunity within credit tends to be a very short window. You know, the credit opportunity during the great financial crisis was a brief window the fall of 2008, whereas stocks continued to go down and down until March of 2009 when they bottomed, and so that credit opportunity does attract a flood of capital pretty quickly. And it's not clear you want an always-on credit allocation because, again, it is very asymmetric. What we like are kind of a subset of hedge fund managers that can make some of those opportunistic moves themselves and make that calculus whether they want equities or the credit be able to compete. So that's, I think, a better way for us at least to get exposure. I know there's also we can talk about. There's been a flood of large institutional capital that's flooded in to private credit and it has more of a private equity structure in terms of A lot of Henny Pennies out there, yes, saying that the sky is about to fall.
Speaker 2:Yeah. So and I don't know if the sky is going to fall, but for us we're big allocators to private equity broadly both buyout growth and venture going out the risk spectrum in terms of the age of the company in which you're invested. But typically we have not done private credit because even though it's a little more liquid than those investments, it's still not very liquid and I want my least liquid investments to be the highest returning part of the portfolio. It's just plain and simple and I don't. I'm not as confident in that the ability of that to compete. So if I want diversifying assets, I'm going to probably skew more towards high quality bonds as a role in the portfolio, but less in terms of private credit.
Speaker 1:And any pure interest rate risk just owning treasuries, or do you feel you need to earn a little bit extra?
Speaker 2:Yeah, no. Well, you know, usually you have earned a little extra when the yield curve is up and sloping. Right now you're not. But the argument historically we went through this again this period that was close to 20 years, where bonds were either zero correlation or slightly negatively correlated Bonds really were this protection against, you know, against again this growth scare, you know, recession scare, some geopolitical event, and we just haven't seen that play out as much recently, right? So you know, from my standpoint, you're probably better off just having a lower duration bond portfolio, which is going to at least be dry powder that you can tap into should your equity sell off and you can rebalance into the equities and it's not going to go up in value necessarily during a sell-off, but also won't go down in value if people. What's causing the stock market sell-off is a fear that yields are actually going to go up.
Speaker 1:Yeah, I mean you mentioned and I think this is a great segue you mentioned how, right now, the equity risk premium is really quite small and to remind listeners, of course, the equity risk premium is always going to be smaller the higher and higher equity prices tend to drive, and we've had a big run-up in equity prices of late. That is, the higher the prices go, the lower we expect returns in the future to be. We believe in a reversion to the mean. It might take a long time, but ultimately, over time, we would expect those prices to correct in the other direction. So the equity risk premium is pretty low, and you indicated and I think this is a good point why would I own credit risk when that's the case? Talk to us a little, though, about the dispersion of returns within equities. Does that tell you a different story? The same story? How do you think about that?
Speaker 2:I mean very interestingly, if the only thing you had invested in the last decade were the largest 10 market cap stocks, you would have done and in the US you would have done extremely well. I mean, more recently it has been. You know the name has been hijacked as the Magnificent Seven, but just say the largest 10 to keep it simple. And you know, we ran an analysis where we looked at if you at the beginning of each decade starting in 1970, owned the largest 10 market cap stocks, held them for the following decade and compared that return to the broad market, you would have underperformed every decade up until this decade. Now we're only now like three and a third years into the decade, but that largest 10 market cap stocks for that a third of the decade is outperforming by several hundred basis points the broad market.
Speaker 1:By the way, that's a really interesting point to make because it casts a little bit of a shadow on I'm not sure if you're familiar with the paper by Bessem Binder where he looks at US equity returns over a very long period of time and he identifies that more than half of total equity returns are the result of maybe 30 or 40 names, suggesting that maybe it's always been the case that we have a very small number of stocks that are driving total return. It sounds like since the 70s.
Speaker 2:Maybe in your study you haven't seen that, but the challenge is it's not always necessarily the same 30, 40. And that's part of it. If you look at the composition, both at the name, the company name level, as well as the industry level, it's changed over those decades. I mean, not surprisingly, the current mix, all large cap technology GE would have been up there.
Speaker 1:Yes, no, GE.
