How I Invest with David Weisburd - E117: What Will Family Offices Invest into in 2025? w/Hansen Ringer

Episode Date: December 3, 2024

Hansen Ringer, Managing Director at Sepio Capital sits down with David Weisburd to discuss the asset class that delivers equity-like returns without the market risk, what distressed credit reveals about market cycles and investor behavior, and what happens when stocks and bonds move together.

We talked about the dominance of the 60-40, and when you can hedge a portfolio with bonds that are cheap and understandable, the need for kind of a defined hedge strategy has been less acute. And I think we all suffer from recency bias. And when you go through a period of underperformance for these strategies as an institutional investor, you get sick of defending the hedge funds that are high fees, that are complex, that have difficult reporting and illiquidity, and it doesn't become worth the squeeze to own them. We expect there to be an illiquidity premium, meaning if we're going to lock up capital, remove the ability to borrow against these assets, remove the optionality of selling

them tomorrow, we want excess return. So if you told me there's two return streams at 10% each, one has daily liquidity and one is illiquid, you're going to choose the daily liquidity just because it's an added feature. Walk me through how you get knowledgeable on a new space. We have lots of... Hanson, I've been excited to chat since our friend Grady Buchanan made the introduction. Welcome to the 10X Capital Podcast. Thank you. Glad to be here. Appreciate the time.

What is Sepio Capital? Sepio Capital is a multifamily office, an institutional asset manager. We oversee about $6 billion of capital on behalf of a limited number of clients. We started the business seven and a half years ago, 2017, in San Francisco. And I'm fortunate that we worked with many of our clients for decades across multiple institutions. How do you guys differentiate against other multifamily offices? David, the way that we try to differentiate ourselves

is on the investment side. We have a fairly robust investment process and we're passionate about that. The alternative space is an area that we spend a lot of time in. You mentioned you have a differentiated investment process. Tell me about that. The traditional asset allocation framework

that we all know is equities, fixed income, alternatives, and cash. And while we invest across all those assets, we use what we call a role-based framework, which we think helps us assess kind of the underlying risks and really the reason why we hold these various assets in the portfolio at a deeper level. So our role-based framework, David, is really four primary buckets. We have the growth drivers, which are the portion of assets intended to grow the portfolio over a long period of time. So really equities is the primary exposure.

They are both private and public equities, though. And then anything that has that sort of higher standard deviation would be competing for capital in that bucket. The second group of assets is what we call diversifiers, which is maybe the most complex group that we'll talk about. But diversifiers are assets with a low correlation to both stocks and bonds, but have return targets more similar to equities over a full cycle. And then the last two are maybe more understandable, inflation sensitive and deflation sensitive. Inflation sensitive assets tend to be real assets like real estate and commodities. Deflation sensitive tends to be the balance of portfolio, core bonds and cash. When it comes to the family offices that you serve, what are the different ways that family offices look at their portfolio construction? We have a really wide range of the way that

families look at the asset allocation. We use the same framework for all of them, but we have families that are very growth focused, if you will. They want high beta portfolios, and they maybe took companies public, and we're managing around a public position that really drives a lot of the other assets that we put in the portfolio. We have foundations and institutions that have defined giving amount of 5% per year, where we know we need to manage risk around the liquidity constraints that they have. What are the different factors affecting decision-making? Yeah, quick question. So risk profile and liquidity constraints are the biggest maybe two variables. I think time horizon affects that dramatically.

So if we have a, and we have a number of them, young entrepreneurs who sold businesses to businesses public with very little in the way of short term cash needs, they tend to be much more aggressive in the way that they can allocate to growth assets. The inverse is very much true as well for folks that have high burn rates, spending rates, whether it's giving or business interests that are driving a lot of the capital where we want to stay very liquid

with assets mitigating that volatility. So today you have a tale of two cities. You have private credit that is the hottest asset. Some people think maybe approaching the end of that cycle and private equity venture capital is cold or not as sought

after as it typically is. As an allocator, how do you look in terms of portfolio construction relative to the hotness or coldness of a specific sector? It's a great question. And it's something that we actually focus quite a bit on. Private credit's been an interesting space because to your point, it's very hot now, maybe peaking or kind of to a place that's unhealthy. I would say it was not that way a decade ago. When rates were at zero, there was very little appetite. And it actually to us was pretty interesting a few years ago, particularly in a world where spreads in the public markets haven't expanded. So high yield spreads are pretty tight. But in some areas of the private credit markets, you actually were getting a decent amount of excess return for the risk you were

