E373: What Most CIOs Get Wrong About Alpha

What if the best investment opportunities are the ones most investors avoid because they’re too hard, too small, or too inefficient to pursue? In this episode, I sit down with Raphael, Deputy CIO and Co-Leader of HighVista Strategies, to discuss the concept of “beautifully inefficient” markets and why durable alpha often exists where few investors are willing to spend time. Raphi explains how governance structures shape investment outcomes, why lower middle market private equity and biotech remain compelling, and how long-duration capital creates structural advantages in venture investing. We also explore continuation vehicles, portfolio concentration, and why the best allocators balance diversification with conviction.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  Rafi, you're the deputy CIO and you co-lead Hi-Vista Strategies, a firm with $14 billion in AUM. Last time we chatted, you said that you love markets that are beautifully inefficient. What does that mean?

• 0:11Speaker 01

  So my CIO partner and co-leader of Hi-Vista, Andre Perold, coined the term beautifully inefficient. And so I'll give him credit where credit's due. Everyone talks about inefficient markets, but what Andre figured out was that there are many markets that are inefficient, but they don't have the repeatability that investors are after. Really, to be a great investment opportunity, you want it to be inefficient so you can get outsized returns, but you also want it to be somewhat systematic, somewhat repeatable, so that there's some duration to the investment opportunity. And beautifully inefficient markets have the characteristic of having a great opportunity that hopefully persists for a reasonable period of time. Nothing lasts forever, but a reasonable period of time. And if you're really lucky,

• 0:54Speaker 01

  it's a market where you can build a sustainable advantage by participating in that market, so that over the course of time, there's also somewhat of a barrier to entry to those who are early to those markets.

• 1:05David Weisburd?

  Those are kind of the frictions. So if you think on one side, you have this one trade. It's an amazing trade. Nobody's looking at it because no one's really set up to do that. They don't have the team to do that. But they might have a high MOIC, high IRR, but it's one time. And then on the other end, you have a trade that's going to be around for 30, 40 years. But at some point, it's a consensus trade and the alpha gets traded away. You look for something in the middle.

• 1:26Speaker 01

  Absolutely.

• 1:27David Weisburd?

  And what do you look at in terms of duration for the trade? What's the ideal range?

• 1:32Speaker 01

  Years, maybe even a decade, is the time scale where there are great investment opportunities that last that long. If you're in a living investment organization with a dynamic focus, probably good chance that you'll find the next beautifully inefficient market that may be adjacent or some change in the market. But hopefully, the experience that you're building in this current market environment will allow you to enter kind of the next great opportunity. We could just talk about one example where, let's just talk about lower-middle market private equity, where I think it's a market for the last 10 or 20 years. It's been an amazing opportunity in terms of outperformance and inefficiency. It persists as a great opportunity. But there's a number of adjacencies to that market

• 2:17Speaker 01

  where I think someone who has a sustainable advantage in lower-middle market private equity will be able to participate in those new emerging opportunities as well.

• 2:25David Weisburd?

  I don't think I've ever met an investor that doesn't want to be in an efficient market. But what does an organization need to do in order to be able to pursue these inefficient markets?

• 2:35Speaker 01

  Let's just use the case of an endowment, a foundation, or a pension that's got a large pool of assets and is trying to consider how they invest, where they should be passive, where they should be active, what their asset allocation is. So for most of those organizations, they're going to have a few foundational questions. How much risk to take? How to diversify? But then they're going to have to figure out where they lean in. And when we say leaning in, it could be developing in-house expertise or just really learning a lot about a certain market. And they may have to partner. But most investing is about partnership at the end of the day. But they're going to have their areas of focus. And maybe that's being an activist investor in South Korea.

• 3:18Speaker 01

  Or maybe it's investing in independent sponsor deals in the United States. There's many opportunities out there. You can't typically know everything about everything. So people do have specializations. But most investment organizations will pick a few areas that they really lean into, at least in terms of their expertise. And then maybe it affects their asset allocation. Because ultimately, if you have more alpha in some area of the market than another, you'd probably shift your asset allocation to have more exposure to the markets with higher alpha.

• 3:47David Weisburd?

  As I mentioned, you co-lead high Vistas. So one of your jobs is picking the games that you're going to play, picking the asset classes, picking the sub-asset classes. What do you consider when you're choosing an asset class like lower middle market or the next asset class you want to go after? What's the criteria look like?

• 4:05Speaker 01

  People talk about total addressable market, TAM. I think TAM is a good way of looking at this, which is if the US stock market today is a $60 trillion plus stock market, that's an amazing TAM. There's never been a TAM like that in the world. But you don't need a $60 trillion TAM to have a really compelling alpha opportunity. Trillion-dollar markets are probably about the right scale where you get Plathor of opportunities, you want thousands of potential securities, at least hundreds. Never want to be down to 50 securities to choose from. So when you have 500 or 5,000 or 50,000 securities in your selection universe and it's right sized, it's not filled with mega caps, but rather has a lot of mid caps or small caps with less

• 4:48Speaker 01

  coverage, with more opportunity for dispersion, more of the power law in investing, you really can get outperformance.

• 4:55David Weisburd?

  Said another way, even if there's thousands of securities, but let's say it's the public markets and it's highly liquid.

• 5:01Speaker 01

  Yeah.

• 5:01David Weisburd?