Speaker 2:Yes absolutely, and at another time, oil companies. So you know, you think of, you know 1980, you had, you know oil companies were the largest you know IBM going way back in time and what is just basic economics?
Speaker 2:two things happen. One is companies that are earning abnormal returns attract competition and historically that's one factor. Second is, companies can't grow to the sky, you know they just at some point their diseconomy is a scale that's set in. I mean, I think back to my first job years ago 1980, was at DuPont, a large, very large global company, conglomerate in multiple businesses, and they just you grow too big, you're not as good at capital allocation, the senior management loses touch with all their disparate businesses. You know GE was recently blown apart and there's an argument that, yes, there's going to be a handful of great capital allocators. You know, maybe Warren Buffett was for a while, you know John Malone, but the vast majority, I just think they get too big and they lose that edge at capital allocation. And then, finally, too big and they lose that edge at capital allocation.
Speaker 2:And then, finally, you have the regulatory impact Companies that, yes, the DOJ, and you're seeing that right now. But you've seen that throughout history. The large companies attract the scrutiny of the DOJ, the antitrust or other regulatory, and that will repeat and so it could be. There are many arguments that these large cap quality because quality, because they have this moat around their business. They're kind of immune to competition. But at some point those moats go away and what was once quality going back decades ago in like 1970, turned into a low-quality company eventually.
Speaker 1:So you know it doesn't sound like you put much stock in the argument that some have made, which is that the current big winners in equity markets are really the products of a change in regime where pretty accepted economic principles no longer apply and we can see increasing returns to scale. It's sort of like you look at that and you say, well, it sounds like a this time is different argument, which is like the worst kind of argument Is that fair to say.
Speaker 2:I think there's some element of that and that's where, again, it's, this time being different. I'm always wary of that as an argument, but I think if you look at these companies, there is something to be said, that there's been this flywheel effect, that they have these add-on companies. They have been able to maintain the same edge, the same focus. Some have kind of renewed their effort. Microsoft went through a period of the 2000s where they were this moribund company, but with regime change partly, which was kind of catalyzed by an activist, they really improved. And now there's flywheel effect. There are these returns to scale. Again that might persist, but again that could attract the scrutiny of the government.
Speaker 2:I mean, the most recent technology AI I mean we've had that debate internally is we invest in venture? It's a big, you know, it's a big part of what we do and there are clearly a lot of venture managers that are all over the opportunity. In AI, similar to other innovation waves throughout history, you're never exactly sure who that winner is going to be. But if you're investing with this kind of this technology ecosystem, Silicon Valley being the biggest, there's going to be winners that emerge out of that. But it could very well be that the winners ultimately will be Microsoft, the Amazon, there will be Alphabet, and so that is the question. I think it's an open question. I think that could be what propels them even further on this flywheel effect, but I somewhat, I'm somewhat suspicious, only because of what I've seen throughout history.
Speaker 1:Well, and you make the point that, even if some of these academics are right and that there are increasing returns to scale in certain industries, that, particularly with network effects, we can see that, even if that's right, you seem to be saying yeah, but don't toss the DOJ out of the picture. That really could change things as well.
Speaker 2:No, Yep, and it's the government here, it's the government in Europe, I mean. So it's a global phenomenon. It's not just the US, although US is certainly a large, important market.
Speaker 1:So you've alluded to the fact that if you had invested in, say, the S&P 500 minus the 10 largest stocks, you wouldn't have seen returns that are nearly so eye-popping.
Speaker 2:With the exception of this last period I actually looked at. I think there was a researcher that we used and we looked at. I think they went back to 1950. And I can't remember it was the top seven or the top 10. And they looked at those versus the other 490 or 493. And they looked at the returns and again it was just negative up until this last day it's been the last decade, it's been this last decade, and so the question is you're completely right, this is what you have seen.
Speaker 2:There's this network effect, there's this flywheel effect. The question is, is what could cause that to revert to what we've seen throughout history, which question that I'm asking is a little different?
Speaker 1:I'm sort of five degrees off that question. Which is to say, we started with the idea that you thought the equity risk premium seems quite low and therefore, why would I own credit risk? But if we take the 10 biggest names out, is the equity risk premium so low?