taking or being compensated. So on a risk adjusted basis. It was interesting. For example, right now, we still really like the distressed credit space. So there's some areas within distressed credit that we think are interesting. It's a pretty wide ranging opportunity set, as you know, but things like just like non performing loans to us, the risk return seems very interesting still to on the flip side, you talked about venture capital and private equity, the late stage growth area of venture to us, I think to a lot of the market seemed really overheated for a number of years, kind of culminating in the declines of 2021, 2022. It looks like we may have an opportunity where companies are going to have to raise it either

down rounds, or there's going to have to be a repricing in the market that will make that an interesting space again. It's challenging to be too tactical for us in the venture and private equity space, given five-year investment terms for the funds and kind of vintage level diversification. We don't try to get too acute on that side, but certainly in areas like private credit, distressed credit lean in and out quite heavily. As a multifamily office, are you more likely to pull money and time credit and hedge funds more than private equity in VC? How do you look at both the relationship as well as the investment strategy? If we go back to our role-based framework to maybe set the stage and put it into practice, with private equity and venture capital, we're really competing for capital there with our public equities.

So when we're looking at the relative opportunity set for those equity beta positions. That's going to be the comparable. Private credit tends to be, depending on if it's performing credit, is really competing with your fixed income. If it's distressed credit, in many situations, we're looking at that as a diversifier. So part of the question is, is that relative between each other? And then also on an asset allocation basis, when we want to be overweight growth versus overweight diversifiers. We've really liked the diversifiers group within our portfolios over the last few years and on a tactical basis have been overweight diversifiers. We've really liked the diversifiers group within our portfolios over the last few years and on a tactical basis have been overweight diversifiers.

And part of that has been through kind of the last five years was being slightly underweight fixed income and then some underweight to growth as well. So there is an interchange between the two, but it's not directly between private equity and private credit, but rather the role that they're playing in the portfolio. I had James Langer on the podcast, CEO of Redmond Wealth Advisors, and he worked with Eugene Fama on the whole three-factor model and going back to his University of Chicago days. How do you look at the public market? Do you expect the Magnificent Seven to continue to outperform? And how do you look at large cap versus small cap or however else you dissect the industry?

Great question. We tend to have a value bias at Sepio kind of across the board. Most of our teams started in equity research roles and in roles that were kind of very valuation centric. And we very much ascribe to the data that you just referenced that in public markets, it's hard to have repeatable alpha. And one of the factors over a long period of time that's shown to outperformance is value. You couple that with a period of a significant dislocation between value and growth. We think the opportunity set for companies that produce a strong amount of cash and are priced at a relatively fair valuation is strong going forward. So I think for us, value versus growth is sometimes hard because it gets a lot into the subsector and it's like, do you like financials and energy or do you like tech?

I think for us, we're more focused on the relative value of the company. And I think right now, to your point on the MAG7, we think the other 493 companies in the S&P have a pretty interesting opportunity to potentially catch up over the next five to 10 years, over the next cycle. And I think part of that's driven by better earnings expectations for the non-MAG7 S&P 500 components and a better starting valuation. If you look at the S&P market cap weighted, the forward valuation is kind of scary for what that might mean for forward returns. On an equal weight basis, it's more attractive. You asked the second question about small cap. I think that the same math applies to small cap

in a couple of ways. Historically, small cap equities, as we all know, have done well. We're coming to a period of significant underperformance relative to large cap and a valuation gap. I think part of that can be justified by the large number of unprofitable companies in the small cap space. So the way we try to tackle that is being thoughtful around getting that exposure to companies that have attractive values and produce profits, particularly in the small cap space, to try to avoid some of the junk in the indices. Let's talk about correlation. Last time you spoke, you said that the decade prior to 2022, stocks and bonds were negatively

correlated. Has that always been the case? Yes, that has not always been the case. It's something that we focused on internally as it sort of became an issue for everyone in 2022. So 2022, we all recall the 60-40 portfolio got hit pretty hard because bonds were down double digits and stocks were down double digits. You didn't have the negative correlation between the two that we experienced

for the prior, you know, really 20 years. Back to 1998, over that cycle, you had this really nice negative correlation between stocks and bonds that made the 60-40 portfolio super efficient. But if you look prior to that, really for the 50 years before 2000, so back to the 40s, you had a period where stocks and bonds for most of that time were positively correlated. And what the data shows you, David, really is that in periods where inflation is sub 2%, that inverse correlation works great and bonds work as a hedge to stocks. In periods where inflation is higher than 2%, that hasn't been the case. Is that because when there's high inflation, treasuries are higher, therefore sucking out capital from both stocks and bonds? Talk to me