  The mere fact that there's a high quantity doesn't mean that it's inefficient. If there's thousands or millions of people looking at the security, you want the opposite side. You want enough quantities for there to be dispersion and not enough focus on it so that there is still alpha to be had in picking.

• 5:15Speaker 01

  Yes, and yet the world's gotten very funny recently. I think since I started at Hi-Vest 20 years ago, the change in markets is pretty dramatic. So just thinking about numbers, you now have all of the big tech companies, the biggest tech companies in the United States, each have a market capitalization that's bigger than virtually any country in the world outside US, China, Japan. Right? So if you stack up France against, you know, any of the top three or four tech platforms, the top three or four each have a bigger market capitalization than France, or Germany, or the like. You also have a case of that $60 trillion of market capitalization, only two, maybe $3 trillion of that is in the small cap market.

• 5:57Speaker 01

  So right there, most companies in the US public markets are small cap. Right? You have 2,000 small caps versus 500 large caps and maybe 500 mid caps. So you have by number a tilt towards small cap, but yet it's only about 5% of the capitalization. And if your goal is alpha as opposed to trying to figure out what's the best beta, which we can talk about, if your goal is alpha, pure security selection, you're going to benefit from a larger N, a larger pool, and you benefit from the fact that the large capital allocators will have trouble moving a lot of capital around in those markets. They don't typically tolerate.

• 6:39Speaker 01

  Billion dollar investments, it's typically investors who are going to be able to invest tens or hundreds of millions of dollars in any one security. And so it creates an opportunity for those who are disciplined to develop a strategy for outperformance.

• 6:52David Weisburd?

  I had a three and a half hour dinner with one of the chairmen of one of the top banks, you probably know him, but it was off the record, but he said that alpha, he said that his definition of alpha are things that are boring and hard. And I often think about this whole paradox, which is you're trying to find alpha, but you also have outside LPs, so you also have to sell to LPs. And one of the reasons why alpha persists is because LPs don't love or it's an unloved sector. How do you square those things together where it's something that there's alpha and that it's worth pursuing, but also something that's marketable to LPs?

• 7:28Speaker 01

  Great one. Let's go back to the LP's perspective. I think it's always useful to take how their dilemma and how they're thinking about the world. If you go back 30 or 40 years, Yale pioneered asset allocation and really investing as a real money allocator. And the two innovations there were you need to own a lot of equities and diversifying within equities to own a bunch of different kinds of equities. That's most of where allocators really need to spend their time is coming up with an appropriate asset allocation. Should you own fixed income? Should you own equities? Remember, people used to invest a lot in oil and gas. And that was very fashionable amongst large capital allocators. And then they pulled back because they found the returns weren't as compelling. But that's really where they have to spend a lot of their time.

• 8:13Speaker 01

  There's a lot of return that can be driven from making great allocation decisions. And we've all seen those studies that so much of a pensioner or capital pool's returns will be determined by those few decisions. How much risk? What geography? What kinds of equities are you after? If you're, if you're buying the S and P 500, you're going to have wildly different experience than if you're buying acqui in a world where hyperscalers are winning and all of that activity is in the US. Nearly all of that activity, I should say. So that's their job. When it comes to alpha and they want to add to whatever they whatever return they can get from asset allocation, alpha is purely additive.

• 8:58Speaker 01

  It just adds a return above and beyond that. And that's why it's so precious. They might be targeting a seven or eight percent return from their asset allocation. But if they can add to that, that's just wonderful. Asset allocation gives you a good baseline return, but it's the alpha that will really catapult you into that kind of top quartile, top decile.

• 9:16David Weisburd?

  Said another way, they're relying on you to be the alpha part of their portfolio, which is said another way is they're relying on you to be contrarian and to take those shops on goal that are outside of just their pure beta.

• 9:28Speaker 01

  That's a very good way of putting it. They have to really focus on the big picture and getting the allocation right. And then they've got a partner. It's all about partnership, figuring out how to add alpha on top of that. Because to really outperform you do need alpha. Alpha is wonderful. It's by definition uncorrelated with the returns of the investor. That is the definition of alpha. So if you can add a source of return that's uncorrelated with the rest of the portfolio, it adds almost no risk in total to the portfolio. The total portfolio risk barely budges, and yet you can move your returns kind of up and up. And so that's really what our firm's about. We're there to partner with the end investor. We do things that are hard. Some of it is quite difficult. We have a 30 plus person

• 10:09Speaker 01

  investment team dedicated to scouring these markets. And it's not just the number of people, it's the number of years of experience that those people bring to the table. And we're there to partner with investors who need access to these markets, which are less efficient, which are difficult, they're time consuming, hard to diligence, hard to access. In some cases, you know, just take a lot of experience and a lot of shoe leather.

• 10:35David Weisburd?

  And you mentioned the Swenson model, which was developed by David Swenson at Yale, now in the 80s, so many decades ago. I had Alex Ambrose from Allocator Training Institute, and he took me through the DPI model. So when Swenson model was around, there was a 24% DPI in private markets. In 2024, there was 9% DPI. In 2025, again, roughly 9%. Is the Endowment model of old broken today?

