Ian Charles - Private Equity's New Rules (EP.431)

Ian Charles is a founding partner at Arctos Partners, a $10 billion private equity firm that strives to create valuable solutions to complex problems. In just five years, Arctos has become the leading institutional investor across the five major North American sports leagues. It also serves as a strategic partner to leading private market sponsors with bespoke capital and liquidity solutions. As part of its effort to support both ecosystems, Arctos publishes data-driven research and content under the Arctos Insights umbrella. Ian is a repeat guest on the show. Our first conversation with co-founding partner Doc O'Connor describing the sports strategy is replayed in the feed. This time around we walk through the changing competitive landscape of private equity, covering the most important narratives for GPs and LPs and how both sides are navigating the environment. We discuss Arctos' taxonomy of private equity firms and the implications of its different levels to a GP's strategic positioning and right to win. Ian has a long history serving the private equity market and is unusually insightful and blunt in describing the complex and evolving marketplace. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (https://thepodcastconsultant.com https://thepodcastconsultant.com/)

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

• 0:01Ted Seides?

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• 0:46Ted Seides?

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• 2:06Ted Seides?

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• 2:47Ted Seides?

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• 3:32Ted Seides?

  Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.

• 3:59Speaker 01

  All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.

• 4:18Ted Seides?

  My guest on today's show is Ian Charles, founding partner at ArcTOS Partners, a $14 billion private equity firm that strives to create valuable solutions to complex problems. In just five years, ArcTOS has become the leading institutional investor across the five major North American sports leagues. It also serves as a strategic partner to leading private market sponsors with bespoke capital and liquidity solutions. As part of its effort to support both ecosystems, ArcTOS publishes data-driven research and content under the ArcTOS Insights umbrella. Ian is a repeat guest on the show. Our first conversation with his co-founding partner, Doc O'Connor, describing the sports strategy

• 5:03Ted Seides?

  is replayed in the feed. This time around, we walk through the changing competitive landscape of private equity, covering the most important narratives for GPs and LPs and how both sides are navigating the environment. We discuss ArcTOS's taxonomy of private equity firms and the implications of its different levels to a GP's strategic positioning and right to win. Ian has a long history serving the private equity market and is unusually insightful and blunt in describing the complex and evolving marketplace.

• 5:36Speaker 02

  Before we get to Ted and Ian's interview, we know that Valentine's Day is right around the corner. Maybe you're gearing up for a heart-shaped chocolate binge, planning a romantic dinner that'll hit your wallet harder than expected, or just bracing yourself to dodge Cupid's arrows altogether. Whatever your plan, we've always got something to make you fall head over heels, a fresh dose of investment intelligence. So this Friday, grab your favorite indulgence, chocolates, wine, or if you're like Ted, a stack of investor letters and tell your Valentine to tune into Capital Allocators, where we help investors steer clear of heartbreak, from investment performance, that is. Thanks so much for spreading the word.

• 6:16Ted Seides?

  Please enjoy my conversation with Ian Charles.

• 6:21Speaker 02

  Ian, thanks so much for joining me.

• 6:23Speaker 03

  Appreciate the opportunity to be here.

• 6:24Speaker 02

  In the past, when you came on with Doc, we were talking about sports and your roots are deeper in private equity.

• 6:30Ted Seides?

  We'd just love to give a little color on what brought you to thinking about the private equity industry.

• 6:36Speaker 03

  I started my career as a limited partner. I worked at a fund of funds platform. I know what it's like to meet with five managers a day, to hear the pitch, to get jammed on a co-invest timeline. That experience as a limited partner early in my career gave me a real appreciation for the market's needs from a client perspective. My entire adult life, I've been very entrepreneurial. And I started a business with some colleagues that was the very first intermediary helping limited partners sell in the secondary's market. That firm was called Cogent Partners and being one of the founders of a business that really changed the cost of capital

• 7:18Speaker 03

  for limited partners forever was an incredible opportunity for me and the rest of the founders. And it was a springboard for me into a career of serving this asset class, LPs, GPs and all of its stakeholders. And that servant leadership mentality has really been a part of my entire career. I come into this new firm that we started five years ago, having served the leaders of other private equity firms, limited partners and being an innovator in the market my entire career.

• 7:51Ted Seides?

  So as you're talking to GPs, what are you hearing are the most important needs and challenges they're facing?

• 7:57Speaker 03

  I don't think most market participants appreciate or understand how complex these businesses are. The management company, the GP, that is a complex business. And as the firms grow and mature, that complexity increases in nonlinear ways. These are challenging businesses, but the leaders of these businesses typically are great investors, but they're also entrepreneurs. And that entrepreneurial journey is particularly lonely in this industry. And so our team's job, the thing that I love, is serving the entrepreneur on that journey.