Speaker 2:and what- no, it's interesting at that point. I mean it's very. I mean, whether you look, I mean there's various ways to do it. It is looking at the remaining 490 companies within the S&P. You know, a simple way is just looking at the equal weighted S&P, which is kind of and you know it's, you know, reasonable, that more reasonable it's still, you know, an equity risk premium that's a little lower than you've seen historically, but it's very reasonable. And again, in the US it's more expensive than outside the US, but there are probably reasons for that as well. When you look at, despite everything we worry about with the Fed, our own politics we're entering an election cycle which is certainly going to produce a lot of stress when we get to this fall in terms of the market, but with that said, this has still been demographically, corporations, in terms of the economic dynamism that you see, is still the jewel of the world, and so there's reasons for that, there's reasons to believe that will continue. With that said, it's priced that way.
Speaker 1:Well, it suggests, though, that there may be an argument maybe not as full-throated an argument as one might want to lobby for owning credit risk right now, but if we strip out the outliers from the equity risk premium, maybe there's something to be said for the fact that the equity risk premium isn't quite as low as it seems, and there's an argument for credit risk. All of which is really to focus on the fact that, in a portfolio, the most important risk that we can own is equity risk, whether it comes in the form of equities itself, credit risk, et cetera, and you've made a career, frankly, of being a very discerning investor around different forms of equity risk to own in a portfolio. I wonder if you could talk a little about what makes owning equity risk in the form of private investments interesting for long-term investors, or is it still interesting? What's the driver there?
Speaker 2:We read a lot of headlines right now that make it sound like private equity is black magic or a hoax for someone to buy a company, leverage it up because it was very inexpensive and then resell it because the valuations continue to go higher. That's the sort of financial wizardry argument. That's all it is. There's nothing more than that and, as we've talked about before, there's many different studies. But if you just you're kind of in the average buyout fund, when you take into account the risks that you're taking and you take into account, in particular, the illiquidity that you're taking and the sort of loss of flexibility, there's nothing there. What is there?
Speaker 1:On average, on average yeah.
Speaker 2:So what is there is there's a very wide dispersion of outcomes. So what is there is there's a very wide dispersion of outcomes. Top quartile managers do extremely well. Much bigger deviation between them, the median manager, than what you would see in a public equity manager. So there's a big payoff to correctly selecting which funds in which you want to invest. The challenge is there's very little predictive content from historical returns to predict future returns of that manager.
Speaker 2:So it really is a qualitative assessment and ultimately, what we're looking for and I think what distinguishes, I mean there's basically three levers. There's buying well. There's making the company better, growing it faster, improving its EBITDA and selling well. The market will give you what it does in terms of buying well. Certainly there are certain managers that have a sourcing edge. I do think, given the number of PE firms, that's harder to hang your hat on and there are certainly going to be ones that sell better than others.
Speaker 2:But ultimately what we're looking for are their capability to make the companies better, their capabilities to maybe not necessarily outbid others to buy well or source well, but select which of those companies are going to be good companies. Do they have the right management team, the right products and the right industry If they don't have the management team. Are they adept at actually changing the jockey in midstream, or have they not been successful at doing that? So making the company but avoiding the landmines? You know private equity firms that pile on a bunch of leverage as a way to make their money, but it's a low quality company. It's very cyclical and the company goes. Let's say it goes into the pandemic. You couldn't predict the pandemic, but you can predict that there's going to be something that bad that potentially happens.
Speaker 2:Are they loading it up with so much debt that they can't survive through that? And so, looking for that in a manager, they put on a reasonable amount of debt or low amount of debt. They're good at fixing up companies either, growing them, cutting costs, improving the management. So it's that element of control, because these are control the buyout, they're control deals and you want to see them take advantage of that. To me that's the most distinguishing characteristic. And then we look for all the other things. Are they the right size for the strategy they're applying? Are they grow too much? Do they also add a bunch of other products? Is the team stable? So there are a bunch of other things that we look for, but to me it's the element of you're giving up liquidity, but you're giving it up so that they can make their companies better. And that's what we try to underwrite and I think that's what the edge of a manager that might persist into the future.