• 11:02Speaker 01

  It's a big question. People totally need to recalibrate how they think about private investing, first of all. Private markets are much more mature than they were. And so the idea of sponsor to sponsor exits at the pace that we saw them over the course of our careers, it's unlikely to return to that level over the long run. So sponsors exit to sponsors at a slower rate, that means privates will be held for longer, it means less DPI, and it means calibrating your assumptions about liquidity. But it also means calibrating your assumptions about returns, because when you have a new market and it's growing, there's almost like a structural

• 11:44Speaker 01

  alpha where this flows and the flows generate higher multiples, higher valuations, and it's just a wonderful feeling, kind of everyone wins, rising tides. I don't think we're in a, an environment where it's sinking tides, it's fine, but you have to recalibrate. It's not going to be as fast an exit. And the emphasis on finding good businesses at really good valuations and finding management teams as well sponsors who can operate those businesses and actually add value. It's very clear that the market shifted and investors are spending a lot of time thinking about that as opposed to, oh, let me just invest a large amount in private equity and the beta will take care of itself.

• 12:26David Weisburd?

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• 13:53David Weisburd?

  alongside filings, broker research, news and more than 240,000 expert call transcripts, turning raw conversations into comparable, auditable insight. Take advantage of AlphaSense AI-led expert calls now. The first to see wins, the rest follow. Learn more at alpha-sense.com/HowIInvest. I was shocked. I've had multiple Ivy League endowments tell me that, all things being equal, they have a preference for non-line pool investing. So whether that's investing in co-invest or investing into direct deals, it's not even the economics. They don't want their capital tied up now for 10 plus one plus one plus one plus one years. They don't want that there for 14 years.

• 14:34David Weisburd?

  They don't want their capital basically burning a hole in their wallet and cash. And they want to have control. Is that something that you see in the market as well?

• 14:43Speaker 01

  There's some elements of that. Some of that's just about investors trying to contract with investment manager and just make sure that they're getting the right thing. We think it's important for investors, for example, one way or another, to have some transparency into what they're buying, what kind of companies they own, at what valuations. Our own program is very focused on lower middle markets where we think, pound for pound, we're just getting better value because we're buying businesses at better prices. It takes more work, but you get paid for that work. So there's return on work. In the largest end of private equity, there's less of return on work. It's more competitive because the rewards are so great. If you can write a billion dollar check to buy a business, well, many sponsors would like to do that.

• 15:27Speaker 01

  That's a very privileged position to be in. So it's more competitive, more of an auction dynamic. And so I think part of it's just about identifying the opportunity, making sure that investors really get comfortable that there is alpha. We found that for many, if you have a really consistent playbook and can show that you're executing on that playbook over and over and over, they can get comfortable that they're underwriting, almost like you said before, a sustainable source of alpha. So something that's beautifully inefficient, and they may not need to get down to the granular level of, show me a deal. They might be willing to do more of a blind pool. But there's definitely an emphasis as well on co-investing and seeing identified pools. We think one trend in private markets that's really exciting now is the continuation vehicle, technology.

• 16:12Speaker 01

  I'm going to call it a technology because I think people are thinking of it as a market. It is a market, but it's also a technology. It's a technique, and it could be used in many different ways. You can use the continuation vehicle to take the companies that are struggling in your portfolio and hold on to them for longer, or you could take them, take the same technology, rather, to go after the crown jewels of your portfolio, the businesses that you know have moated advantages that you want to see grow over a longer period of time. So we think the continuation vehicle market That technology will now increasingly be used by sponsors to hold on to their best businesses. That's not how it started, but that's where it will be applied. And that's an exciting opportunity because if you're an endowment, you can look at a business and say,

• 16:54Speaker 01

  I like this business. I even did a call maybe with management team or I have a partner in that market. And I know the business. I know the track record of management on execution. I know the track record of the sponsor. And I want to be invested in that business for the next five years.

• 17:07David Weisburd?

  I love continuation vehicles. I had Michael Woolhouse from TBG who has a $1.9 billion fund just focused exclusively on that. I think they just crossed $110 billion in AUM continuation vehicles. They've really proliferated in the buyout space. Do you see them making more of an appearance in the venture capital space?

• 17:23Speaker 01

  I've seen a little. It's, I think it's underpenetrated. Even, even lower middle market is very underpenetrated. We've, we've studied just the buyout market alone. And what you see is that overwhelming percentage of deals are flowing through the middle market. And actually, as you know, most companies are lower middle market. Most sponsors are lower middle market. That's by number where the opportunity is, but it's not where the dollars are. So if you're a broker, it's going to be more exciting, at least at first, to go find the bigger businesses that you can do CVs with. But the technology is out there. It's pretty well established. People aren't confused by it anymore. They kind of know how it works. They know how incentive alignment works. They know how to structure, how to document.

• 18:05Speaker 01

  And so now that it's more of a developed market, it will be applied more and more in lower middle markets. And I think the same could be said for the technology world, venture capital and growth capital, where it definitely is going to make a stronger appearance over the next decade. But it's, it's going to follow buyout. Buyout will lead the way.

• 18:24David Weisburd?

