E391: $17 Billion CIO on Taxes, Private Markets, and Building Wealth

What if the biggest driver of long-term investment success isn't finding better investments, but helping investors avoid their own worst decisions? In this episode, I sit down with Ron Albahary, Chief Investment Officer at LNW, to discuss the unique challenges of managing wealth for taxable investors and why portfolio construction is as much about psychology as it is about finance.

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

• 0:00David Weisburd?

  So Ron, you're the CIO of L N W, which today has $17 billion under management, mostly taxable investors. You've been investing for over three decades. When it comes to investing, what's the biggest difference between taxable and non-taxable investment?

• 0:16Speaker 01

  Well, there's an obvious answer, which is taxes, but let's put a pin in that for just a second. I think it's an appreciation that not only do you have to be a great investor, but you're dealing with humans and they have emotions. And so you have to have a high EQ. You need to be a psychologist, an educator, an exceptional communicator with those types of clients. So understanding, managing wealth for humans has a multifaceted role, especially since humans get pretty emotional about their money.

• 0:46David Weisburd?

  Reminds me, I had the CIO of McKenna, Larry Kochard, also famously an endowment CIO. And he said, "One of the most underrated thing about building portfolios is making sure that portfolios aren't only good coming in, but could be held through long periods of time."

• 1:04Speaker 01

  That's exactly right. I mean, from an investment psychology perspective, one of the greatest challenges in working with individuals is getting them to stick to a plan. So I often refer to the investment policy statement as a business plan. A lot of individuals spend more time planning their vacation than they do thinking about their portfolio. And the reality is, they should be very disciplined about managing that portfolio, with our help, of course, and creating the structure around it through the IPS and really focusing on the levers that we feel we can exert some amount of influence over to narrow the probable outcomes of that portfolio over time. So I said, "Put a pin in taxes."

• 1:46Speaker 01

  The reality is, taxes are a draw on the portfolio. And so if we can effectively minimize taxes... We're keeping more money in the portfolio that compounds over time. And that's a lever that if we pull it, we have a high degree of confidence of what the outcome is. So the name of the game for us in wealth management is trying to narrow that dispersion of outcomes over time, but focusing on the decisions where we have a high batting average, where we think we have a high batting average of success, of knowing the outcome.

• 2:15David Weisburd?

  What are some of these high batting average opportunities?

• 2:19Speaker 01

  First is taxes, right? We know how to minimize taxes through direct indexing with a tax management quarterback. We have clients with concentrated stock positions, low call spaces. There are strategies that enable us to diversify that position while mitigating the tax impact. Asset location as well. So put the high income producing or tax inefficient strategies like hedge funds in your retirement plan, in your IRA, and keep your equities, which have an implicit tax deferred component to them, keep them in your taxable account. Fees are another lever that we can pull. That's an easy one. You know, we're a $17 billion shop. We can negotiate fees with asset managers. If we can drive down those fees, that drops right to the client's bottom line.

• 3:03Speaker 01

  And those dollars stay in the portfolio and they compound over time.

• 3:07David Weisburd?

  Taxes are really upstream of compounding. It reminds me, Warren Buffett was asked, how did he amass so much wealth? And his response was, I started investing really early and I lived into my 90s and invested into my 90s. And everybody kind of disregarded it as this throwaway statement. But if you actually look at his wealth over the years, you could chat GPT it, you'll see it really is basically just compounding 20% over 70, 80 years. It's almost like that exercise when you're in your 20s and you look at Roth IRAs. You're like, well, if I put in $4,000 a year and I just keep compounding at 12% over 40 years, then it's going to be this large number. Warren Buffett has institutionalized that through Berkshire Hathaway.

• 3:52David Weisburd?

  And the way he did that is through a tax favored structure. And obviously, good investment, I'm not taking anything away from his investing. But the structure in which he invested is probably one of the most underrated aspects of how he's compounded as well. You mentioned taxes as the main difference between taxable and non-taxable investors, of course, but how does that play out in portfolio construction? Are these fundamentally different portfolios?

• 4:13Speaker 01

  I'd say there's a lot of crossover between the two. But again, for example, global equities. If you're going to allocate to global equities, you're likely, if you can, going to allocate to a tax management, direct indexing strategy. You're not trying to find investment alpha, you're trying to find tax alpha. So you hire a tax quarterback and you make sure that that tax quarterback is trying to minimize tracking error to the benchmark while minimizing taxes. And holding that tension is their expertise. I mean, it's definitely different than working with institutions. Additionally, on the fixed income side, you're going to invest in tax-exempt bonds, not taxable bonds. These are simple blocking and tackling strategies. Hedge funds. If you're an institutional investor and you're not worried about taxes, you don't care about the tax inefficiency. Hedge funds generate a lot of ordinary income.

• 4:58Speaker 01

  So as I said earlier, you want to allocate those strategies or locate those strategies in your tax-deferred accounts if you can, as an example.

• 5:06David Weisburd?

  Is there an argument that if you don't have these tax-deferred accounts, you just shouldn't be in certain asset classes?