• 8:40Speaker 03

  The way that we do that is powered by data. And some really cool tools to break down the market, to break down firms and the competitive landscape and particular strategies. That's what we bring to these conversations. But it's funny, when you go talk to a GP, they are so hyper focused on their business, on their strategy, on their team. Very rarely do they have a perspective on the broader market. They tend to pop their head up every three or four years and go ask for money. They're not in the market data with a pulse on the market. That's just not their job. And we have some really powerful tools to measure sentiment. And that's part of what we do every quarter.

• 9:21Speaker 03

  We call them our now narratives, where we can mathematically summarize the things that GPs care about right now and the things that LPs care about right now. And we actually push those out every quarter to the leaders in this asset class.

• 9:37Ted Seides?

  What are those most topical narratives in the market today?

• 9:41Speaker 03

  The now narratives for Q1, which we're about to publish, are the election's impact on M and A and animal spirits. It's the consolidation and M and A of managers with other managers. It is the challenges of the fundraising environment. And new is a particular spike in people talking about their value-added capabilities. That hasn't been in the now narratives in a while, but it's very thematic now. We think it's because it's time to do deals. The cost of leverage is prohibitive, pricing is prohibitive. So you've got to craft a narrative about how you can do great deals while still buying

• 10:26Speaker 03

  at full prices with very expensive leverage.

• 10:29Ted Seides?

  You could summarize this, and I don't know that there's anything that you said that isn't top of mind. As you said, it's what we know that everyone knows. How do you then discuss that with a GP that has their heads into just their own strategy?

• 10:43Speaker 03

  What we do every quarter is we take those themes that matter and then we break down the data behind why they matter. We bring all of this machinery to the conversations with the leaders of other firms to help them understand where the market is going and why. That's very powerful in and of itself. But then we also have a completely different set of software and tools to help firms understand their own capabilities, their competitive landscape, their right to win, their alpha generation, and tie all of those things into how can your firm be successful, given the changes in the market that are

• 11:26Speaker 03

  taking place right now. So it's this holistic perspective on the market, but also applying that to each firm uniquely, based on their capabilities, their skills, their goals.

• 11:37Ted Seides?

  And as you go through each of those now topics, you can take one at a time, that M and A elections and deal activity, what's the narrative around why that's happening?

• 11:50Speaker 03

  There's this animal spirit around the election results, the new administration, deregulation, and you can see that animal spirit in the price change of publicly traded alt managers, strategic advisory firms, their share prices have moved in non-market ways, reflecting that animal spirit. Whether that manifests itself into actual deal activity, to be determined. Manager consolidation and M and A is a theme that has been emerging and dominant for the last couple of years. But it is an emergent trend from several themes that are happening under the surface within this asset class around fundraising,

• 12:35Speaker 03

  product proliferation, insurance, wealth.

• 12:39Speaker 03

  All of those subthemes are driving M and A and consolidation. And we have a whole framework to break down firms that look similarly from an organizational complexity perspective that allows you to understand why certain M and A is taking place and anticipate moves on the chessboard for some of the bigger consolidators, what we call level nine and level 10 firms.

• 13:06Ted Seides?

  You mentioned this framework for figuring out where these different firms are in this landscape. What is that framework and how did you design it?

• 13:15Speaker 03

  It's designed to look like a pyramid where at the very top are the most complex, the largest, the most sophisticated firms. We call them level 10s. All the way at the bottom, at the base of that pyramid, the level 1s, those are startups, zombies. They're micro firms, two people and a dog. We track 6,000 private equity firms, predominantly in the U.S. and Europe, who have raised institutional capital in the last seven years. And each firm is put into one of 10 levels that are defined by the size of the firm,

• 13:58Speaker 03

  the breadth of their product mix, the number of asset classes that they serve, the types of products that they offer, their own capabilities. Are they local or are they global? Do they have a public stock as a currency? Do they have their own balance sheet, their own wealth distribution capabilities? Do they own a captive insurance business? And what's interesting is if you organize the industry based on these 10 levels, changes in the market impact firms that share a level a lot more than firms that share the same strategy. That's pretty unique. A level eight infrastructure firm and a level eight buyout firm are impacted by the

• 14:43Speaker 03

  market in more similar ways than a level two and a level eight infrastructure firm. And this framework allows us to help managers understand why things are happening to their organization, why things are happening to their competitive landscape, and what are the changes they need to make organizationally to achieve their objectives.