  And it's so interesting that continuation vehicles are this new vehicle where you might have a fund and your fund is at the end of its life. And now you double down instead of selling that, your best asset, you put it into an SPV and you, and you raise money around it. But if you think about it from first principles, I had Sam Zell's longtime partner, Mark Soter, who still runs his family office. And he talked to me about the absurdity of how private equity works, which is you take an asset, you build it for five years and then you sell it to your competitor. And it's just not, doesn't really make sense from first principles outside of the DPI schedules and LPs, I would argue fetishizing DPI and wanting to constantly redeploy capital, even if it's in suboptimal investments. But if you think about it, not only do you have asymmetric

• 19:06David Weisburd?

  information on that asset, so you've now worked with them for five years, but the entire process of buying and selling companies over and over, it has huge frictions, not only financial frictions, but also time friction. The first year, you're getting up to speed on the asset, then for three years, you're actually productively growing that asset, and then the last year, you're growing it up. I see this all the time. I've never met a buyout portfolio company in its last year that's not somehow dressing itself up for acquisition. It is just the nature of incentives. And if you think about now, you have, you contract then, you have, you still have the one year where you're setting up with the asset, now you have three years, but now you get to compound that asset for seven, eight years with the same management, with continuing to press your advantages. Just imagine Hi-Vista, you've been there since before you even started in 2005 as a firm. What if you

• 19:48David Weisburd?

  were cut off in 2010 or 2012? How much more room is there for the firm to grow?

• 19:54Speaker 01

  Yeah, the geometric growth, the potential, whether it's in growing a firm like ours, or the potential for a company is so obvious. Not every business has that, right? Some run out of ideas. They had their playbook, they needed to make a quick fix, and then they should just sell it to someone else who has a better idea. Because ultimately, companies should be owned by the management team or sponsor that has the best idea for them. That's what's so great about our economy. It's so dynamic. It's so easy to transact relative to other places in the world. And we're blessed by that because it really creates a lot of efficiency. But this is a new tool that will enhance efficiency because when the sponsor can convince the capital that they have the best idea to continue with this business, that actually keeping the management

• 20:37Speaker 01

  team in place, creating even stronger alignment of incentives, they have a great plan, that's a wonderful outcome. And yet,

• 20:46Speaker 01

  The privates for longer trend means that some investors don't necessarily want to hold on to their businesses for 10 years. They may be very happy if they have a three or four X outcome in year five. They might say, that's great. I want to take some or all of the winnings off the table and redeploy it, or maybe they have actual spending need. So it really gives investors more flexibility. It gives the sponsors an ability to lean into what they're doing best. And it gives investors, I think, opportunity to align with the sponsors and really challenge and make sure, you know, is this the business that we want to hold on to, that the sponsor has a right to win, that is this the right management team? And so I'm excited about the technology. I think it's going to be used in venture growth world as well. It will mature. You know, we're kind of going into a second decade. It's 10x'd in

• 21:30Speaker 01

  the last decade. It was $100 billion market last year, which is kind of an incredible number. And it will continue to grow. I don't think it will 10x in the next decade, but it's going to grow and it will enter new markets and be applied in new ways.

• 21:43David Weisburd?

  When I think about venture, one of the leading pioneering firms on this is Harbor Vest. They're starting to really actively do CVs. There's also a fellow Bostonian firm.

• 21:52Speaker 01

  From our window, we look right out.

• 21:54David Weisburd?

  You can see the Harbor Vest sign. And I think one of the frictions there is CVs are still considered secondaries. So firms are not RIAs are going to struggle for a while to do that without the right financial partners. But if you look at, if you take a step back and look at DPI on the venture side, there's no reason to believe that the quote unquote DPI crisis or DPI is going to return to venture capital, just because we're going to have the OpenAI's SpaceX, Anthropic's. There's no reason to believe that that's going to solve this DPI crisis in the future.

• 22:25Speaker 01

  No, it's, it really is a case where I think investors are realizing that early stage venture is a long hold game. And you're not likely to find exits in the first five or 10 years. It's going to be in years 10 to 15 and sometimes beyond. You're seeing venture funds that sometimes have amazing outcomes, but it takes them the full 15 years. So it isn't for everyone. But if you're a patient institution that is investing over the very long run. Investing in the means of production, whether that's through industrial companies or service companies in the bio space or with the innovative economy in the venture space is really the only way to invest outside of fixed income markets.

• 23:08Speaker 01

  You have to ultimately invest in the economy. Some of that's in public markets, of course, super important. But there's 3,000 public companies in the US and there's probably something like 100,000 investable private companies. So it's just a much bigger market. It's in many ways a more important market for investors, not more important for the world. The public markets serve an amazing function, but for investors, the private market just gives you way, way more flexibility, more opportunities. But you do need the right duration of capital for venture capital. And particularly if you're not investing in the top 10, 50 or 100 businesses, the ones that are likely to go public in the next few years. That's also a great opportunity set. Some investors are focused there, but there's still early-stage innovation to invest in.

• 23:50David Weisburd?

  Which is another form of alpha. Everybody is saying, I want DPI, I want shorter timelines. One source of alpha is going in the opposite direction, saying, I'm OK to be the longtime partner as long as I have these higher hurdles.

• 24:00Speaker 01

  Yeah, we're 100% believers. So our lineage in venture investing goes back to the mid 1990s. It's actually a team that joined Hi-Vista.

• 24:08David Weisburd?

  Tell me about it.