• 5:12Speaker 01

  No, I wouldn't say that at all. That's a binary question. We look at strategies on a net of fee, net of tax basis. So if a strategy can generate a return that justifies its fees and justifies its tax inefficiency because of its role in a portfolio. So you have some hedge funds that when you put it in a portfolio, you're looking for it to be less correlated with everything else in the portfolio. That's accretive to the overall risk-return profile of that portfolio as what I like to call an ingredient in that portfolio. And so while taxes are consideration, they don't drive the decision-making. We're looking at taxes as a drag, but we're also looking at the contribution of that

• 5:57Speaker 01

  strategy to the portfolio's risk-return.

• 5:59David Weisburd?

  It goes back to what we were talking about, which is the sustainability of the strategy. One of the roles that hedge funds and specifically diversifiers play in a portfolio is it could help off-balance some of the volatility in the market. So if the equity markets are down a lot and you have something that's uncorrelated or sometimes negatively correlated to the market, you're cut from doing this very destructive activity, which is selling at the bottom.

• 6:23Speaker 01

  Yes, in fact, we call the allocation hedge funds diversifiers. We've created that asset class, if you will, but underneath that umbrella, we have hedge funds as well as private credit. But the roles of that allocation are twofold. One is, to your point, they're somewhat of a shock absorber as it relates mostly to equity beta drawdown risk, which most clients have a significant amount of equity beta in their portfolios. So you want that offset to equity beta. But also, you want strategies or ingredients populated in that diversifier's allocation that can be opportunistic as well, that can take advantage of volatile markets. So I wouldn't say that hedge fund's sole purpose is simply to mitigate equity drawdown

• 7:07Speaker 01

  risk or to be uncorrelated with everything else. It's also to be opportunistic, especially when investors are heading for the exits and there's a risk-off trade. You want strategies in your portfolio that can take advantage of that.

• 7:21David Weisburd?

  You want to be a net liquidity provider when everybody's looking for liquidity.

• 7:24Speaker 01

  And you want to take advantage of the fact that most investors are plagued by all kinds of emotional cognitive biases which drive them to poor decision-making.

• 7:34David Weisburd?

  Speaking of hedge funds, portable alpha is all the buzz today. How would you define portable alpha?

• 7:41Speaker 01

  I'm laughing because it was all the rage pre-global financial crisis when I worked at another employer, where that other employer, and I'll keep the name out of the discussion, became very enamored with building products and porting credit alpha onto equity products. And I was the sole dissenter, the sole voice within the organization articulating a question of, maybe we've spread this portable alpha across too much of the portfolio, across all of these different products, like it was immune to risk. And so, you know, when you ask me about portable alpha, it just reminds me, after 36 years in the business...

• 8:27Speaker 01

  So many of these cycles, some of the mistakes that were made, they come back in a different form. So I'm not necessarily, because of my previous experience, I am skeptical about the concept. And I think to a large degree, that's a reflection of the fact that a lot of the players in investment management today, they're just young. They just haven't lived through multiple cycles. I have, I've managed money through multiple cycles. And so I have the scars to prove it and lessons learned.

• 8:54David Weisburd?

  A lot of people like to think about these cycles as purely economic cycles, but there's a narrative component and a human component, meaning human beings, even high IQ human beings, could oftentimes make very predictable errors. For example, something becomes hot, they productize it, they ride it up, they don't see the long tail risk in it, it blows up, everybody forgets about it for 20 years and that, and then it becomes all the rage. You have these very human cycles that show themselves over and over again, once everybody in the market has forgotten about them.

• 9:28Speaker 01

  You've just articulated the value of having an advisor like Ellen W., because I've often said in my career, the greatest detractor for a client reaching their goals and objectives is the fact that they're human, that they are subject to emotional cognitive biases. If you add their money, which they get emotional about, and sprinkle on a little volatility onto that equation, you have humans that are making decisions that are primarily based on emotion and primitive urges, primitive biases. And so as their advisor, we have to protect them from themselves. And part of that equation is, as I said earlier, building the business plan, the investment policy statement, but that's just, that's just a part of it.

• 10:08Speaker 01

  It's really understanding the, how individuals think, and answering their questions before they ask them, and playing offense with communication with them, setting and managing their expectations. So when, especially when times are good, when equity markets are raging on the upside, nobody wants to talk about their return, their portfolio. Everybody's happy, they don't want to talk about risk. There's a pro-cyclical nature to a client's assessment of their own risk. When markets are inflated...

• 10:40Speaker 01

  They're risk-seeking. When markets decline, all of a sudden, they become risk averse. And so, as their advisor, we need to be very clear with them upfront on how that portfolio could react in different environments. One most important point is, something I learned a long time ago, is you want to express that scenario analysis in dollar terms.

• 11:01David Weisburd?

  Tell me about that.

• 11:01Speaker 01

  I can tell you about that by way of example. I met with a prospect, gosh, I want to say about 20 years ago, and she had $20 million. And I asked her, I said, "Do you mind if I ask you two questions?" She said, "Of course." I said, "Well, if you give us the privilege of managing your money, and fast-forward a year from now, your portfolio is down 10%, how would you feel about that?" And she looked at me, she goes, "I think we could tolerate that kind of risk." She was in her early 60s, if I remember correctly. I said, "Look, let me ask you the second question, then. Same scenario, you entrust us with your $20 million, we invest it. A year from now, I sit down with you and tell you that your portfolio is down $2 million, how would you feel about that?" She said, "We can't tolerate that kind of risk." True story. I didn't know whether she would fall for it, but she did.