• 15:08Speaker 03

  There's only six firms at level 10 and they are enormous. They look more like Goldman Sachs than they look like Arctos. Ares, Apollo, Blackstone, KKR, it's the biggest of the big. Level nine, there's only 10 or 11 firms and they're typically missing one thing. Maybe they don't own an insurance business or they're not in credit yet. But each level nine firm in their own language is trying to figure out how to close the gap with the level 10s. They're thinking about their product portfolio. They're thinking about how to sell product that they don't have today. 95% of the level nine and level 10s are publicly traded.

• 15:49Speaker 03

  And you can anticipate the moves they're going to make based on the gaps that they have to go from level nine to level 10. But those 15 firms, which is 0.2% of the universe that we track, controls about 20% of the AUM. If you go down just two more rungs, go level seven to level 10, those 700 firms control 90% of the capital. It's crazy. There's this massive power law of capital concentration within the asset class that I think most investors are aware of. They don't appreciate how strong that power law is.

• 16:31Ted Seides?

  As you're talking to GPs about this framework, how do you think about the importance of what their goals are? Is the goal to move up the pyramid? Is it to make sure you don't fall down the pyramid? How does that change based on where you sit in the pyramid?

• 16:48Speaker 03

  Managing partners tend to be hyper competitive. So when you tell one of them they're a level five, they want to gamify why? And how do I get to, well, hold on a second. Where are you actually trying to take this firm? A level five firm is typically single strategy, best in class manager. They are very, very good at what they do. They're very content to just stay where they are and come back to the market every two to four years. If you want to stay a level five firm, because of changes in the market, you have to put energy into managing that business to maintain your level five place.

• 17:29Speaker 03

  The market is changing, the client is changing, and the competitive landscape is changing in ways that require you to level up your firm's capabilities, even if you just want to stay where you are. And that's a big shift that's taken place over the last four or five years. As this market has matured, the quality of talent that is required to just stay where you are is significant. If you want to grow, which is kind of what leveling up implies. I said it earlier, the organizational complexity is nonlinear. The capital that is required to grow is significant. And depending on how you grow and where you grow your organization,

• 18:12Speaker 03

  one of the things that we challenge you on is do you have a right to win in the direction that you're going? Do you have the skills in the six or seven areas that we think are critical for these businesses? Do you have the skills to compete where you're heading? And that's part of our process and part of the keystone value add to these managers is helping break down their organization, their capabilities, and doing that against their historical alpha generation and the competitive landscape of where they think they want to head. We were talking to the head of distribution for a great firm, and I was walking him through this framework, and he said, oh, my gosh,

• 18:54Speaker 03

  I wish I had seen something like this six, seven years ago. Because for us, it was all about going from level six to level eight, but no one knew why. And he said, we lost ourselves on the way to level eight. We lost the thing that made us special. One of the things we try to do is challenge the leaders of these firms on what is your vision? As important, why is that your vision?

• 19:18Ted Seides?

  When you look at a firm that, say, wants to go from level six to level eight, how do you diagnose where they have a right to win?

• 19:28Speaker 03

  We have what we believe is one of the most sophisticated software platforms for isolating and estimating alpha generation for the manager. It's a service that we provide to the manager. It's a collaboration with them. They give us very detailed data because they're about to make big strategic and talent decisions. So we have this very clean data that goes through a proprietary process for diagnosing skill versus luck. And then breaking that down across every strata that matters. Industry, deal partner, size strata, geography, product.

• 20:13Speaker 03

  As you start to disaggregate performance, you can start to identify where in the process that came from. First of all, have you generated enough alpha to justify taking illiquidity from the client? A lot of firms, the answer is no, especially Neta fee and carry. But for those where it is significantly positive, where is it coming from? Do you buy really well? Do you exit really well? Do you pay full or high prices? But create massive change within the organization while you own it?

• 20:54Speaker 03

  We can measure those things and that gives you clues as to where the skill within the organization is different from the competitive landscape. And you know, I'm not a huge sports fan, but the ArcTos brand started in sports. And I've learned, there's actually tons of similarities between the sports industry and the asset management industry. The higher the skill level in a competitive game, the more luck determines the outcome. If you took a average Major League Baseball player today and put them into the game in the 1950s, they'd be a Hall of Famer. The same is true in asset management and the same is true as you move up in levels.

• 21:39Speaker 03

  The more competitive the game, the higher the skills are required to compete. But the higher the skill level, the more luck comes into play. And with this data, you can then help them gut check if the moves they're about to make are supported by the data or not.

• 21:59Ted Seides?

  Curious how your conversations with GPs at different levels in the pyramid change.