• 24:09Speaker 01

  A team that joined Hi-Vista used to be called Flag and started this in the mid 1990s. So it's now 30 years of investing in early-stage venture. So totally focused on the innovation economy. You end up taking bets on things that are head-scratcher because they just sound crazy at the time. But in the fullness of time, they kind of make a lot more sense. So I remember actually when I started Hi-Vista 20 years ago, 22 years ago almost, Google had just gone public. And it's like, what? These guys are like a better form of Yahoo or something? And it's like, I don't know. Is this like 20 billion?

• 24:45David Weisburd?

  What's wrong with Yahoo?

• 24:46Speaker 01

  20 billion dollar plus valuation? Like, does this even make sense? Like, how will they ever make money? Like, how much money could they make? Fast forward 20 years and you see like what kind of innovation they've brought to the economy and the rewards for that innovation, as well as the monopoly positions they've created for themselves, amazing business. And those are created in the venture capital ecosystem every single year. There's always great companies being born.

• 25:12Speaker 01

  The challenge is there's thousands of businesses being formed every year. You know that you're very involved in the space. You know how many businesses there are. And there's a thousand venture capital firms funding these thousands of businesses that are created every year. Most will fail. Most should fail. That's what's great about markets. And it's that power law where the most successful businesses will be in that bright tail and could get you 100,000 X returns or maybe even greater than that. And every venture investor, their dream is that they have a unusual batting average and they're going to find a disproportionate number of those 100 X, 1000 X returns. You have to be in the ecosystem. You gotta know the right groups that have the right access to that deal flow.

• 25:56Speaker 01

  It's very hard as an investor to just wake up one day and say, I want to be an early stage investor. Let me, I'm going to move to Sand Hill Road and see what businesses come my way. They're unlikely to knock on your door.

• 26:08Speaker 01

  But there's so many venture firms that one could partner with and as well as innovative ways of investing in that. We think it's a great place to be invested if you have that timeframe.

• 26:17David Weisburd?

  I've coined this term strategic ignorance when it comes to venture capital, which is venture capital, capital V. Everybody wants it. Everybody wants to get in these funds. But if they knew what they were investing to into, especially at the time, they would not like that. They would not like, why are you investing in defense tech a decade ago? How are you going to go against the large primes? Why are you investing in this cryptocurrency? Isn't it going to be hacked? Every single trend by definition, for it to be an early stage investment and for it to grow 1000 X needs to sound crazy. So it makes a lot of sense, especially when people are managing other people's money and that somebody to report to, to have this wrapper around this portfolio that's called venture capital with these extremely spiky assets that since the 1970s have, has outperformed

• 26:59David Weisburd?

  every other asset class on average, if you're in the right managers, not knowing exactly what's in your portfolio, not figurative, not literally, but figuratively is a huge advantage to investing in that asset class.

• 27:09Speaker 01

  A hundred percent. And the way we look at early stage venture, let me start with this is. One of our partners had a slide a number of years ago that showed what was the best business created in the venture ecosystem every year going back in time? And where did capital flow in that year? Which sector was capital flowing to within venture? And where was the best business? And it was never the same. So the best outcomes was always in some space that people weren't thinking about. And all the money was going into the crowded trade. So there's definitely a part of being a great venture investor that requires a discipline, almost being a contrarian and looking for weird ideas. But really great entrepreneurs in potentially very large markets. The best venture firms have figured that out.

• 27:54Speaker 01

  A lot of it's about entrepreneur. The business plans adjust, but if they're in a great space and you've got a great team, magic can happen. And we've seen so many examples of that where businesses started with business plan A and then they become known as completely different company. I mean, let's think about an automobile company that's become an AI company, for example, right? Tesla is just the perfect case study of how much they've accomplished. That has almost nothing to do with automobiles. And so that's so important in venture. You need this large portfolio, large number of bets. So if you want a somewhat predictable outcome over time, but you also need to think in a little of a contrarian style. I'm not just going to put all of my money into the hyperscaler. I'm actually going to go look at some very differentiated.

• 28:40Speaker 01

  Some of it's in the AI native companies, but some of it's in other areas of innovation. I mean, defense tech is obviously going through a massive innovation wave. And I think the next few years, we're going to see even more of it. Investors have to kind of pick their spots.

• 28:56David Weisburd?

  Speaking of contrarian investing, you guys are bullish on biotech.

• 28:59Speaker 01

  Yeah.

• 29:00David Weisburd?

  Many people are withdrawing from the segment and think it's very difficult due to many different issues. China, the IRA and other kind of pricing mechanisms that are going against biotech. Why are you so bullish on biotech?

• 29:13Speaker 01

  So let's start with healthcare. You know, you hear people talking about healthcare is out of control. It's just too high a percent of GDP. But if GDP compounds the way it's been compounding.

• 29:26Speaker 01

  Actually, healthcare will grow as a percent of GDP. And it's almost like a rule of economics, actually. The cost disease, there was, I think, a Nobel Prize given for this work. Kind of explains why healthcare costs will rise over time.

• 29:41David Weisburd?

  It's one of those things that rises to the top, top of the right.

• 29:44Speaker 01

  Yeah, as a society gets wealthier, the amount they'll spend on the raw ingredients in their meals goes down. The amount they'll spend on oil or coal or natural gas or rubber or steel goes down. But the amount they'll spend on experiences as well as wellness just goes up. And that occupies a greater and greater percentage of income. So, you know, we're sitting here in Soho and how many restaurants are there within a few blocks distance? And if we were to go back two generations, how many restaurants were here? People didn't eat out as much. People are eating out more. They want great healthcare. They want wellness. Well, within that basket, so you have GDP growing, you have healthcare growing faster than GDP. And then what's going to take a bigger and bigger percentage of healthcare?