• 11:45Speaker 01

  It's because 10% sounded like a small number to her, but $2 million? She then could do math at that point and realize, you know, that's several years. It's like eight or nine years of her lifestyle. And so, if I stopped at asking the question the first way, I would have been fired after a year. So, it's so critical when working with individuals to really communicate in a way that they understand it. More often than not, people in my chair are trying to sound smart, and they're trying to obfuscate what they do by using terms the client doesn't understand. I and Ellen W., we take the opposite approach. Our goal is, we're trying to get that client to understand their plan, to understand their

• 12:29Speaker 01

  investments, in a way that they can relate to, to protect them from themselves. And that means communicating in a way, meeting them where they are from a communication perspective.

• 12:39David Weisburd?

  It's interesting, because phrasing it as $2 million versus 10%, not only is it clearer, but, and not only to keep that client, but also kept that client from doing the difficult thing. I had the former CIO of CalSTRS, and they had this competition for the best investment idea. This was in 2021. And the idea that ended up winning for the best investment idea was preparing for the next crash. Like, what would you do? And the best analogy to this is the military. Why does the military play war games all the time? It's not because they can't do it through a model or they can't predict these things. It's because they are trying to wire into everybody down from the generals, down to the foot soldiers, what it means to be in a nuclear war,

• 13:23David Weisburd?

  what it means to be in the most dramatic situations. So that when they happen, hopefully not if, but when they happen, you're not in this panic mode. Because going back to this human bias, all things being equal, if you're not prepared for something, you are just going to go into this fight or flight. Expert calls have always been one of the most powerful ways to build conviction. But today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their TGS call service team sources experts based on your research criteria and lets the AI interviewer get to work. The magic is in the AI interviewer. Purpose-built and knowledgeable-based information to conduct high-quality, context-rich conversations on your behalf, acting as a trusted extension of your team.

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• 14:52David Weisburd?

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• 15:24Speaker 01

  You hit the nail on the head. By the time the crisis happens, it's too late. So. The good news is the equity markets go up historically 70% of the time. So 70% of the time when you're in a client quarterly meeting, the client advisor should be revisiting, defining expectations, managing those expectations, running through scenario analyses framed in dollar terms. Hey, I know your portfolio is up from $20 million to $25 million over the last couple of years. I know you're feeling good about that. But how would you feel if the portfolio drops, I don't know, $5 million? Would you lose sleep at night? Oh, yeah, I would lose sleep at night. Well, maybe now's the time to start thinking about trimming some of that equity exposure

• 16:08Speaker 01

  and allocating in other parts of the portfolio. Too many advisors in our industry fail to understand that every quarter, that's an opportunity and I think a necessity to re-educate, revisit expectations with the client and assess their, gauge their risk tolerance, given that, especially in positive market environments. Because like I said, when markets are dropping, it's too late at that point. Now the client is consumed by emotion and they want to drive decision-making. That's probably going to be suboptimal for them.

• 16:38David Weisburd?

  Reminds me of the Stanley Druckenmiller quote I heard on another podcast, which was, "Nothing looks as cheap as after it's gone up 40%." And hearing Stanley Druckenmiller, arguably the greatest trader of all time, hearing that it's difficult for him was actually, really gave me space to take a step back and think, if the greatest trader of all time has difficulty managing his emotions, maybe the name of the game is not becoming world-class at emotions. And maybe it's really a portfolio construction question, or maybe you could put some guardrails. One of the things I love about venture, for example, is its illiquidity. Couple of years ago, I spoke to a couple dozen crypto funds and they all more or less admitted that some of their best investments

• 17:23David Weisburd?

  were just because they're illiquid. This, I call it the virtue of illiquidity. Sometimes you could structurally put, go into an asset class. Liquidity is seen as this end-all and be-all, this positive thing. And then some people will argue, well, you get an illiquidity premium, so you should be more illiquid. But I think it's further than that. I think illiquidity could also protect you from.

• 17:41Speaker 01

  There's no question that the design of the product being illiquid does almost eliminate behavioral issues. I mean, now there is a secondaries market that may actually pierce that protection. But I do want to get back to Drunken Miller and the idea of even such a professional investor can have these issues with their own biases. I tend to be a left tail thinker. My dad lost his parents when he was eight. He was orphaned. I grew up in a household where you're always worried about the worst case scenario. And I know that about myself. And so what I've learned is in investing, you can't be necessarily only focused on the left tail. Unless I was just focused on shorting.

• 18:23Speaker 01

  And also, one has to be an optimist to be an investor, generally speaking. That most of your assets are going to be, the success of them over time, compounded over time. Has to be based on some form of optimistic view of the future. But understanding my own bias is, I'd say, 75% of the way there in terms of mitigating it. The rest of the way there is what I've infused in my investment team. And that is, every person on my investment team

• 18:54Speaker 01

  needs to feel comfortable being vulnerable to disclose their own bias. So over the years, as I've built investment teams, I try to build such a deep level of trust amongst those people. So that everyone feels comfortable being clear about their bias, so we can hold each other accountable.