• 22:07Speaker 03

  One of the themes that we've talked about with our investors is we are in a scale matters environment. It's kind of a winner take all phase. One of the things that I've been talking to our investors about is that the rules of the game that you've been playing, tear them up. There is a new game that the 15 biggest firms in the world are playing. And the wake of chaos that they're leaving behind them is the new game everybody else is riding. There is a capital aggregation theme that is creating a completely different experience for them. I'll give you some data just to like frame this up.

• 22:48Speaker 03

  Last year, the six biggest LPs in North America committed about $55 billion to funds. The six biggest private banking and warehouse platforms committed about $110 billion to funds. It's 2X the number. In the last 12 months, the level 10 firms in our framework have raised $250 billion from insurance companies they control or through the wealth channel with sales forces that are theirs. They don't have a capital origination problem. They have a deal origination problem. That is the world of level nine, level 10 firms.

• 23:29Speaker 03

  For everybody else, capitalist constrained, there is a maturity wall coming in 25 and 26 for a ton of firms who've been able to bootstrap it and scrape through the last three or four years. Understanding the rules of the new game is really important for both LPs and GPs.

• 23:49Ted Seides?

  As you see this reckoning coming, there's a subset of the existing GPs that are going to struggle in that environment. What do you think happens with the talent at those firms? If, let's say, they're unable to raise a successor fund?

• 24:07Speaker 03

  Everyone wants to go back and find the thing that looks like the new thing and draw comparisons. There's nothing like what you're describing. After the GFC, there was this wave of firms that got labeled zombie firms. They hadn't raised any money, weren't going to earn carry, lots of value trapped. That's not what we're talking about here. There is tremendous unrealized value and unrealized gain managed by really talented people. And the firms that they're a part of are going to come to market in the next 12 to 24 months, and they will not

• 24:49Speaker 03

  achieve the fundraising target that they need to feed all of the ambition and the mouths at that organization. I don't know what happens to those firms. We're trying to help some of them figure that out right now. There's lots of paths those firms can take, but they're not zombies. They're almost penguins on a melting block of ice. You don't know how fast it's melting. It might not even be melting. And you can just sit and wait it out. You can jump off and find your way back to land or a bigger block of ice. Helping these firms prepare for this challenge, make sure that they're clearly articulating their right to win, making sure

• 25:33Speaker 03

  that they have the skill and talent in every area that matters that is required to compete for whatever capital is available. That's what we're focused on.

• 25:45Ted Seides?

  Let's turn to what you're seeing from the LP's perspective and maybe go back to the narratives that are most popular for LPs.

• 25:53Speaker 03

  The dominant now narratives for LPs are all around liquidity and constraint, or changes in the market that might be eroding traditional LP control over this market. The lack of liquidity and the lack of exits, what that does to the fundraising environment, that's a big theme in the LP land. But continuation vehicles in the secondary's market, things like that hang from that. The growth of wealth and permanent capital and private credit away from the traditional LP GP architecture, that is something that is starting to become dominant in the language that LPs are using.

• 26:36Speaker 03

  Consolidation of relationships, focusing on re-ups, doing more with fewer, which is a derivative of, or it's caused by the lack of liquidity and the slowdown in fundraising. But there's a feedback loop or kind of a reflexivity component. These are why consolidation is happening on the GP side. They're all interconnected. But those are the dominant themes from the LP's perspective. Some of our tools help LPs understand changes in the distribution environment, in the cash flow environment, and how that might impact their allocation model.

• 27:15Ted Seides?

  How do the tools you've developed help an LP think about their cadence of investing?

• 27:21Speaker 03

  One of the questions we get a lot is will the deregulation and the animal spirits and all of the focus on exits, will that unlock an exit boom? You have to use very precise language when you talk about distributions. Because what actually matters to the LP is not the dollar value of distribution. It's the distributions relative to their unrealized book. That yield is actually the important thing. The yield of private equity today is as bad as it's ever been. You're in the bottom quintile of distribution yield right now.

• 28:03Speaker 03

  But over the last 10 years, dollar distributions have been pretty consistent out of North American buyer of about 40 billion a quarter. There's only one exception, it's the 2020, 2021 bulge up. Ten years ago, there was about 20 billion a drawdown to quarter to this really nice net cash flow yield. But over the last decade, while distributions have been very consistent at 40 a quarter, drawdowns have doubled to 40 and NAV has tripled in the last five years.

• 28:42Speaker 03

  So the yield has just nosedived. If you just get an average yield on all of the accumulated NAV, this year would be the biggest exit year ever, and it would exceed the best year ever by about 20, 25% in dollar volume of exits. And that's the challenge. Unless the asset class flips to a cash generative piece of the portfolio, it will not change the fundraising environment for all but the biggest firms in the world.