Speaker 1:Yeah, it's kind of a simplistic way to describe it, but our listeners will remember from our private equity episodes earlier that we draw a distinction between traditional buyout managers that are focusing operational efficiency, et cetera, and leveraged buyout managers, who are usually continue to work with current management, and it's about reengineering the balance sheet. Is it fair to say that when you're looking for buyout managers, you tend to lean toward the first rather than the second, or is it just yeah, I would say it's a little kind of black and white, but I'd say yes, for the most part Correct and if that's right, is that something that the average investor can do, or do you think it takes a lot more Well?
Speaker 2:A. It's hard to find these managers. It's, you know, because A is a very qualitative assessment. You have to get to know the people that are running these firms, find out what makes them tick, find out how they're kind of aligning their interest with the companies in which they're investing, as well as the team internally. So it's hard.
Speaker 2:And again, this notion of you might find a great manager and they may be great for a fund or two, but then all of a sudden people realize they're great and people just throw money at them. There has always been this kind of evolution in a fund life where they might start with friends and family money, prove out the model, Then they get some high net worth endowments money and then they prove it out further and then they get some pension money. At the other end it's going to be sovereign wealth funds that just throw billions at them. And there are a lot that will resist and basically say what I'm trying to do is go down in the. I heard this someone say this I want to go down in the return hall of fame as opposed to the asset management building hall of fame.
Speaker 1:But then there's others that just look at those buyout managers who themselves are publicly traded entities, where there's going to be a big pressure on them to show returns year on year. It means you're going to emphasize, at some level, the assets under management rather than-.
Speaker 2:And so the top thing is you find a manager. You love them. They're doing great. The next fund, they double in size. You think, okay, that's fine. Then the next fund they double in size. You think, okay, that's fine. Then the next fund they double in size again. And they add a bunch of new partners, they add a couple of new products, they add some new offices. You have to be clinical about that decision of at what point do you get off the treadmill? And so we want to be long-term investors, we want to be long-term partners, but we just don't sit there and just take it all in.
Speaker 1:So it sounds like you're constantly trying to source, not only sourcing great managers in the first moment, but it's a kind of an ongoing evaluation, ongoing sourcing because so?
Speaker 2:we're in this kind of steady state where we like our current mix of managers and we're probably adding another two per year, knowing that there's a natural attrition that will happen. But yeah, there's a lot of work involved at just not just sourcing but maintaining that relationship and really understanding the nuance of what's going on within that firm.
Speaker 1:So is it fair to say some of the proposals that we've heard coming out of the industry and out of the SEC, from other quarters urging the SEC to permit private equity, principally buyout, be available to the general investing public? Currently they're just restricted to those who are qualified investors. In your view, can a retail investor expect to earn those excess returns if it becomes available to them? And if it does become available, what should they expect?
Speaker 2:I think it just becomes tough. I just I go back to the very simple, and I know David Swenson argued this too, for you know he was the sort of the person that was most advocated the approach of investing in managers that are in asset classes that have a wide dispersion of outcomes, but being only when you have the capability of doing the research to do that and find that, whether it's top quartile or top decile, which in some asset classes is even mandatory to be able to make the returns. But other investors should probably keep it really simple and maybe just go passive, and there's nothing wrong with that.
Speaker 1:And going passive is kind of an interesting point, and you and I have discussed this before. I have a kind of a pet theory that it's utterly unproven and untested, but a pet theory that for the last 20 years or so, the small cap premium has just been non-existent. And my theory goes something like this Well, what makes the small cap premium exist in the first place is companies that stop being small. They grow the top line, they get more and more successful and their capitalization grows, they get big and that results in these outsized returns. And if buyout if I'm focusing on just the successful buyout managers if they're successful at identifying those small public companies, taking them private, fixing them, selling them, and that's where the excess returns in small cap come from. Maybe that's why, for the last 20 years, we haven't seen the excess returns in small cap.