about the intuition. Yeah, you're exactly right. It's a function of rates. And in a world where rates are going down, so in a period like the first 20 years, so from 2000 to 2020, you had essentially a declining rate environment with slower growth. And the Fed can lower interest rates when you have a shock to the system, which makes your bonds rally when your stocks are probably going down because there's a recessionary environment. If we think about the issues like 2022 or the 70s, it was not the same. You had inflation causing the shocks to the system. Thus, the Federal Reserve couldn't lower rates to solve the issues. They had to, in some cases, raise rates. So your bonds were selling off for the same reason your stocks were selling off. And in some ways, if you think about the correlation in corporate bonds and stocks is that sometimes the same risks are there

for a corporate bond in an equity position because you have the same position in the company. Normally, that's offset by interest rates coming down in some periods that create that hedge. So when that's not happening, you have that positive correlation. Are there any assets that are just dominated by other asset classes, whether public or private, that just never make sense to invest in? Yeah, that's a good question. Nothing immediately jumps to mind of a broad asset class that a lot of people invest in that you generally shouldn't. We've looked at maybe a different way to answer this question. Yeah, potentially speculative assets, I guess, is a way to think about it. We don't tend to invest in assets that

we can't understand the fundamental case of the intrinsic cash flows. Some people can gamble well and probably trade those, but it's not what we tend to do. We've looked a lot at the 60-40 portfolio because it's often the benchmark that we think about. And in our framework, it's still a component, but we talked about having something like diversifiers, which aren't represented in that 60-40. And when we backtest adding 10% in diversifiers, so 60-10-30, 30% bonds, it really meaningfully increases the Sharpe ratio of a simple portfolio on a long-term back test. And in this case, we proxy diversifiers with a managed futures benchmark. So not perfect, but managed futures are kind of an interesting diversifier that we like to look at. And in that case, you had higher Sharpe ratio because you had improved returns with less

downside or volatility. Tell me more about diversifiers. Which diversifiers are you talking about? And what do you like to invest in? When we look at diversifiers, what we're really looking for is the characteristics of the asset, which are principally low to negative correlation of stocks and bonds with equity-like returns of our full cycle. And that opportunity set is fairly wide. And there's a lot of esoteric assets within that category.

And at different cycles, like we've talked about, different things may be interesting. But some of the things that we're focused on at Sepio in that bucket are things like distressed credit. We talked about non-performing loans. There's kind of a group of assets there that we think exhibit equity-like returns, particularly now, but don't have a correlation to equity market. And we would say in some cases have a negative correlation given the drivers of returns there. Managed futures are another. So basket class within diversifiers, I just referenced them. But things like managed futures that can be trend following trade, various underlying securities that have no correlation to stocks and bonds, turn the long and short side, have historically shown significant benefit to the portfolio

by increasing the true diversification while having equity-like returns over a full cycle. We also look at absolute return-focused multi-strat hedge funds or partnerships that have a similar effect of targeting equity-like returns with very little correlation to both the stock and bond market. Today's episode is brought to you by Reed Smith. The practice of law has the power to drive progress, to move businesses forward, and support them in achieving their goals. By seizing opportunities and overcoming obstacles, Reed Smith is focused on outcomes.

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Why do you think so many institutional investors are down on hedge funds today? It's a great question. I think that the commonly cited reasons would be high fees, illiquidity, complexity, and probably most importantly, a lack of alpha over the last 10 years. And I think we, I guess at a high level, we agree with all those things. And it's been a challenging time for anything that's hedged. If you think about sort of the last period of bull market and S&P 500 dominance, if you've had any hedge to that equity beta, you've almost by definition underperformed on a relative basis. As well, we talked about the dominance of the 60-40. And when

you can hedge a portfolio with bonds that are cheap and understandable, the need for kind of a defined hedge strategy has been less acute. And I think we all suffer from recency bias. And when you go through a period of underperformance for these strategies as an institutional investor, you get sick of defending the hedge funds that are high fees, that are complex, that have difficult reporting and illiquidity, and it doesn't become worth the squeeze to own them. And we agree with all those things. We have a very high bar for any partnership vehicle, particularly if you're giving up daily liquidity for something that is less liquid. So when we're looking at a hedge fund vehicle, we're looking at something that's truly different. We don't invest in many of the traditional hedge fund sectors where you're essentially getting S&P 500 exposure with some

hedges on it at an expensive price. We would look at things like managed future structures that truly have or trend following systematic strategies that have truly negative correlations with interesting return profiles. And the intuition being that those hedge fund strategies, whether the market goes up or down, it's independent of that because it's just looking for some kind of other signal or maybe some futures based on crop cycles or things like that. What are the futures that you like to invest in? That's exactly right. Most of our managed futures, managed futures funds that we invest in have a component of trend following in them, and they're trading really all asset classes.