• 29:15Ted Seides?

  Why do you think that that's happened? Where do you think it goes from here?

• 29:19Speaker 03

  Before I tell you why we think it's happened, let me explain why it's actually worse than what you and I just talked about. Distribution yield is very low, but that includes what I think the market now calls inorganic distributions, distributions from continuation vehicles, NAV loans and all this other activity. By our estimate, between 15 and 20% of all the exit activity the last two years has come from inorganic transactions. So if you just talk about the distributions that powered the models and assumptions that most investors use today,

• 30:00Speaker 03

  IPOs, M&A, sponsor to sponsor, the yield from those traditional assets is actually even worse than what you and I've talked about. We think there are four important ingredients to the equation on how you get yield back to normal. The first is you need an accommodating macro environment. And all of the tools that we use and we think matter suggests you are in as good an economic environment as this asset class has ever seen. U.S. economy is growing. It's the most attractive risk reward proposition in the world today. We call it the Goldilocks zone where you have strong growth and high confidence in that growth.

• 30:45Speaker 03

  Over the last 25 years, when you're in this kind of market environment, the distribution yield is typically top quartile and private equity is typically undervalued relative to public equity by about 10 to 20%. Both of those are not true today. The second part is around intrinsic value. If private equity is not cheap relative to public equity, it is hard for the IPO environment or M and A to get excited. We have some powerful tools that measure the intrinsic value of private equity relative to public equity. And today, they suggest that private equity is overvalued by about 10%. That's a lot better than being overvalued by about 40%,

• 31:30Speaker 03

  which is what those tools said 2022 looked like. So you're slowly closing that gap, but you are still overvalued. And that makes it really hard for a big part of the exit channel to be very excited. The third part of the equation is the spread between the entry price implied return on asset and the cost of leverage. Prices today at a macro level, public equity and micro, private equity, entry prices have never been this high. You're in the 90th percentile plus in every valuation metric that matters for U.S. public equities.

• 32:13Speaker 03

  And entry multiples in private equity have never been this high. And holding multiples have rarely been this high. Entry price matters. You invert the entry price, your return on asset is historically quite low. That is a challenge that can be overcome if debt is very cheap. But it's not very cheap today. Spreads have compressed. The cost of an LBO financing, especially compared to the last 10 to 15 years, is above average. And that creates an ROE carry trade that's not accretive. And that matters for sponsor sponsor trades. The fourth part of the equation on how you get back to a normal distribution yield is incentives and alignment.

• 32:58Speaker 03

  When I talk about the changing rules of the game, that's an important part of this equation. We think the new rules that have been set over the last four to five years are creating a framework where sponsors are reluctant to sell to each other. And when they can, using a CV type transaction to hold on to an asset, to grow their fee-related earnings, and in effect, create inorganic AUM growth, is a powerful incentive, especially when you're not sure the old rules apply, where if I deliver a great exit to my LPs,

• 33:43Speaker 03

  they're going to round trip some of that money and support me on the next fundraise. People don't trust that game anymore. Because if the LP is over allocated, they're over allocated. And if the LP is trying to do more with fewer, they're trying to do more with fewer. And so if you're a middle market GP who's worried about this fundraising environment, and you can CV an asset, grow your revenue streams, create a new carry pool for your team to keep feeding the talent that you're responsible for, and live to fight another day, a powerful incentive. It may make you reluctant to sell to another sponsor. The old rules, sponsors left a little bit of juice in the deal for the next guy. They helped create the growth plan for the asset.

• 34:28Speaker 03

  It was part of the pitch. You buy this thing, here's how you unlock the next five years. Well, now, if I'm a sponsor, and I'm getting a book from another sponsor, and they're not CVing it, I'm a little suspicious. What am I missing here? Things are changing in ways that are not captured by old datasets, the old incentive mechanisms. I'm not saying it's good or bad, it's just different. And those things flow through into...

• 35:01Speaker 03

  How you manage your firm, how you think about the competitive landscape in which you compete, and how LPs need to think about building their portfolio for success over the next decade.

• 35:14Ted Seides?

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• 36:01Ted Seides?

  So as LPs see the trends and how you're describing the challenges of getting back to a distribution yield that might work for them on a longer-term basis, how do you recommend LPs go about thinking about their portfolios in this new environment?

• 36:20Speaker 03

  When we ask GPs, what is your vision and what is your right to win? We ask the same thing to the LP. What are you trying to accomplish in your private markets portfolio? What is its role? What is your right to win as an LP? One of the things we've been telling the LP community is you need to scale with alpha generators, not with capital aggregators. They're very different things. So do you have a process and a set of tools that allow you to identify alpha generation? If the answer is yes, are you aggregating your exposure with the managers that are producing that alpha? And over time, those managers should have scarcity, access issues.