Speaker 2:Are those companies never went public at all Ever and they happen to be good companies, then they just stay in private hands all along and there's probably much more of that between the take private as well as never go public of quality companies, that I think there's probably much more of that between the take private as well as never go public of quality companies. That I think there's some element of that. I would say I still think there's value of active management within small cap because you know, kind of separating the wheat from the chaff. I do think it's fertile ground, but I think, again, getting back to the average company is of lower quality today than it would have been years ago.
Speaker 1:Which I imagine makes the passive answer you gave me.
Speaker 2:But that's how you, how do you implement passive? Because when most people think of passive, there's an ETF for everything. It doesn't matter how narrow. You know there's now an AI ETF. It doesn't matter how narrow it is now than AI ETF you just name. There's a GLP-1 ETF.
Speaker 1:I mean there's like yeah, I read today that there's an ETF for the stocks that members of the Democratic House of Representatives own, an ETF for the stocks that Republicans own. That's great. Kind of bad. Yeah, that's kind of.
Speaker 2:But this kind of circles back to my first point about how people have become more macro. It's so much easier, so passive investing from my vantage point is you own the whole market, which includes now, if you're being the beneficiary of owning ever bigger and bigger successful companies, you're getting a bigger percentage of that. You own the whole market.
Speaker 1:You don't try to time in and out, you just own the whole market and call it a day, as opposed to just and so if I want to own that risk, if I want to own the small cap stocks that aren't going to be small anymore and earn these outsized returns and the quality of public small cap companies is so poor- you can just own larger cap.
Speaker 2:You own a passive, I mean that's more or less.
Speaker 2:So I guess what I'm hearing you say is that it's just really hard to own that small cap risk unless you can access a really strong, active manager and the active manager you know we've talked about this before is I've always been had a bias towards activism, and you know it's a way of getting some of the benefits of buyout, of being able to change companies and do it in the hands of a public manager that has a capability that they don't own control of the company, but they have an ability to sway other investors and then ultimately, if they're successful, they have a greater capability of swaying management teams and boards, of listening to them because, well, they've had a good track record, they've convinced others to do it, and so I do think there's some merit. If you're going to invest in small cap, have a capability of being an activist.
Speaker 1:Well and this seems to go back to your point earlier about different styles in private equity, even though I think I make the distinction a bit too black and white about buyout managers is that activist investors are going to be the ones in public small cap space who are most likely to change management, which I think is what you want if you're going to own that kind of risk and you can't own buyout, how about at the other end of the spectrum? So, when owning equity risk in the form of privates, there's buyout. It's got its challenges, as you've described, but what about venture capital at the very early?
Speaker 2:Yeah, I'd say we're fans. My firm happens to be located on Sand Hill Road in Menlo Park, which I think does give us an edge. It just in terms of I've heard someone use this term, so I will borrow it it's not an asset class, but it's an access class, and so it's this notion of there's a really skewed difference in terms of good venture managers and unlike in buyout, where there's very little statistical persistence between a successful fund and then another fund, which is part of what I said, makes it hard.
Speaker 2:What's hard with venture is to get access to those funds, because Because the really good ones are consistently really good they're consistently really good and part of it is that good entrepreneurs want to go back to the same venture capitalists that backs them because they think they're going to provide more help of helping them grow the company, helping them take them public. For smaller companies where it's not about going public, helping them just sell them to a strategic Sometimes they sell to actually just a larger buyout fund, but there the access is that those strategies tend to be more capital constrained, they tend to be smaller in general. And then those big premier platforms where again they just persist. They're bigger but they're very good. It's just hard to get access to them.
Speaker 2:There are a lot of small seed funds, some of which are very good, but it's kind of a narrower universe of funds in which you want to be part of, and then you know we have those as well, as we're constantly looking for some of those newer funds that have some of the elements that we think are going to produce success.
Speaker 1:So you think it's not only identifying those managers that are currently successful, but you think there's room to identify the future successful managers?
Speaker 2:No, I do think there is. I mean without a doubt, and you know part of our. You know venture means different things to everyone and some allocators have buyout growth venture. We have kind of growthier buyout funds which we talked about before.