So from equities, fixed income, currencies, commodities, both on the long and short side. So what that equates to is that even if we have multiple strategies in that same bucket, they don't tend to move like each other either because it's such a wide market. It also is a very interesting space because your counterparty isn't always profit seeking. You could be trading French power contracts and your counterparty is not looking to make a profit on that trade, where if you're a hedge fund shorting Apple,

almost in all circumstances, your counterparty is trying to take the other side of the trade and make a profit on that. So it's not just two really smart people trying to outsmart each other. Similar to secondaries where somebody has a liquidity need, which is why they're selling that. That's exactly right. Yeah. We like secondaries at times for that same reason. Speaking of secondaries, you like GP-led secondaries. Tell me about that opportunity set. We like GP-led secondaries for a lot of the reasons that any secondary transaction,

historically LP-led secondaries for a lot of the reasons that any secondary transaction, historically LP-led secondaries have been interesting for a portfolio. You get a shorter duration asset in the private markets. Typically, you reduce your J curve by getting invested quickly. I think GP-led secondaries are interesting in this time period because we've had such a lack of transactions over the last few years that have led to funds really seeking liquidity for some of their best performing assets that they don't want to sell or take public at this particular time. So GP-led seconders, you often have really strong alignment from the general partners

that they still have conviction in their deal. You don't have the blind pool risk. And you have this arbitrary deadline that sometimes can create really interesting opportunities for great assets near the end of their hold period. Walk me through that. What happens when a fund is in year 13, year 14? How have you seen that play out? Yeah, yeah, we're seeing it. I think as many institutional investors are, we're seeing it right now because you've had funds that were sort of banking on getting liquidity in 2022, 2023, and then the window, the perceived window wasn't open and they had to figure out other ways to do

that. So, you know, one of our partners had an asset that they have a lot of conviction in. It's been really their winner for the last decade. We're hoping to take it public. The window at the time, they didn't feel like it was open. So ultimately, they went through this secondary process where you hire an investment bank, they come in, value the asset, give all the existing LPs the opportunity to get bought out at that price. If they choose to, that's where the new investor comes in to backfill that demand. Otherwise, you have the opportunity to re-up at that defined valuation for another five-year continuation fund or whatever the terms

is on that next continuation fund. But it tends to be five years, maybe with another two one-year extensions. And that's kind of a common way to extend a position that you have a lot of conviction in. Otherwise, you have to go and fire sell your assets and try to wind the fund down as quickly as you can. As an LP, let's say that your venture fund or private equity fund has delivered a top quartile return via DPI in the first 13 years. How do you look at these continuation funds and lack of liquidity? Does that still irk you or is that just kind of standard practice? Yeah, it's not ideal from our underlying client's perspective, because oftentimes they had sort of a fixed timeline in their minds.

I think for us, hopefully by that year, by year 13 of being a partner with this general partner and understanding their, the assets they own, we hopefully have a pretty good understanding and agreement and aligned with them on whether these assets are worth a continuation fund or not. And most of the times we've been very aligned with the general partners we work with on the decisions on that end. So, and for us, if you have a defined, well thought out private equity allocation, that's perpetual and self-funding, ultimately, if you've gotten DPI throughout the period, you should be okay to potentially extend that last

piece if it's going to be the highest potential IRR on that investment. So we've generally been okay with it. While it's not ideal, and in some cases continues to drag down an IRR, even with a good multiple, as you extend that out, we agree that you should try to get the best price for the assets you have. In many cases, it tends to be kind of the crown jewel of your fund. That's the one that you're extending, because if you're an earlier stage manager, it's the company that's continued to raise capital and move toward the public markets, and that's taken some time. It's the Stripe or the SpaceX that has stayed private for so long and compounded. There's other structures in the market. How do you look at evergreen funds,

specifically something like GP Stakes that is providing income starting in year one? We like evergreen structures on the margin, particularly for things that have the liquidity matching the underlying fund structure. And what I mean by that is sometimes we have concerns about a private credit fund that's evergreen that offers monthly or quarterly liquidity. But if you understand the underlying assets in the portfolio, they may not be that liquid. So the concern is always, how do you message that constraint where it says quarterly liquidity, but we all understand that there's going to be gates or delays if everyone runs to the gate at the same time. It's a tool chasing a solution, but it's not

inherently part of the strategy. Exactly. So I think when we think about it from ourselves, if we're allocated, I think the evergreen structure provides a lot of flexibility that should be able to be helpful as you're thinking about investing over periods of time. You don't have arbitrary investment deadlines that constrain you or periods of time where you don't have capital to put to work. On the limited partner side, we just have concerns sometimes about the mechanisms for getting liquidity with no fixed term. So you see it in the real estate space where they provide liquidity on some basis and it