• 37:06Speaker 03

  We've been telling our limited partners, you have to be able to pitch those GPs on why you're the right partner for them. What are your unique capabilities that will allow a partnership together to not only help you succeed, but that GP succeed? If you can articulate that, that's a differentiator. That'll stand out. You also have to start to build real time active portfolio management capabilities. We think the asset class today is overvalued by about 10%, but that measurement moves a lot. And the liquidity, the asset class can come in and out rapidly. If you have a data-driven perspective on relative value and liquidity, and you have

• 37:49Speaker 03

  an information advantage on your own portfolio, you could be an active buyer and seller of your own book, whether it's fund positions or CV reactions. You will be able to pick up nickels and dimes of excess return as an LP that other LPs won't be able to pick up. And with entry prices where they are, with macro prices where they are, every nickel and dime is going to matter over the next decade. Those are the kinds of tools we're trying to build for our LPs and for ourselves. We think those are going to be the keys to differentiation from the limited partners perspective.

• 38:26Ted Seides?

  On the way that fund flows have increasingly concentrated into the level nine and 10 firms, the one you hear most about is private wealth. If all of this money is going into clearly asset aggregators, what happens with all of this private wealth capital coming into the space over the next five or 10 years?

• 38:46Speaker 03

  There are really big firms that generate tremendous alpha. There are really big firms that have a couple of products that generate tremendous alpha. We call these organizational competitive advantages, OCAs.

• 39:01Speaker 03

  There are some firms that have built firm-level OCAs. The firm has this machinery that creates alpha. If you have firm-level OCAs that are transferable across strategies and across markets, you can be a high conviction alpha generator across products, across industries, size strategy. But it is rare. I bet only about a third of those level nine and level 10 firms have that. The changes that are happening, unlocking the wealth channel and bringing more regulatory-friendly product to the insurance channel. Those are just packaging for the alpha and the beta.

• 39:46Speaker 03

  And then the question is, what is the cost of delivering the package? If a scale manager who has broad-based alpha generation can put that into a package that is digestible and accessible by the wealth channel with a cost structure that leaves some of that alpha with the client, that's an incredible thing. That will help solve a lot of the actuarial challenges and demographic challenges that we have, especially in the US retirement system. If the packaging costs more than the alpha, then we're just selling people a bunch of really expensive beta, and that's not good. I think some firms are going to do a really great job helping bring some of the benefits

• 40:29Speaker 03

  of this asset class to a much broader part of the investment community. And I think some firms are going to provide expensive beta.

• 40:40Ted Seides?

  I'd love to talk to you about your most recent initiative the last couple of years. You mentioned Keystone, the strategy of how you're trying to serve this marketplace with an investment product.

• 40:50Speaker 03

  I said at the beginning of this conversation, this is a lonely job running these firms. Most founders have great investment talent, and they leave a big organization to start a business, which is a very different thing than being a great investor. Some founders are excellent at both. Some of them are excellent one, not the other. But the higher you get in the leveling framework, the leadership that is required, the skills that are required, become significant. And as the steward of your organization, you have an obligation to all of your stakeholders

• 41:34Speaker 03

  to make sure that you can compete and defend your right to win, let alone expand your right to win. You have to bring it every day if you want to win. And the keystone strategy is all about locking arms with the entrepreneur along that journey. All we care about is the most important thing to that leadership team. It could be an opportunity, it could be a constraint, it could be a challenge. Whatever is the most important thing to them is what we care about. And we want to break it down with them and help them come to the right answer for their firm, aligned with their goals and their stakeholders. If there is a way for us to put capital behind that solution

• 42:16Speaker 03

  that accelerates it, increases the probability of success, that's a keystone deal. If we can put capital behind a great manager who is an alpha generator, who is trying to unlock something really, really important that will impact their firm, their people, their portfolio, their clients, that's a really cool project for us to jump in and learn about. If they're a level seven firm, there are 600 other level seven firms, and they're all probably starting to think about the same challenge or some subset of them are. And like I said, if we can help that level seven firm and we learn from it, that positions us to be a better thought partner for other level seven firms,

• 43:01Speaker 03

  who might be coming up to the same opportunity or constraint in six to 12 months. And so we have this very flexible special situation strategy that just serves sponsors. And there's really nothing like it. It is GP innovation. It's helping great firms do great things. The keystone species is the species in an ecosystem that helps the rest of the ecosystem thrive. And that's what our team tries to do every day, is help great firms thrive. Because if they're thriving, all of their stakeholders will benefit.