• 19:10David Weisburd?

  How did you institutionalize that?

• 19:13Speaker 01

  It's a lot of hard work. I mean, it's just relationship building. You know, it's being present.

• 19:18David Weisburd?

  Leading from the front?

• 19:19Speaker 01

  It's absolutely leading from the front. It's volunteering vulnerability. It's admitting when I'm wrong as soon as I feel like I am wrong. Or changing my mind in the span of a one hour conversation where I had a help. Of you and my team convinced me otherwise. It is expressing that vulnerability. I've told the story of my upbringing and in some cases I get a little tearful about that. It's not manufactured, it's real. It's leading from the front that way so that my team's a safe space and that yields far better investment decisions because I've had teammates who I would call pathological optimists. I'm the left tail guy and they pitched me an idea. I start looking at all the things that can go wrong. They say, "Your left tail's raging." I get it.

• 20:04Speaker 01

  Those are all good points, but let me give you the positive argument. The last thing you want on an investment team is one loud voice, one strong personality making all the decisions because they are subject to their own behavioral biases, just like Drunkum Miller admitted to.

• 20:18David Weisburd?

  So it's so interesting, even with two people, I'm more optimistic and my business partner is more cautious, but we both know our biases. And the funny way to explain that is when I get optimistic or I get excited, that's fine, but when my business partner gets excited, I actually get excited. So you could have this meta-understanding and this shared language that you talk to internally, like to your point, and share your biases, it's extremely powerful thing. And everybody wants to pretend like they're perfect, they have no biases, and that could lead to these systemic issues, especially when there's a power imbalance.

• 20:55Speaker 01

  That is exactly right, but also what you reminded me of is one of the elements of our investment philosophy is humility. I think too few people in my chair have humility. They're overconfident. If we're going to talk about biases, overconfidence is certainly one that plagues, I think, folks in my seat, or at least they feel they need to show overconfidence. And what I've learned is there's actually a lot more power in showing vulnerability and admitting a mistake, especially when you're working with a client. That breeds a lot more trust than always trying to come up with a rationale for why a portfolio underperformed.

• 21:35David Weisburd?

  That's especially the case when you're managing tens of millions or hundreds of millions of dollars. These people did not make that amount of money through random chance. There's always some skill involved and... Sometimes when I'm eating at these dinners at these private wealth groups and I could see the chief economist predicting every single narrative that happened in the last 20 years and I'm looking around, people eating dinner and listening to that and I just think that might feel good to talk like that, but it can't possibly build trust.

• 22:05Speaker 01

  Not at all. In fact, another part of our investment philosophy is we can't predict the future. We, no one can. And so our focus is not trying to predict the future. Years ago, because I was young in the business, we were spending all this time trying to come up with our own macroeconomic views and what's going to happen with inflation, the US economic growth, the levels of the equity markets, to try to make tactical trades. We thought, I thought at least 20-plus years ago, that the more decisions you make as an investment professional, the more value you're adding. It's actually the inverse.

• 22:45Speaker 01

  The less decisions you make, as long as you're making decisions related to your high conviction, your high probability outcomes, that's a much better strategy than trying to make too many decisions, which just increases decision risk, increases the risk of getting things wrong. And so, less decisions, more impactful, more material decisions, where you have a high degree of confidence, is a far better way to manage money than trying to be tactical, which I haven't found really anyone who's very good at that with a high batting average, especially in wealth management.

• 23:20David Weisburd?

  And that's not even taking into account the friction of trading?

• 23:23Speaker 01

  Trading and taxes. Exactly. That's exactly right. So I call myself a reformed tinkerer. And I think investment professionals generally are tinkerers. And in wealth management, there are some folks who believe that in front of a client, you need to always be recommending a change in the portfolio. But not making a decision is a decision. And sometimes that's the hardest decision to make, is not necessarily doing anything, especially when markets are raging and there's hurting mentality towards the latest and greatest trend like AI or prior to AI, it was Bitcoin or cryptocurrencies. And so-

• 24:07Speaker 01

  Really, working with clients, getting them to understand, not every quarter, we're not going to make a decision every quarter. At best, we may be rebalancing the portfolio to stay disciplined, but we're not looking to move levers around all the time just to showcase value. The great value that we bring to the table is minimizing that desire to make decisions at the wrong time.

• 24:31David Weisburd?

  Just to play devil's advocate, isn't there a principal agent issue here in that you're incentivized to make changes, you're incentivized to take action? Because at some point, the underlying client, whether it's an endowment board, or whether it's a high net worth individual, they're going to be wondering, why are we paying him so much money to make a decision?

• 24:49Speaker 01

  What you've hit on is a fundamental challenge and issue with our industry, and that is how we frame our value with clients. Not often enough do we, in the sales process with a prospective client, do we explain to them the multiple facets, the multiple drivers of value that we bring to the relationship, of which one of many is our proficiency at managing investment portfolios. But we also add value in tax strategy, whether it's on the investment portfolio itself or from a financial planning perspective.