works in the periods of time where you're able to refinance and keep bringing capital back to the portfolio, and you have new investors who want to come in, and there's these mechanisms that create liquidity. In periods where that dries up and you're not selling buildings, you just have to understand that in an evergreen fund, there's no defined term, and you might be in there for years. And I think if you understand that constraint and you're comfortable with that, it can be interesting from an investment perspective. On the topic of liquidity, is it fair to say that the liquid strategies compete against each other and the illiquid compete against the liquid? In other words, by being a liquid manager, are you in essence competing against lower expected returns from an opportunity cost basis? We expect there to be an illiquidity premium,

meaning if we're going to lock up capital, remove the ability to borrow against these assets, remove the optionality of selling them tomorrow, we want excess return. So if you told me there's two return streams at 10% each, one has daily liquidity and one is illiquid, you're going to choose the daily liquidity just because it's an added feature. That being said, we don't think of the risks in a daily liquid public equity like we would in maybe a illiquid private credit where you're higher in the capital stack. So we may have a different return bar across different asset taps. But if we're thinking about, to keep it simple, private equity versus public equity, we do think of there being a different hurdle rate for the different assets. So let's talk about private equity and venture capital. What's your breakdown in your portfolio between private equity and venture capital? We tend to be at a target of roughly two thirds to private equity and growth equity, if you will.

So maybe later stage venture or growth equity checks to one third more true venture capital. Obviously, these terms, we know the nomenclature can change over time, but we think about it as sort of that first bucket in private equity being cash flowing businesses that you're potentially buying a majority of, then the next bucket being growth companies that are large, stabilized businesses where you're buying a minority check, and then venture capital being, I think, the way we all think about ventures earlier stage with a lot of upside, but kind of an unproven outcome at this point. Talk to me about growth equity. A lot of people are very down on that asset class, even more than private equity and traditional venture. Tell me

about the opportunities you're seeing in growth equity. This is where the nomenclature is interesting because I think when I hear growth equity, and I think most people, I sort of jump to late stage ventures. So series, C, D, E, F, in this environment of funding, but really kind of venture-like companies and venture firms doing those later stage rounds. And I think that's a component of growth equity. That's an area that maybe I mentioned earlier that we've been, that we had challenging investing in earlier in this decade when things were very expensive. There's also a form of growth equity where you're investing in profitable companies that are maybe more old line growing companies,

but you're not buying the majority of the business, you're providing a growth check and you're not using financial leverage. And we think that's an interesting area of the growth equity market, meaning it's not necessarily late stage venture, it's more, the businesses look more like private equity, but as opposed to doing a buyout and using a lot of leverage

to try to generate extra returns, you're looking at those types of businesses that are growing quickly and you're taking a minority check and you're looking to get a rate of return based on the growth of the underlying earnings as opposed to reducing costs using leverage and doing some financial engineering. Oftentimes in asset classes like growth equity or secondaries, the money is made on the purchase and on the structuring. Talk to me about that and where's there room in a portfolio for family office for something like that? It's been interesting to us

to see over the last couple of years to see structured terms coming back to rounds of financing. So liquidation preferences and notes that carry interest rates and some of these things. And for us at a high level, we're always looking at risk adjusted returns. So we've actually done some sort of structured deals in the private equity and venture space where we're collateralizing shares or doing different things to try to generate those risk-adjusted returns. It goes back to this principle of if we're going to get 10% private equity or private credit, we'd rather be higher in the capital stack. And if you can make private equity have some downside constraints and maybe your return target's the same, we're going to choose that all day long. Of course, there's

this component of not being predatory in the financing and being founder friendly. And we certainly ascribe to all those notions, but we've tried to do things to protect the downside and look at more structured opportunities. When we last chatted, you talked about Cambridge data on venture capital, various sub-asset classes that help us all assess if our individual checks are top decile, top quartile, bottom quartile, et cetera. They benchmark against the other opportunities in that specific vintage and these specific sub-asset classes. And that's a really helpful tool for us to see how we're doing on our commitments. One of the takeaways that Cambridge, I think, has popularized is around what types of funds and what fund sizes tend to outperform. And this is an area that we agree with them on in a few areas. So we look at earlier fund vintages