• 43:32Ted Seides?

  What are some of the examples of what that most important thing has been in some of the partners that you've worked with?

• 43:41Speaker 03

  Thinking about consolidation and how you should play it is a big work stream in our pipeline today. Helping firms build their balance sheets so that they can continue to grow their firm and make big commitments to their funds in spite of the distribution slowdown is really important. Helping firms think about their right to win around new products. If what you're trying to do is create opportunity for a subset of your talent to keep them here and keep them hungry and keep them motivated, here is the thing that the math implies you are great at, that we know LPs are looking for. This is the thing you should do. And then how do we help you finance that growth and increase the probability of success?

• 44:25Speaker 03

  Another big thing is how do I do all of these things without selling permanent equity? Your options today are sell equity forever or take on a loan. That's it. And I'm not sure putting a loan on a firm that does leveraged buyout is an incredibly stabilizing thing. It's probably not a good idea. Unless you're huge, it's the next 800 firms that are not well-served. And so if we can help you finance innovation and change in your organization in a non-permanent way, that's powerful. It's more aligning with your investors, more aligning intergenerationally with your team. And another part of our pipeline today is helping firms

• 45:09Speaker 03

  that have sold permanent equity buy it back. We just helped Hafin, one of the largest private credit managers in Europe, buy 60% of their firm back from a big pension fund.

• 45:23Speaker 03

  And so now, for the first time ever, management has a path to owning the vast majority of their business because of our partnership together. But helping the next gen of a firm buy back that 10% that was sold in mistakes rates seven years ago, bringing that equity back into the firm, creating generational ownership transition machinery, the kind of self finances. Those are the themes of the pipeline and the conversations today, helping great firms navigate this pretty unique landscape.

• 45:53Ted Seides?

  In some of that generational transfer of equity, what are the parts of the toolkit that you've seen that have led to more successful transitions?

• 46:03Speaker 03

  That is a hard one to generalize. How do you measure successful transition? That in and of itself is kind of hard. One of the things that we have found in the data is that there is more stability in performance or durability in a firm's path along the leveling framework, depending on how founder centric the firm is. If your name is on the door, it's hard. If your firm started as a spin out from a big financial institution, which is actually quite common in Europe, it's less common in the US. But in a spin out, there's less of a founder mentality.

• 46:47Speaker 03

  There's a stewardship, a shepherding mentality. If the firm started with that architecture, the generational transitions tend to be a lot more seamless and stable compared to firms that are founder centric. There is a way to measure founder centrality mathematically. You basically have to scrape tons of LinkedIn data. We, a long time ago, supported some really cool academic research on using network dominance to predict venture fund performance. It was actually better than Cortiles. You could actually measure how important and how connected someone was mathematically.

• 47:27Speaker 03

  Through their connectedness on LinkedIn and a firm, especially a venture firm, is really just a collection of the leaders' networks. And so you could measure if the aggregate network of the firm was growing in influence and importance, or if it was eroding. And for firms that were managing the generational transition well, their ascending partners were growing at a rate of importance that exceeded the decay of the setting partners' network erosion. That's one way to mathematically think about it. But then you also have to have the economics transitioning in an elegant way. It's really hard.

• 48:09Speaker 03

  We have the benefit of having gone through it a few times ourselves, and we have the benefit of being entrepreneurs and firm builders ourselves, and that gives us a lot of credibility in the room with the leaders of other firms.

• 48:20Ted Seides?

  As you're doing all this research and trying to share it with the industry, how can other people glean the benefit of the insights that you're creating?

• 48:30Speaker 03

  Well, we actually have a business unit here called Arctos Insights. Insights pushes out really valuable content through a couple of different mediums. We have a couple of closed research newsletters where we send out information that serves decision makers in private markets and serves decision makers in sports. Those are the two sectors where we try to be servant leaders. Arctos Insights is the data science business that we run to serve the decision makers in the industries that we participated. And so if people are interested in being a part of that distribution outreach, they just have to ping us and let us know.

• 49:11Ted Seides?

  So you've got the sports business, you've got this working with practitioners in the space. How are you seeing these two collide?

• 49:20Speaker 03

  It's been a beautiful, like, emerging property of the last five years. If you look at the people, we have purchased control of North American sport teams over the last decade. Eighty percent of them come from tech or private markets. It's because they're business builders. They have a sophisticated institutional grade mentality on change and the value of change. But they also have lots of ordinary income. And the sports properties create a huge tax shield. They are not correlated with healthcare or tech or finance. You're not allowed to use a lot of leverage. So if you are a titan of private markets, you have a lot of levered exposure to all kinds of equity.