Speaker 2:We also have growth managers within our venture bucket, and our growth managers are a subset of managers that they tend to be smaller. They tend to be the first institutional capital into a company that had bootstrapped itself up until that point, so they were self-funded. They sell, they sell funded. They didn't take any early stage money, seed money, early stage money um, it got to a point and then now they just need capital to grow, and not only the capital but the assistance. And so there's this subset of managers that we call growth equity. They tend to shop in the non-big VC markets in the hinterlands of the country. Oftentimes they are software companies in which they're invested, but they may not be in Silicon Valley, they could be in Tampa, florida, they could be all these other in Canada. And that's a very attractive strategy because A they're not dependent upon the public markets for an exit. They typically are exiting to either strategics or just buyout funds. They take the company to kind of a critical size and then they will sell. But that's a very interesting strategy.
Speaker 2:That's when we're constantly trying to find new managers, because what often will happen is the manager gets big. It's just a different strategy. Some successfully make their transition and they become much more of a growth buyout strategy and some can do that and some don't make the transition as successfully. But we're constantly looking to try to source some of those managers and for them, like their edge is sourcing. They're constantly trying to beat the bushes to find a company. It's a quality company. It has a quality little niche that their problem, that they're solving for the customers. Again, it's not going to be as competitively shopped and they're just trying to beat the bushes to find these entrepreneurs.
Speaker 1:So it sounds like when you're talking to your managers, your venture capital managers, that it's not just that there are these great opportunities, but it sounds like these managers are seeing their portfolio companies less eager to tap public markets and to stay private for longer. It's not just a headline. Can you talk a little bit about what you're hearing from your managers in terms of that? Are the headlines just a little overstating the case? Are private companies really staying private for longer and why would they tap public markets if they were going to do that at all? I mean, they have.
Speaker 2:They have stayed longer private longer, without a doubt. I mean, I think there are differences of opinion on this. I've heard one argument put forth that basically said the public markets is a good. It's the time for the really imposing discipline on the company, because one of the downsides and you saw this a lot during the kind of the frenzy of 2020, 21, 22 is that these companies were just it was all growth at all costs, and so they would burn capital. They'd go back and raise more capital, but they weren't poised to make money anytime soon.
Speaker 2:The beauty of the public markets is there's more discipline that ends up being imposed upon them. The counterargument is that they become very short-term oriented as opposed to being long-term thinker, because there may be times that it's easier to grow and maybe growth is the right solution, but there are plenty of companies that shouldn't grow any further. They just actually have. They're good where they are right now and they should, at some point, start returning profits to shareholders, should start making profits and then returning it to shareholders, and the public markets is well suited for trying to impose that kind of discipline on companies.
Speaker 2:With that said, there's still there's so much private capital available. Clearly, the fundraising has slowed down to certain pockets, but you have a lot of dry powder, unfunded commitments in the hands of large buyout funds, large growth buyout funds. That's not going to go away. You have large allocators again the sovereign wealth funds, the pensions that continue to view that as an attractive alpha source. They've been doing it for a while so they're good at doing it. They also can kind of figure out which are the funds that are going to do that well, and so there's a big pool of capital that will buy these companies and keep them private.
Speaker 1:Yeah, but to put that into perspective really, even as large as the private equity console has gotten, all of US private equity is really about a fourth of the size of the US public equity market.
Speaker 2:Oh yeah, so it's still a fraction. No, it's still and still, I'd say the ultimate is a public company, and again, I think it's this notion of capital discipline, profit discipline. So anyway, I think there's a lot to be said for that.
Speaker 1:So, going back to your earlier point on rates, to what extent do you think higher base rates means that there's more or less incentive for private companies to go to public markets, or do you think it's neutral?
Speaker 2:I think the higher base rates. What that does getting back to the comment I made earlier is I think you haven't seen it yet, but if they are higher for longer, at some point you're going to see pain inflected upon the weak companies. And I think what is the closest to that is probably real estate is probably where you're going to see the biggest risk of not being able to refinance debt. But that's, it imposes discipline from that. So what that could lead to, or opportunities for attractive, good assets at attractive prices, people have been talking about the next distress cycle for now a couple of decades. It hasn't materialized.