• 25:28Speaker 01

  I've gone on record as saying, as part of my job as CIO, we're trying to collect nickels and dimes for clients. But if you do great planning for a wealthy individual, prior to, let's say, a liquidity event, you could be picking up $100 bills for them in terms of tax savings. So, looking at all the different value levers that we can pull for that client and framing those value levers with the client upfront, tends to minimize the risk that there is that principal agent problem, where all you're thought of is the investment tinkerer, the investment decision maker. So unless I'm making decisions that are concrete, I don't have value.

• 26:11Speaker 01

  We've, I think, become very successful at LNW at elevating the conversation. So, we're very clear. We think we're very proficient on the investments, but we're going to make a lot of other decisions, and we're going to prevent you from making bad decisions.

• 26:25David Weisburd?

  We've talked a lot about the taxable investor, but in many ways, as crazy as it sounds, the taxable investor is a new phenomenon. What do I mean by that? As a percentage of the institutional market, it's always been much smaller. Now, today, you have tens of trillions of retail coming on board. I had the CIO of iCapital, Lawrence Colcano, who predicted this over a decade ago. What are the second order effects of that? Are you seeing products being developed for taxable investors today?

• 26:51Speaker 01

  You're seeing proliferation of these evergreen structures being spun up by asset managers to try to capture that retail, the asset flow.

• 26:59David Weisburd?

  Some friends of the pod, Hamilton Lane, stuffs on those kind of.

• 27:01Speaker 01

  Sure. The evergreen structures, whether they're private equity evergreen structures, like tender offer structures or interval funds, have been getting a lot of press lately, given the private credit issues. So, yes, you're seeing asset managers realize, this is a channel that we want to invest in and build products that are designed for those types of clients. The issue I have is the products are designed, in most cases, well, but the wealth managers that are advising their clients aren't educating their clients well about those structures. For example, you see this tsunami of asset redemption requests from these, some of these private credit interval funds.

• 27:46Speaker 01

  And in some cases, there really isn't a fundamental issue with those portfolios. But the press has been largely out there saying there's an issue, private credit space. And you have the retail investors who are saying, pushing the exit button. And their wealth advisors are allowing them to do that. When we use these evergreen structures, and we use them very sparingly, and we're very discriminating in terms of which ones we use, because they have to be structured the right way for our clients and the hands of asset managers that we believe in, we are very clear. Those structures should be the last resort in terms of your liquidity hierarchy. So if you're looking for liquidity in a portfolio,

• 28:30Speaker 01

  you should treat these structures as if they were illiquid. They are not piggy banks.

• 28:36Speaker 01

  Ultimately, these private equity wrappers, or wrappers around private credit, more so private equity, you're wrapping illiquid assets. And yes, there's a liquidity

• 28:46David Weisburd?

  So you shouldn't rely upon them?

• 28:47Speaker 01

  You shouldn't rely on that liquidity.

• 28:48David Weisburd?

  If they're available, why not use the liquid? Or are you just saying that you shouldn't rely on them?

• 28:52Speaker 01

  You shouldn't rely. If you are looking to tap liquidity, you want to start with your other assets first, before you tap that structure. However, if you're tapping that structure for what I would define as a legitimate reason, like, let's say, a client just sold a business for 50 million. They have no private equity in their portfolio. They're a qualified purchaser. They can invest in drawdown vehicles. But we all know, if you're going to practice vintage year diversification, be programmatic about your approach to private equity, it's going to take years to get up to, let's say, a 15% allocation.

• 29:28David Weisburd?

  Maybe five to six years.

• 29:29Speaker 01

  Exactly. So some of these evergreen structures that are providing private equity exposure can be useful at the starting point of that relationship.

• 29:38David Weisburd?

  They may already have three, four years of diversification in the

• 29:41Speaker 01

  Already embedded in the product itself. So there's invested assets in the ground in private equity markets. You can put a stub position to start that client off, let's say, with a 3% to 5% exposure in that private equity evergreen structure, just to get them started on their 15% allocation journey, which is going to take five to seven years to get there. So that's, to me, a good use case because as time progresses and the client is investing in more and more drawdown vehicles, you can then systematically redeem from that evergreen structure, not at a point where you need the liquidity or a point of panic. It's because it's part of your program.

• 30:22David Weisburd?

  It's such a good and underrated point. I had the CIO of North Dakota Land Trust, Frank McHale, and that's how he entered asset classes. So if he wanted to deploy over private equity for three years, he wouldn't want to keep it in treasuries or in low-producing assets. He would put it into an evergreen structure, or a couple of evergreen structures. You obviously need diversification. And then as he found a manager that he liked, he would start redeeming and investing in that manager. And there's two aspects to that that are really smart. One is you're getting private equity exposure. So yes, you could argue it's beta and that's kind of how you looked at it. So first is you're actually getting exposure to the beta. So you're not in treasuries, which of course is could be a huge drag on your portfolio.

• 31:06David Weisburd?

  But secondly, you're never in a place where you have to deploy. You never have a set amount of managers in a year you have to do. So the bar is always can it beat that beta threshold? Going back to these behavioral issues and sometimes the way that we think about things, having your money be literally in a benchmark they have to beat as you're deploying into managers could be extremely powerful.