• 50:05Speaker 03

  And you have a lot of ordinary income. There is a really unique benefit to being a direct sports owner. If you are coming from the finance industry. And so from time to time, we have the opportunity to help leaders of private markets firms become owners of sports assets. There's actually a really unique overlap between our Keystone business and our sports business. In that some of the leaders of both industries are the same. Look at Josh Harris and David Blitzer and Ostrover and Arigetti and Rubenstein now. It's a pretty impressive list.

• 50:47Ted Seides?

  So when you bring this all together in your framework, at which level does ArcTOS sit today? And where are you hoping to take the firm over time?

• 50:57Speaker 03

  ArcTOS is what I call a skinny level seven, hanging on by our fingernails. Our goal has been the same. The entire time we've been building this place, it was a beautiful part of our origin story really early on. The founders got together instead of doing the things that founders want to do. Find the office space, finalize the logo, pick the name, all the kinds of things you feel like you have to do. We paused for a couple of days and did some really hard work to figure out what are the core values that we want to instill in this thing we're going to build together? And how are we going to define our vision? And the way that we do that is our passion and our niche.

• 51:41Speaker 03

  Passion is we want to disrupt and innovate the markets that we serve. And our niche is how we do that by solving complex problems with creative solutions. So what we want to do is disrupt and innovate the markets that we serve by solving complex problems with creative solutions. We do that in sports and we do that in private markets. And we have a right to win. And we know how to articulate that right to win that alpha equation very clearly. As an investment committee. We make sure that that alpha equation is demonstrable in everything that we do. And then we just try to delight the client. That's it. Where that takes us, level eight, level six, level one. I don't know.

• 52:25Speaker 03

  But I know that this has been an incredible journey. I'm grateful for the journey. And being entrepreneurs and being founders allows us to serve founders better.

• 52:36Ted Seides?

  And I want to ask you a couple of different closing questions than you've heard before. What was your first paid job?

• 52:43Speaker 03

  My first paid job was working construction in my hometown in Alaska. The construction industry in Alaska is very seasonal. You've got to get it done in the summer. If you're a punk kid and you can carry plywood around, you can make a lot of cash. But all my buddies blew their cash on beer. And I realized there was nothing illegal about me learning how to brew beer. So I befriended the local owner of our homebrew store. And I started brewing beer and selling that to my buddies in the winter. That was my first paying job that I enjoyed.

• 53:24Ted Seides?

  How's your life turned out differently from how you expected it to?

• 53:28Speaker 03

  I thought I was going to be a physics teacher. And have a beautiful family with my incredible wife. We're both from the same small town in Alaska. And when you're from that town, you don't know what's possible. One of the things I'm so grateful for is I've got that incredible partner. We've got this beautiful family. And I figured out in undergrad, I wasn't going to make very much teaching physics. And the math in macro was a lot easier than the math in nuclear physics. The thing that has surprised me is how much this industry has impacted our lives. And I'm grateful for this industry. I want to find ways to serve this industry for the rest of my life.

• 54:13Speaker 03

  To know that I've got that passion and that's something that I can do for a very long time is an unexpected gift along this journey. And something I'm really excited about.

• 54:23Ted Seides?

  What's a mystery that you wonder about?

• 54:26Speaker 03

  I spend more time than I probably want to admit trying to understand the most complex parts of cutting-edge physics today. Things like gravity loops and how time changes quite a bit depending on where you are, how fast you're going, and how strong the gravity is. I would love to understand the things that happen right on the edge of a black hole. That's where things get crazy. And that's where some of the smartest people in the science world are focused today is on how general relativity and Einstein's physics connects with quantum mechanics.

• 55:11Speaker 03

  That harmonizes somewhere right on the surface of a black hole and nobody understands it. I would love to understand that. That'd be pretty awesome.

• 55:19Ted Seides?

  All right, Ian, last one. If the next five years are a chapter in your life, what's that chapter about?

• 55:25Speaker 03

  It's about appreciating I might be in the best phase of my life. I love what I get to do professionally. My family is thriving and healthy. And I know that it's rare for all those things to be harmonized in a positive way. And I hope and pray that they stay harmonized over the next five years. And I hope that the next five years is about me appreciating that and being grateful for that and bringing gratitude every day.

• 55:56Ted Seides?

  Ian, thanks again for sharing your incredible insights and efforts to service this community.

• 56:02Speaker 03

  I always enjoy it. I appreciate the opportunity very much. Thank you.

• 56:08Ted Seides?

  Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one and see you next time.