Speaker 1:Well, yeah, it reminds me of how we talked about inflation for a couple of decades, and then it came, then it finally came.
Speaker 2:So if it is higher, for longer you're going to see again this wider dispersion of winners and losers. You're going to see attractive prices for some assets. Some are just not attractive assets, ones are just they're unattractive. But there could be some attractive assets and that could be a good sourcing opportunity for PE firms.
Speaker 1:I'm wondering, though, beyond, whether these things are all going to be true. If you're an entrepreneur and you've taken a little bit of institutional money, you're on a good growth trajectory. You might otherwise have felt it's safer to remain private. I do wonder whether higher base rates, and therefore higher equity risk premiums, doesn't maybe lead you to think you can do better raising capital in public markets. Or do you think that's not really the case?
Speaker 2:Yeah, I don't have a strong view of that. I mean the attractive. I mean when you think about what are some of the most successful companies throughout the centuries. A lot of them are in private hands. I mean, the ideal scenario is you have well-run companies, companies that have some kind of monopoly position. They grow sensibly, so they don't grow at all costs. They grow sensibly, they take their cash flow, they distribute it to their owners and then reinvest attractively. But they are doing it sensibly because there's no.
Speaker 2:A lot of these inefficiencies are the principal-agent problem, where the principal, the owner, is subject to the desires of the agents and if they're one and the same, you've got alignment. And that's partly what private equity does successfully is you get that alignment, and so that's the argument for keeping that alignment. And that's one of the problems when public, when you do go public, I think there is a short-term discipline that's imposed, but there's a long-term cost. That can be, if you have these management teams, that they're incentivized by their lofty salaries and maybe it's not aligned completely with the shareholder quarterly results.
Speaker 2:And versus you know it's someone that's, that's their money and you know there's there's a lot to be said. That's the, that's the value out of keeping it public, more so than anything. That's that's the way I would. So I'm not even thinking of it in terms of hire for longer. I I just think the value that these are independent ideas.
Speaker 2:Yeah, the principal agent problem is real and having it be one and the same is what creates them probably the most efficient. But if they do need capital to grow like they have some great idea, then it could be that's when they need to tap the public markets. Or right now, if there's enough money privately, which there seems to be, they can tap the private market.
Speaker 1:Particularly. I suppose if your business model is one like we were describing a little earlier, where maybe there are increasing returns to scale, that's when you'll need the kind of capital you can get in public markets. Need the kind of capital you can get in public markets. All right, well, owning equity risk in the form of private equity, whether it's buyout, venture capital or growth equity has some really attractive qualities, but principally, the attractive quality is the ability to earn returns in excess of the risks, and you've done a great job of explaining to listeners some of the difficulties and challenges in doing that. The last three years, though, venture capital, growth equity and buyout have been really painful. Can you talk a little bit about that and how investors-.
Speaker 2:Yeah, we've gone through this period where the public markets have zoomed. There have been very little in the way of transactions, whether it's IPOs, whether it's M&A that have validated private prices other than where they were financed at the last round, and so the private markets have lagged the public markets, and you always see this Whenever you see a quickly ascending public market and the private markets don't catch up quite yet, until you start seeing transactions.
Speaker 1:And I suppose you could say the same in reverse. When public equity markets took a nosedive right around the time of COVID, we didn't see privates move nearly so aggressively.
Speaker 2:Exactly, and so you know, one of the things that we always have to try and understand is you know A you can't time that with the private markets, but you're going to have these big deviations. We looked at other times in history where you've seen the biggest delta. We just looked at a buyout because we had a longer history of data. The biggest deviation between the public markets and the private marks is what we actually just saw was one of the biggest. And then if you look historically, if you look forward the next several years, in essentially every instance the private markets outperformed the public markets, and so I would be pretty confident that will happen going forward.
Speaker 2:But there's always this kind of hand-wringing that occurs and you occurs and it's you want to produce. The only reason we do privates because it comes with the cost of illiquidity. The only reason you do it is you think over a long period of time you're going to outperform the performance. As I said before, I think for buyout is the value add For the venture. It's more the access and getting access to innovation that I think that will continue. The only reason it might not is if because the argument that some would produce is that the reason we saw the great returns in the last 20 years. There was more and more money coming into private markets with just then bid up prices, so it was just self-fulfilling. But I don't see the private money going away. I really don't.