• 31:29Speaker 01

  Getting back to your question about, you know, asset managers looking at the retail space as becoming almost as substantial as the institutional space. The, I wouldn't call it a concern, but something that at least is in the back of my mind right now is with the spin up of all these evergreen structures and the asset grab of from retail investors to invest in, let's say, private equity. The question we have to ask ourselves is will that illiquidity premium actually start eroding? With more and more capital coming into the private equity space, is that going to affect the actual spread, that illiquidity spread? And I don't have the answer to that, but it's a question we are asking ourselves now and will continue to evaluate.

• 32:14Speaker 01

  With all of that said, I, most of those assets going into those structures from platforms like iCapital and Case are with managers that are trying to deploy billions, tens of billions of dollars of assets. And at L and W, we're focused on the off the radar, private market managers, boutique managers, managers that are raising three to $500 million vintages, not three to $5 billion vintages. Only in very unique cases are we looking at some of those larger managers. But we're not in the camp where like a lot of wealth managers who have just discovered private markets, where they think if they just invest in some of the name brands, they won't get fired even for underperformance.

• 33:00Speaker 01

  We've been investing in private markets as a firm and personally for 30 years. So we've been in the space for a long time. We have great networks and we're looking for those smaller managers that are fishing in very idiosyncratic ponds where they're writing smaller checks, but the ability to drive returns is higher.

• 33:18David Weisburd?

  You're very charitable in questioning whether the liquidity premium would disappear from large buyouts. The answer is yes. And here's why I'm so confident on it. One is already today, there's enormous amounts of dry powder. So already today, there's too much supply of capital in these managers. What will happen when there's tens of trillions of dollars? There's going to get even more capital. Unless these private companies just compound at some insane rate, otherwise known as the rate of capital going in from retail, then there must be, by definition, the liquidity premium will go down. And actually, that's why I love the lower middle market thesis, which is this will not only not affect the lower middle market.

• 34:00David Weisburd?

  In fact, I think to date, 95% of all retail capital has gone into five buyout funds.

• 34:06Speaker 01

  That's right.

• 34:06David Weisburd?

  95% out of thousands and thousands and thousands. Lower middle market is the net beneficiary of all this capital.

• 34:11Speaker 01

  Yes.

• 34:12David Weisburd?

  Because what are the odds that one of these large buyout funds returns back capital? I think that's also close to zero. They must at some point deploy this capital. What are they buying? Are they buying public companies taking private? Maybe a small amount, but they're really buying middle market firms and lower middle market firms. And what does that mean? That means that these lower middle market firms have almost infinite demand for their assets. And it works at both sides of the barbell. Not only are their best assets going to get a serious premium, their middle assets are going to be bid up. And I would argue, actually, even their worst assets, as long as they're not completely terrible, are going to get some bid from some firm. A lot of these times, people don't look at these different asset classes like capital markets, but they are. They just have trillions of dollars.

• 34:57David Weisburd?

  There's supply and demand. And if you just look at it as a market, which it is, then you could very predictably choose at least what the beta will be. Now, you could say, well, maybe Blackstone or KKR may overperform the beta, or maybe they could underperform. But the beta is more or less noble if you know the amount of capital in the market and you also have some assumption about GDP growth.

• 35:21Speaker 01

  Also, you might be alluding to this, is those mega firms, because they're applying leverage.

• 35:29Speaker 01

  To some degree, those large private firms are subject to the same risk factors as the public equity markets. They start moving more like public equities than private equities. We want to invest in areas where the manager can actually create value. And it's not subject to macroeconomic factors necessarily. It's subject to buying a family business, professionalizing that business, bringing in new management, incorporating technology that increases operating margins, helping them with their sales and revenue generation strategy. These are drivers of return that are concrete as opposed to financial engineering. So the lower middle markets, because the vast majority of those companies are family-owned,

• 36:14Speaker 01

  they need those value drivers. That's where we see great opportunity. It puts us in a great position because we are experts at finding managers that are raising 300 to 500 million dollars, that can write the smaller checks to buy the firm with 10, 20 million dollars in revenue, which, I won't name names, but the larger firms...

• 36:36David Weisburd?

  I think there's over a million of these companies that are sub 100 million. There's some insane amount of companies.

• 36:42Speaker 01

  I was looking at some stats recently. There's like 200,000 companies that have revenues between 10 and 50 million dollars. And that's probably just scratching the surface, really. I mean, I've seen all kinds of numbers. So it's probably between 200,000 and a million. And there's a lot of them always being created. And so focusing on lower middle markets, which I should clarify, that is not the only space we invest in from a private markets perspective. But we like the lower middle market space in terms of the core of a private equity exposure. So we think of portfolio construction in private markets as you have a core private equity exposure, it's well diversified, the risk-return profile is right down the middle,

• 37:26Speaker 01

  it's private equity beta plus. And then beyond that, for larger clients with more of a liquidity budget, who have the ability to invest in what we would call satellite exposures, that's where we invest in other types of strategies beyond lower middle market.

• 37:41David Weisburd?