• 30:29Speaker 01

  Technology or manual labor? And it seems pretty obvious that it's technology. So biotechnology is wonderful because if you can get the right medicine, even if it's only for a small population, if you can get the pill that helps 1,000 or 10,000 people, that's an incredible amount of value that you can bring to this world. And compare that to the rising cost of healthcare of staffing a hospital or an outpatient clinic. Yes, it's expensive to develop these medicines, but there's so much leverage in you develop it once. And you don't have to hire as many people to treat that population. So the macro is wonderful. You have this tailwind of growing GDP, growing healthcare as a percentage of GDP,

• 31:11Speaker 01

  and growing pharmaceutical innovation as a percentage of healthcare spend. Yes, there's headwinds in the form of people don't like hearing about the drug prices, often priced in the thousands, tens of thousands, or sometimes hundreds of thousands of dollars. These are very expensive and particularly for those

• 31:28Speaker 01

  very small populations where you have some orphan particular indication where you could be only a few hundred people taking a certain medicine. That's going to be very expensive to develop on a per person basis. That's the backdrop. What we like about biotech is that backdrop, but also the alpha opportunity in the public markets.

• 31:48David Weisburd?

  Alf, in general, this is a pet peeve of mine. People talk about asset classes as if the pricing is fixed.

• 31:54Speaker 01

  Yeah.

• 31:54David Weisburd?

  For example, they'll say, I love early-stage investing, or I hate early-stage investing. But if you have the same asset, you're investing at a $25 million valuation, or you're investing at a $5 million if it's extremely out of favor. That is fundamentally a different investment. And people talk about it as if it's good or bad versus what the right way to talk about it is whether it's overpriced or underpriced.

• 32:12Speaker 01

  Yeah.

• 32:13David Weisburd?

  There is no really bad asset. And same with biotech. If everybody in the world now thinks biotech's a bad sector, at some point, it becomes one of the best sectors in the world because there's just so many opportunities. And when everything goes down, even if there are a lot of bad assets, sometimes there's some gems there that no one's looking for.

• 32:29Speaker 01

  100%. It's challenging because you get these procyclical moments where when the market turns and becomes pessimistic, it's hard to access capital. And some of these companies, when they can't access capital, like in the venture ecosystem, you know, it means they go away. So you need to maintain access to capital. That's why there's so many public.

• 32:47David Weisburd?

  There's a momentum aspect to it, whether you like it or not.

• 32:49Speaker 01

  There's a short-term momentum and a longer-term reversal. And so there are great contrarian value investors who saw biotech just getting hammered over the last few years. And some of them timed it really well, kind of getting in at the nadir and just saying like, okay, yes, there's a lot of headwinds in terms of momentum, but eventually there's a reversal. You get to some point where you're buying businesses for less than the net cash. And you're saying, okay, even a mediocre management team should be able to handle this one. I mean, we're trading at less than the liquidation value. This is amazing. And then if you have a good management team, I mean, it's like many ways to win, right? This is amazing. So you get those opportunities. There are moments in biotech where the beta turns very favorable, and there are moments where it's less favorable.

• 33:31Speaker 01

  We, as a firm, don't think we're like the best at market timing. We leave that to others. Kind of got to know what you're good at, what you're less good at. We tend to focus on the more consistent application of alpha generation. So it's the security selection. How do you get relative value? But there are investors, that's really the CIO's job at an endowment to say, I'm going to reallocate some money from China to biotech or from biotech to Korea.

• 33:56David Weisburd?

  So there's principal agent issues on your side, which is if you go to these LPs and the LPs know that biotech is out of favor, it's a heart, you need to have a lot of political capital to do that. But also, let's say that the head of biotech or the head of Alts wants to do the investment. Now they have to go to their CIO, and then their CIO has to go to their board. So it's. All these levels of governance and all this complexity that you're going against this friction. On your point on market timing, I've actually pretty much come to the determination that market timing is an unknowable force. And the reason I could say that with high confidence is I've talked to some of the best public investors in the world, and none of them know what catalyzes a recalibration. And I actually don't even think it's that they don't know. I think it's unknowable. I'll give you an example.

• 34:40David Weisburd?

  GameStop, was that a knowable thing? That was fundamentally unknowable. But even even smaller aspects of that, sometimes you have somebody come in with an activist campaign. Could you know? Could you predict that? Well, maybe if you knew the activists and they gave you a phone call before that, which would be, of course, insider trading. But outside of that, there's these memetic things in the market, especially now with social media, that are fundamentally unknowable. What will actually catalyze the change? What do you need to do as a great public investor? You need to make sure that you have enough of a runway for luck to basically run its course.

• 35:10Speaker 01

  I think that's right. Look, geometrically, you may have some understanding of a market, but it may not work out arithmetically. And let me explain the difference, right? You look at GameStop and you say, I kind of know where this is going to end, but you don't know where the next day, the average of the next 100 days might be very bad if you go against the mania. Over the long run, you might be right, but you might be carried out before you're right. And so particularly when you're short, it's extraordinarily difficult to be short because it becomes more of an arithmetic game. And on some days, you could just lose so much money that you can't even make up for it. When you're a long biased investor and you're holding a security, you sometimes could fight the crowd. It's possible. You want to diversify because you never know.