in a firm's life, meaning the data would show that funds kind of two through five tend to do very well. And part of that is structural, right? If you have done very well in your early funds, you get the right to raise larger funds and generate higher asset management fees. And that's good for the business, but can often lead to strategy drift and reduced alpha as you continue to succeed and grow out of what made you successful, just structurally. So we couple that with fund size. We're very deliberate about the size of the fund being raised. And we want that target fund size to match the underlying strategy. And that varies

dramatically from early stage venture to private equity. But we want there to be alignment with that. And Cambridge data would show, I think, that oftentimes smaller funds outperform. And I think that's just a function of funds getting larger and losing alpha and maybe getting some strategy drift along the way. When you look at private equity managers that are just a function of funds getting larger and losing alpha and maybe getting some strategy drift along the way. When you look at private equity managers that are in a fund three, fund four, fund five, let's say they've had top quartile performance. What else are you looking for? Like what would get you not to invest in a top quartile fund?

It's a great question because what's so interesting for us that I think everyone thinks about when you're making a commitment here as an LP is that you're signing up really for a partnership for a decade plus. And so historical performance is important, but it can sometimes be irrelevant when you look at a new vintage and see the people deploying the fund. So for us, making sure the track record of the firm matches the current investors. Oftentimes, if you've had a few great funds, you were very successful and it can lead to succession and change of hands. So making sure that there's continuity in the team and that that structure is set up to last. And you've got succession plan and you can look at firm ownership and make sure

that there's the right alignment for the team members to succeed for the next 10 years. The other thing, I guess, is related to what I last mentioned. If the firm did great and funds two, three, four, and five at $250 million funds, and then are raising a $5 billion fund and are going to be focused on a very different strategy, then for us, it's kind of a totally new underwriting process, and we might not give a lot of credence to the prior track record. Outside of team continuity and fund size, what are other red or yellow flags for you to re-op an existing manager? Concentration of returns. So if there's been a low hit rate, that could potentially be a concern across these assets.

I think in private equity, you're not likely to see the outsized return of one company over time like you do in venture. So we'd want to see those returns distributed. We'd also want to see generally the ability to produce returns in different interest rate environments. I talked about financial engineering, but I think some private equity firms' strategies have been more heavily predicated on lower interest rates. So we'd want to see the ability to produce these types of returns in a world where the cost of capital is not close to zero. Hey, we'll be right back after a word from our sponsor. Our sponsor for today's episode is Carta, the end-to-end accounting platform

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What data are you using and how do you bring benchmarking to your decision making when it comes to asset allocation? We use benchmarks in a pretty material way across all asset classes. So in our reporting software, we look at our assets, each of our individual line items relative to the benchmark that is the best proxy for what they're trying to accomplish. So when we're looking at returns, we're looking at risk-adjusted returns relative to a policy benchmark that represents the risk in their portfolio. And some of our clients tend to be very benchmark agnostic, meaning they don't care what the S&P did necessarily, if it was up

or down. What they care about is sort of the risk return of their portfolio and tends to be more absolute return focused. On the flip side, we have institutional clients that have an investment committee that are very much oriented toward relative performance versus the benchmark. In the U.S. large cap, it tends to be hard. It's an efficient market. It doesn't mean that we don't try to lean into value and be systematic, particularly when there's excesses like we're seeing now that we talked about earlier. But on margin, it's harder to have alpha numerically in U.S. large cap because of the efficiency. In some of the areas in diversifiers that we talked about, there's not great benchmarks. And we think taking that benchmark risk, if you will, is valuable to the portfolio.

So we look at it on a sub-asset class basis, on an asset class basis, even within equities, small cap equities tend to be less efficient. There's more room for alpha and active management in small cap than there is in large cap, for example. And the reason the benchmarks don't really make sense in the hedge fund strategy is because so many of those are idiosyncratic. It's like the price of corn or the weather or some global event. And they're almost by de facto, by not being correlated, the benchmark is almost nonsensical in those cases.

That's right. And then from a client perspective, the benchmarks are also irrelevant. I think most of our clients have mental benchmarks of what the S&P has done, what fixed income has done, maybe treasury market. And those become mental benchmarks for how their portfolio is doing. Some of these esoteric areas, you could show a benchmark, but if you don't even understand what the benchmark is, it becomes less meaningful as you're working through that. And those diversifiers are essentially just a way to get higher than treasury returns in a non-correlated way. So taken to the extreme, you could just have the money in cash or treasuries, but you want to have a higher return without increasing the volatility of the portfolio. That's correct. And I think to our correlation point earlier, in a world where stocks and bonds may be positively correlated for some periods of time, it's an asset class that can provide diversification against that. So if you look at

2022 as the example, most of these strategies that we have in our diverse fires bucket did very well, despite a year when both stocks and bonds really struggled. Outside of a concern for liquidity, is there ever reason to own treasuries or cash? There certainly could be periods of time where the risk-free rate of a treasury relative to a public equity looks attractive. I mean, I think if you look back to the 70s and understand where rates were for some of those periods of time, and if you could have locked in, again, better than equity-like returns, 10 plus percent in a treasury bond, with hindsight, you'd probably say that's a pretty good trade. And then over that period, you also had rates coming down steadily and improving prices on your underlying fixed income instrument. So I do think there are times where your risk-adjusted returns can be better.