  You mentioned operational improvement, which lower middle market really does well. And that's kind of where their alpha comes from. I was just having dinner with somebody from Thrive Capital, Josh Kushner's venture firm. And they're starting to roll up these boring businesses like accounting firms and starting to integrate AI. Is this just something that a couple of firms are doing? Are you seeing your managers execute the strategy?

• 38:03Speaker 01

  We're asking that question more and more of our managers. How much are you incorporating AI, not only in your business, but also in your portfolio companies? We are seeing more and more of that. There's one manager I just asked the question of just a few months ago. And they have hired someone as an AI specialist. And they also hired a third-party firm to act as their thought partner, a third-party firm that's in the AI ecosystem, that's building fintech. And my contention is, if you're going to be successful in AI, hiring a person in-house is part of the way there. But that in-house person is going to be constrained because they're not part of the ecosystem. So you want that in-house person to partner with an outside firm. And that's what this GP is doing.

• 38:48Speaker 01

  So we are seeing more and more of that. We own a lower middle market strategy that just focuses on community banks. And it's a very basic value creation strategy, as I suggested earlier. If you know community banks, you know they're typically formed by local business owners who want a community bank in their particular community. They don't really know how to run an institution like that. And there are only two GPs out there that are exclusively focused on community banks. It's a small universe. It's a highly specialized expertise because you have to understand the banking system and the regulatory framework. And this strategy that we invest in has been investing in that space for 30 years. And they're raising $300 million funds. That's where we're going to find alpha.

• 39:33Speaker 01

  We're not going to find alpha investing in a large-cap buyout strategy that's raising $10 billion.

• 39:41David Weisburd?

  One of the chairmen of the largest mess of banks in the world, I had dinner with him, it was off the record, so I won't say his name. His definition of alpha was things that are either hard, boring, and ideally both. And no offense to community banks, but that's probably a mixture of both. So you guys have deployed some capital into venture. Has your view changed on venture today?

• 39:58Speaker 01

  So I'd say five years ago, we, our default core private equity exposure would be an allocation to venture, growth, and buyouts. That everyone should have those three exposures. The percentages varied. It was a lower percentage to venture and then equal percentages for growth and buyout. We are in the process of revisiting that thesis. One of the reasons we are is venture obviously has long-duration assets, it's highly skewed, it's becoming far more concentrated in terms of the capital in the hands of fewer managers. It's harder

• 40:42Speaker 01

  for us to find those smaller boutique idiosyncratic managers that we lean into.

• 40:47David Weisburd?

  Just takes a lot of bodies. There's thousands and thousands of them.

• 40:50Speaker 01

  The outcomes are so skewed. And if you go back to what I was mentioning earlier, our major role in terms of the outcomes of a portfolio is to narrow the dispersion of those outcomes for a client compounded over time. Venture can skew those outcomes. Now, for some clients, that may be appropriate if they are highly aggressive, risk-seeking, they can take a lot of illiquidity risk, they have a very long time horizon. So the long duration of venture doesn't faze them at all. They like the idea, a handful of the names in a broadly diversified portfolio becoming potentially the next Anthropic. And that's the game.

• 41:31David Weisburd?

  Don't ask me about all the other companies. There's plenty of losses in there as well.

• 41:35Speaker 01

  We are starting to think about venture more as a specialist or satellite exposure for certain clients. And we're also starting to think that

• 41:47Speaker 01

  There are a lot of venture managers out there that are really growth managers masquerading as venture. And so there's probably more alpha to be generated with in the pre-seed, seed exposures. And so we're trying to find a solution there versus investing in some of the more mainstream venture.

• 42:08David Weisburd?

  Kind of a lower middle market of venture.

• 42:09Speaker 01

  Exactly.

• 42:10David Weisburd?

  Yeah. I've had several CIOs take me through the math of expected return and volatility. And essentially, if your expected return is high enough and your volatility is low enough and you obviously avoid these black swan events, over time, your expected value becomes more and more predictable. The analogy that I give for this is you have a dice with three sides and you roll it. If two of those sides are positive, as long as you don't roll three negative in a row, you're going to be in a good place. Have you seen these kind of high expected return, maybe higher volatility strategies actually perform like that over the long term?

• 42:52David Weisburd?

  Or is this a purely theoretical way to think about it?

• 42:56Speaker 01

  Volatility is a broad factor. I mean, it's there's upside and downside volatility. I often say that the efficient frontier, you know, Markowitz was optimizing on volatility, but didn't optimize on the fact that there's good and bad volatility. He wanted as much good volatility, upside volatility, and want less downside volatility. So the volatility number itself, while interesting, is not as important as understanding that upside, downside. You could think of it as upside volatility, downside volatility, upside capture, downside capture. And so we are in a portfolio trying to incorporate ingredients that maximize that upside, downside asymmetry.

• 43:41Speaker 01

  Try to get as much upside as we can while minimizing downside volatility, which gets back to.

• 43:46David Weisburd?

  That's by having uncorrelated assets.

• 43:48Speaker 01

  Exactly. Which is where I was going to. It gets back to having diversifiers in your portfolio that can mitigate that.

• 43:53David Weisburd?