• 35:55Speaker 01

  There could be corporate events that change the ultimate trajectory. But I think fundamentally, the point you're making is right, that it's very, very difficult in these situations to kind of time and to get those dynamics exactly right. We're more focused on the dispersion of opportunity, making a basket of investments where you think.

• 36:19Speaker 01

  The basket is biased towards that kind of top quartile outcome. When you have a high dispersion market, you don't even need to be 99th percentile. If you're 60th percentile on average in a high dispersion market, you just are going to outperform by hundreds of basis points.

• 36:36David Weisburd?

  Kind of goes back to this strategic ignorance aspect, which is if you need every single investment to work and to get the timing right, you're misusing the asset class. But if you build a basket of it, knowing that on average, you're going to have these very spiky, very high alpha trades, then you could actually have a pretty diversified and pretty predictable alpha producing portfolio.

• 36:55Speaker 01

  Yes. Now, I want to go back for a minute to what you said, if we can. You said, you said the magic word before, governance. I think so much of this is about governance and agency. And if every investment organization, whether you're an investment manager like HiVista, or a pension, or sovereign wealth fund, if every investment organization could clarify what they do, what they don't do, where they should focus their time, and how decisions will be made, that will lead to just much better outcomes. There are organizations who we've partnered with, who really can lean in and out of markets, who have the governance to do that in a time effective way. They can actually move around their asset allocation in a pretty dynamic way. Most organizations can't.

• 37:41Speaker 01

  And if you have that knowledge of which organization you are and how your governance, do you have to go to your investment committee? Does the CIO have discretion? How much career risk would the CIO be taking, by the way? And can the CIO withstand?

• 37:52David Weisburd?

  And do they have upside?

• 37:53Speaker 01

  Do they have upside? What if the market goes against them? Will they double down when the market's down? Or did they cut their losses? Why should they double down? Why should they cut their losses? Obviously depends, right? Sometimes market moves against you. You say, information's on my side and this is just random? Or even worse than random, it's just some nonsense fad, you know, trend that's going to reverse itself. I got to add even more to this position. There's other times where kind of more of the classic hedge fund approach, which is, hey, it's moved against me. I just have to get out, cut my losses, and I'll reevaluate and see if my thesis is intact. Both have their place as, as risk management or investment philosophies. But you need to think that through in advance. You need to know if you're going against the crowd, if you're making a big decision, what will you do on the day where it goes against you?

• 38:35Speaker 01

  And how will your teammates, how will your colleagues, how will your supervisor or your committee react?

• 38:41David Weisburd?

  It reminds me of this famous pension fund study that found that 90% of a pension fund's performance could be predicted by their asset allocation.

• 38:47Speaker 01

  Yeah.

• 38:47David Weisburd?

  And their sub asset allocation. And you think upstream of that, what is that? That's governance. Going back to Alpha, governance is probably the most importantly sexy thing on the planet. And yet, when I interview people, especially former CIOs, where I love to interview former CIOs because you get, you get the full picture from them. They're, they're no longer within the organization. And I interview people like Larry Kochard, who was former McKenna, UVA Georgetown, or Britt Harris, who's actually become an advisor of us, former U Timco CIO. They all say the same thing. A, it all comes down to psychology.

• 39:17Speaker 01

  Yep.

• 39:18David Weisburd?

  They basically realized 20 years into their career that they're a psychologist. And, and then two is it comes down to governance. And even current CIO Scott Chan, if you ask him, how did, how did you return 13% on $360 billion at Callisters? The answer is he had a decentralized system. Because how, how else do you move with so much capital? You need to empower everybody in the organization to be able to make decisions. Now, of course, you have risk guards on that. Certain check sizes require discretion, all these things, but you have to allow people at the edges to execute their discretion.

• 39:48Speaker 01

  A hundred percent. It's really a lining between the particular dynamics of the capital source and the organization that's formed around that to get to the right governance model. There's no one governance model. I think, you know, in our own case, because we're investing across lower middle market private equity, early stage venture, asset backed private credit, as well as biotechnology, there's a lot of ground to cover and we couldn't do it without having a really strong platform, which means governance. And it also means, of course, having like great client functions and operating functions so that investment teams can really focus on making great investment decisions. There's different investment committees, different composition for each of our different areas of focus.

• 40:30Speaker 01

  And so those investment teams can focus on their craft, on making good decisions and, and partnering with an overall broader platform that supports that craft.

• 40:40David Weisburd?

  You mentioned this whole aspect of career risk. My favorite example of this is Scott Wilson at University of Washington, St. Louis. And he meets with his managers.

• 40:48Speaker 01

  They've done well.

• 40:49David Weisburd?

  They've done exceptionally well. He's one of the top CIOs in the country.

• 40:51Speaker 01

  Incredible.

• 40:52David Weisburd?

  And he meets with the top managers in his portfolio. And he asks, where are you at your concentration limits? In other words, you're 20% in this position? I want more of that. What he's implicitly saying is that even at 20%, you're underweighted. Why? Because little Johnny still has to go to college. Because that CIO still has a certain risk factor that they could take. So he fundamentally goes and meets with every manager, figures out where they fundamentally cannot put in more, and actually doubles and triples down on that, which is very counterintuitive. Usually you would think about in portfolio construction, you want to do the opposite. But because he's so diversified across managers, going back to the structural alignment, he's able to take these asymmetric bets in their highest conviction bets.