In the times of high interest rates, in the times when treasuries are at high numbers, does it ever make sense to lock in those rates over long times? Yes, we think so. We think so. Even over intermediate or short-ish timeframes, we think back to a year ago, you could get slightly higher rates in money market funds than you could in a one-year or two-year treasury. But the reinvestment risk to us in a treasury or three-month T-bill looked fairly high given the probability of rate cuts at some point. And the market prices that into some extent. Obviously, it's a relatively efficient market. But we like to, with our clients, we were looking at kind of a barbell strategy work within the treasury space where

you're locking in some higher yielding short term T-bills from kind of six month, one year, two year, to then going out and locking in some yield at 20 years. And so far, I think it won't always work. It's played out over this period as rates have come down more recently, and the expectation for rate cuts has increased. We've gotten some price appreciation, importantly, locked in rates that felt attractive at the time. You've been at Sepio Capital for seven and a half years. What do you wish you knew when you first started at Sepio? I don't think I fully understood at Sepio how vast the investment universe would be for us. Prior to this, I had been at various investment banks and institutions with a walled garden, and you saw the same types of strategies. And I think our hope at Sepio was going to be that we'd

have the opportunity to look at more niche opportunities. And I don't think we understood at inception just how wide that universe is for better or for worse. There's a lot of very unattractive opportunities that are shown to us and to clients. But the amount of interesting things that you can invest in across the space, if you truly have an open architecture, is broad and it takes a lot of team capacity. So we've staffed up and tried to get in a place where we can diligence really anything in the investment landscape. Talk to me about how you've improved your skillset and your knowledge base over your seven and a half years. I've been fortunate to have really sharp and impressive colleagues that

I've been able to learn from. I've tried to really lean in and work on kind of everything in a team oriented way. So at Sepio, we don't have a sharp-elbowed culture where one individual owns something and takes all the revenues from that strategy or workflow, but rather a team-oriented process. So we have team members that focus on real estate. We have team members that focus on private equity. On the direct side, I focus more on the LP side. And for me, working in a collaborative way

across our alts platform, working as an investment committee to really understand what's attractive without sort of any bias for our own coverage area has been really helpful for me. And I think as a firm as well, to be able to be nimble and look at different areas, it may become more attractive based on the macro environment. Talk to me how you would get comfortable or how you would accelerate your learning growth in a new space like GP Stakes.

Yeah, we're very comfortable diving into new spaces. We've done it often. I think for us, it's a time in resource management and really what we think makes sense to our clients. So where we have client demand or we think it's a need for a client, we'll kind of put whatever resources necessary to dive in and understand that. GP-led stakes have been, I think from that client perspective, sometimes challenging to understand who's going to benefit from the economics of a GP stake, given that it's our client's capital. But maybe we'd be aggregating capital on behalf of them as a firm and making sure that they get those underlying benefits.

At times, it hasn't been overly clear to us. So it's not an area that we spent a lot of time on. But if the opportunity presented or if it felt like it was a need, we would certainly dive in. Walk me through how you get knowledgeable on a new space. Do you bring in advisors? Do you talk to prospective GPs? Yeah, we've done all of those things. We've had investment consultants in the past, particularly when we had a leaner team that we could lean on for kind of high level diligence. We of course have access to all of the major research platforms that provide good data. And then the software systems like Bloomberg and PitchBook and all of those underlying opportunities to get data. So part of it

becomes a quantitative process of understanding in a certain space what investment partners have the best track record. And that's not overly difficult to try to screen for those things. And then to your point, we have lots of discussions with general partners. So when we're exploring an area like distressed credit that we referenced before that maybe was less interesting to us before, became very interesting to us, we're going to end up talking to 50 plus underlying firms, understanding the market as well as we can, diving in on track records, the quantitative process, and ultimately getting comfortable with various partners. What is the minimum amount of GPs you would want to talk to before investing in a new strategy? I think the minimum amount of GPs you would want to talk to before investing in a new strategy?