  It's funny because on my bachelor trip to Vegas, this just goes to show what kind of friends I have, one of my friends took all of his money and put it on red. And he won and all me and all my friends were shocked that you could actually win. We all assumed that it's such a dumb idea and and obviously not investment advice, not gambling advice. Everybody assumed that he was going to lose the money, but of course there's a 50 50 shot.

• 44:19Speaker 01

  Yeah.

• 44:20David Weisburd?

  That you could win it.

• 44:20Speaker 01

  Flip of a coin.

• 44:21David Weisburd?

  People don't think about volatility and risk in these.

• 44:23Speaker 01

  It's a little bit less than 50 50, isn't there? Aren't there a couple of green slots?

• 44:27David Weisburd?

  If it was 50 50, there'd be no business.

• 44:29Speaker 01

  That's right.

• 44:30David Weisburd?

  AI is in seemingly everything. How do you go about hedging your AI?

• 44:34Speaker 01

  I've been playing with this concept of implicit leverage within the equity markets. And the way I'm defining implicit leverage is what you just said, that so much of the equity up move, especially in the US, is tied to either the first or second or third order of the AI narrative. And so since most clients, most wealth management clients have a preponderance of their portfolio, majority of their portfolio in equities. And if most of those equities or a lot of that equity exposure is tied to the AI narrative, what can we do about it? Obviously, that's been a benefit to clients thus far. We haven't figured out a way to hedge against it, nor do we want to.

• 45:19Speaker 01

  We're very bullish on the AI adding value, increasing productivity in this country. Yeah, but what we are focused on, and this has really resonated with our clients, is looking for ingredients that aren't tethered to the AI narrative, like that community bank, lower middle market strategy that isn't tethered to AI whatsoever. Are they applying some AI to the operating of those underlying banks? Sure, but the actual success of that strategy, not tied to AI. Another strategy we recently underwrote is a hedge fund manager that invests in micro cap emerging market companies as a friendly activist. And all they're trying to do is get close to the company and explain, look,

• 46:01Speaker 01

  if we help you change your governance structure, maybe institute a dividend payout strategy, a stock, a buyback strategy, if you translate your earnings calls into English, you'll attract. Foreign institutional capital and that'll raise your value. It's a very simple, boring playbook.

• 46:20David Weisburd?

  Very intuitive.

• 46:21Speaker 01

  Very intuitive and it can be repeated, rinse and repeat over time. And now they're

• 46:25David Weisburd?

  And hard to execute. I'm guessing this is done on the ground.

• 46:28Speaker 01

  It's done on the ground, emerging markets, South Korea being one of the markets. Japan is not an emerging market, but they're also in Japan because the government of Japan has literally mandated that if companies are trading below a dollar of book value, they need to get it above a dollar, which plays right into the hands of this friendly activist. The point being their strategy is not predicated on the AI narrative and whether that narrative gets pierced or not. So trying to find other ingredients that we can populate in the portfolio whose drivers of risk and return are not related to the AI narrative is not necessarily a hedge, but it's just a way to offset some of the embedded AI exposure you can't necessarily hedge against.

• 47:13David Weisburd?

  AI is so pervasive that you have to keep a list of things that aren't correlated to AI versus things that are correlated. I've been keeping a mental list of that. One is certain types of real estate, specifically stuff like section eight housing or something completely uncorrelated to the economy. In that case, it's the government paying for it. Arguably my favorite sports teams, the framework that I have around sports teams is it's NFTs for decabillionaires. So there's only 30 or so NBA teams. And the more decabillionaires there are, the more demand for these NFTs. It's these kind of, these assets that you can't just create out of thin air. And then there's all sorts of other ones. But the framework that I have for this is if you humbly assume that so much of

• 47:58David Weisburd?

  your portfolio is somehow related to AI, even private capital could be correlated to AI if it's backing AI companies. So all things being equal, you should really think about it as a risk vector and you should think about the net new dollar. If you have the opportunity to invest, think about what could not be correlated to.

• 48:17Speaker 01

  And that you've articulated exactly what our focus has been recently. It's that net new dollar, can we find an ingredient? That isn't tethered to that AI narrative.

• 48:26David Weisburd?

  Said another way, all things being equal, if you have an incremental dollar, you're trying to hedge against this.

• 48:30Speaker 01

  Yes, and it's helpful that we have 30 plus years of experience in private markets because there are plenty of areas in the private markets we can find that are not tethered to AI as well as in hedge funds. We've been investing in hedge funds for 30 plus years and so we can find hedge fund strategies that also aren't tethered to that AI narrative or could take advantage of downside market volatility.

• 48:53David Weisburd?

  You just mentioned you've been in the industry for over 30 years, I think 36 years to be exact. If you could go back 36 years ago and give yourself one timeless piece of advice, what would that be?

• 49:02Speaker 01

  Being disciplined about investment decision making, being humble about your ability to predict the future, not allowing your left tail tendency to drive your decision making, understanding what we talked about earlier, which is more decisions actually increase the risk of being wrong. And so focus on the most material decisions where you have a better understanding of what the possible outcomes could be.

• 49:33David Weisburd?

  Ron, this has been absolute masterclass. Thanks so much for jumping on.