• 41:29Speaker 01

  And that, I think, was pioneered by the pod shops, really. The pod shops really came up with this idea of a center book where you're upsizing. We do that across all our portfolios, actually. So we're doing that in private equity, venture, private credit, and biotech, where we'll partner with specialist GPs. And then you're trying to lean in. You have to build a lot of diversification to be able to lean in. Because if you lean in on an undiversified portfolio, in the end, you're just taking too much idiosyncratic risk for the client. But if you have 100-plus company diversification in a portfolio, you could afford to lean in and still not really be taking on that much risk. How do you get to 100-plus company diversification in any program? You need to do it through partnership.

• 42:11Speaker 01

  No organization's really set up to invest directly and know hundreds of businesses cold. You need to know the businesses, but also have really good partners that you can rely on, and then co-invest, whether it's an independent sponsor, or a small venture manager, or a hedge fund. Co-investing alongside them or upsizing a name is a very powerful tool.

• 42:31David Weisburd?

  I think this is one of the fundamental. Flaws in asset management, this idea of over diversification. There's this rule of 22 and a half, which is completely arbitrary. It just means that you have like 97% diversification. If you take it to the most extreme, you have many founders that have 100% of their money in one company. And then you think, okay, how diversified? I'm in one asset. That doesn't sound very diversified and it's not, of course. Then you think, well, now I do nine more investments. I have 10 investments. How diversified am I? It's actually a very easy math equation. You're now 90% more diversified. And now you do another 10, now you're 95% diversified. This is where the 22 and a half, it's just this, it's an arbitrary rule. It's this number that people have come up with, but there you're 97% diversified.

• 43:14David Weisburd?

  But at what cost? And a lot of, this goes back to principal agent problems. If you're an endowment and you're a CIO and you don't necessarily have the upside, you want to make sure that if, if everybody else is at 8%, you're between 7.5 and 8%. So from a principal agent problem and a principal agent position, it makes a lot of sense to be hyper diversified. But from a net return to the underlying capital pool, it makes much more sense to be spiky in the way that Scott Wilson does it and you guys do as well.

• 43:44Speaker 01

  So a couple of comments on that. I think, I think that's right. When you diversify roughly, the idiosyncratic risk that you take relates to the square root of the number of investments you have. So if you go from one to nine investments, you're kind of cut your, you cut your idiosyncratic risk by factor of three. When you get to 25, you cut it by factor of five, assuming they're all kind of different sectors and that you're, at some point, you're actually making many bets in the same sector. And so that's where that diversification really does start to matter less once you get to the 10, 20, 30.

• 44:21David Weisburd?

  You feel like you're diversified, but you're not.

• 44:23Speaker 01

  Yeah, because, because when you start diversifying cross geography or sector or themes, in the beginning, it's very powerful, but then you have many bets in the same theme or the same sector. It's not as powerful. For the capital allocator, their job is actually not to over diversify and to not think, I need to hold equal weight US, Spain, Vietnam. That gives me more diversification? Like, that's nonsense, right? When you're thinking about capital allocation at the highest level, your starting place should be. The world, take the Acqui index, for example, and say like, hey, that's a pretty good index. And then if you want to lean in one direction or another, sure, lean. Once you drill into a market and say, hey, how am I getting exposure to Vietnam or Spain? Well, yeah, you don't have to index in that country because it's not really going to

• 45:08Speaker 01

  matter. If you made three bets versus 30, it doesn't matter. Then it's just about agency risk. Once you're in the drilling down one layer, it becomes about agency risk. But agency risk, I would argue, is real. I think even when you invest for your own portfolio, if you don't have enough diversification, you might make the wrong decision at the wrong

• 45:29David Weisburd?

  Makes you more fragile.

• 45:31Speaker 01

  More fragile. You might lose faith in a strategy that you had thought through pretty carefully because you don't see enough evidence that it's going in your direction.

• 45:38David Weisburd?

  That's the other thing I'm obsessed about, rootedness of thesis. An example I use on Bitcoin. If you had invested, if your friend, you went to MIT, your friend came to you and said, there's this awesome thing called Bitcoin, you have to invest, and you invest at $10. And then it goes up to $160. And you're like, great, I'm up 60 next. And then it goes down 20% to $120. What are you going to do?

• 45:55Speaker 01

  Yeah, so actually, a friend of mine from my days in Cambridge did come to me 14 years ago. And he's a brilliant computer scientist. Actually, this is his field. And he said, this was going to change the world. And he was, I think, on a professor's salary. So I don't know how much he invested, but he was advocating that like, everyone should invest. I actually just had no idea what he was talking about and couldn't understand it. So I didn't invest. You know, I think I would be in a very different situation today had I taken his advice. But yeah, you have to understand what you're investing in. You have to have core beliefs, and you have to be willing to stick to those, even when the evidence is a little murky.

• 46:35David Weisburd?

  Well, Rafi, this has been absolute masterclass. Thanks so much. And thanks for being a partner to our firm. And thanks so much for jumping on.

• 46:42Speaker 01

  Thanks for having me. It's really great to be here and look forward to our next conversation.