Speaker 1:Yeah, I mean at short intervals. It's really unreasonable to think that you're going to see any returns for skill. That's kind of by definition, skill is something that shows itself over longer time horizons and in shorter time horizons what you'd expect to see is just the result of the systematic risks you own. So underperforming publics, I think at a smaller interval shouldn't be problematic. But I can tell you in conversations with my own clients, some of whom are pretty smart people, it's been a tough conversation.
Speaker 2:And it's understandable because people should look at every interval of time for performance. But I do think over a long period of time private is going to outperform. I do think, getting back to the difficulty of just identifying managers, making the portfolio management decisions, of when to move on from certain managers for their next fund, that's hard. But what's also hard is just managing commitment pacing. How much do you commit, making sure you don't overcommit, knowing that you really can't time the private markets. You want to be in it for the long term.
Speaker 1:Yeah, you make a really good point, which is, in addition to finding or having the qualitative skills yourself, to choose better buyout managers, better venture managers or, in the case of venture, maybe to have access to them. But what we left out, which is, I think, equally important, is making sure that you own all vintages, because, as you say, the data are clear that you can't really time vintages any better than you can time public markets. You need to be in it for the long term, and that's a very complicated thing. Even for a smart, sophisticated family office that has a lot of access and a lot of input. It's a really difficult thing to do. So increasingly, there are evergreen structures like your firms or other kinds of structures, where managers are trying to take that guesswork out of the equation, and I think it's a good point to mention to listeners that you want to focus on that as well.
Speaker 2:No, we both the endowment as well as the current firm we have a risk department that spends a lot of time thinking about. I always talk about market risk in terms of what is the risk in the portfolio? Going up and down particularly down is what you're concerned about but then the liquidity risk. What is the liquidity profile of the portfolio? And the challenge with privates is you commit, so you have unfunded commitments and there's a lack of predictability in terms of when they're making their purchases of companies and there's a lack of predictability in terms of when the money's coming back and what. We try to model that as best we can, but also stress test it. So there's a lot of analytical work that goes into that.
Speaker 1:Larry, this has been great. I want to close our episode with something that I like to do with guests a little off the cuff, and that is to ask you to share with listeners a pearl of wisdom. It can be about investing, it could be about life or personal things. Be whatever floats your boat, but what would you leave our listeners with? As a coda.
Speaker 2:I'm going to leave people with two. I would diversify.
Speaker 1:Two pearls of wisdom.
Speaker 2:One is there's a book that I read and I had everyone on my team read a few years back called Range, and it's this notion of people are always been taught that they need to become a deep expert in one thing Just become the best in the world at this one thing, whether it's playing the violin, the piano, investing. I've been a big believer in the book profiles all these people throughout their lives that had a variety of careers, education, experiences, and then it could have been that wasn't until their 50s that they found their true calling, but it was that portfolio of experiences that led them to be better, ultimately, than that one person that just had this very narrow career path or path journey to where they ended up. And so I'm a big believer in range. So that's one.
Speaker 2:The second one is one of my core principles is focus on where you have an edge. We're always trying to find managers that have an edge, and that's a pretty amorphous concept, but it is basically something that is very special and you think they're uniquely situated, whether it's a buyout fund, whether it's a buyout fund, whether it's public equity manager, where I think the bar is that much higher because the markets are so efficient. But I think you need to be introspective and just think about what is your edge. You should always be assessing what do you do best. Play to that strength. You don't have to do everything well, but just play to your strength. And so having range which gives you kind of multiple shots on the goal figuring that.
Speaker 2:But figure out where your strength is after enough experience, but then focus on your strengths. So those are my two pieces of wisdom.
Speaker 1:I love it. Well, thanks so much for joining us. It was a terrifically interesting conversation, Really a pleasure to have you, thank you, I enjoyed it. You've been listening to Not Another Investment Podcast hosted by me, edward Finlay. You can find research links and charts at notanotherinvestmentpodcastcom. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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