I think the minimum number of GPs we'd want to talk to before investing in a new strategy is probably 20. If we felt like we had a curated list of 20 of the best GPs in a certain subsector. In a space like venture, I probably end up talking to 100 plus GPs a year. It's very referral based and there's lots of new entrants and smaller funds and it's a little bit different than certain areas of the investment landscape. So maybe warrants more conversations. Those 20 being warm introductions? Correct. Yeah. So potentially spanning from hundreds of firms, those are the 20 that you were told to speak to. And then from those 20 conversations, you start to get a good sense of the space. Yeah. If you think about the traditional funnel in every investment deck,

we're probably going to look at, you know, a hundred plus GPs in any one of these areas and trying to funnel it down to kind of a smaller group that we do initial screen call with. And then, you know, get down to some amount of call it 20, where you're going to really do some, some diligence and have multiple calls with team and, and multiple constituents internally and externally to try to understand the opportunity set. As an LP, what mistakes have you made in terms of investing in GPs? What has looked good that's actually not good? Some challenges we've had on initial LP checks

is understanding how good partnership dynamics are internally. We've invested in folks before where we felt like their partnership was very stable. And then you get a few years into a fund and you start to understand that maybe the underlying chemistry of the partners wasn't as good as you thought. And you have to deal with a GP breakup mid-fund. And I think that sometimes coincides with investing earlier in a firm's lifecycle. So if you're investing in fund two or three, sometimes there's still some kinks to be worked out and you hit a more challenging period and you have general partners splitting. So that's been a challenge. It's something that we spend a lot of time trying to assess and make sure that the partnership's in a good space before we engage as a limited partner. You suss that out by taking them to drinks, taking them to coffee, seeing how they are with their families. How do you suss out that risk?

How do you become better at understanding the partnership dynamics at a GP? Extending the diligence period. So really getting to know people, not necessarily in time, but in the amount of time spent with the GPs. I think reference calls can be very helpful. And maybe more than anything, not everyone, but many of the folks we work with are driven by the economics at some point. So some of the situations we've seen that haven't worked out were in part potentially

driven by one general partner owning more of the firm and potentially doing an equal amount or less of the work and no mechanism for that changing over time. So I think on a quantitative basis, really making sure that we've got a good understanding for the underlying economics of the business and making sure that they feel sustainable through the life of a fund. How do you make sure that your reference calls get to ground truth? And what are some non-obvious signs? I'm sure it's unlikely that the person says

as a terrible person, never give money to them, but what are some things that you look for that would indicate that the person might not be a GP that you wanna invest in? Yeah, for on-list references, for references that were provided, you sort of have to assume that they were curated because they've got a good relationship and they're going to tell you

that they're a great fund manager i think the common advice that that i've gotten and read in books about references for whether it's hiring or these sorts of things is asking open-ended questions and asking follow-up questions i think when you ask um you know how if you're talking to an entrepreneur how were they you know through this process they're going to say good and then if you say tell me about that um and they'll tell you, you know, how they did well. And then, you know, what was one of the struggles you've had? I think at that point, they tend to be a little bit more open to telling you about some of the challenges they've had throughout that process. So I think I found if I have a list of 10 questions and I go through and just let the reference answer kind of yes or no or the first question.

And it was someone that was provided. you're just going to get great answers. If you ask one layer, two layer, three layers down in a way that doesn't feel threatening and you agree with the initial premise that they're great, you tend to get some open feedback from the referencee. I think to my point of off-listers references, if you can find folks that can speak freely, knowing that it's more anonymous because they weren't provided as a reference, it becomes much easier to get at the truth, if you will. And even them unwilling to jump on a call after opening your email is a pretty strong signal itself, correct? Correct. Yeah, totally.

And I think you've probably seen this. We've all felt this. It's a small world. And most general partners are one degree of separation through another GP or through a company. It hasn't been too challenging for us to find someone that we can connect with off list. One thing that I try to do in my reference calls is to get to the truth while providing plausible deniability to the interviewee. In other words,

not making them say this person is a terrible person, but perhaps seeing how they answer, the enthusiasm, what they say, what they say without being prompted. Those are all very, very strong signals, especially on a live call. Totally agree. What would you like our audience to know about you, about Sepio Capital or anything else you'd like to shine a light on? Hopefully this has been illustrated throughout our conversation, but we have a flexible wide mandate on the investment side. So we welcome any opportunities to look at interesting strategies. We're also more than happy to dive in and talk further about our asset allocation, our high conviction investment opportunities, and what we're looking at now. Excellent.

Well, I appreciate you jumping on the podcast and look forward to sitting down soon. David, really appreciate the time. Thanks so much. Thank you for listening. The 10X Capital podcast now receives more than 170,000 downloads per month. If you are interested in sponsoring, please email me at david at 10xcapital.com.