Invest Like the Best with Patrick O'Shaughnessy - Scott Wilson - Non-Traditional Endowment Investing - [Invest Like the Best, EP.297]

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Starting point is 00:01:04 trusted by the world's most innovative entrepreneurs and fastest growing companies. With Brex, you can move money fast for instant impact with high limit corporate cards, payments, venture debt, and spend management software all in one place. Ready to accelerate your business, learn more at brex.com slash best. That's BREX.com slash best. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest like the best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy asset management.

Starting point is 00:01:58 All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunisei is. Aeshae C asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest today is Scott Wilson. Scott is the CIO of Washington University's endowment, which manages over $13 billion. In this conversation, we discussed WASHU's non-traditional endowment model and cover a variety of asset classes and geographies. We talk about the qualities Scott looks for in managers, lessons from investing in Asia and emerging markets, and red flags in the venture space. Please enjoy this conversation with Scott Wilson. I had the great benefit of being with your team live in New York City yesterday, and we were laughing over breakfast about how to begin this conversation.

Starting point is 00:02:54 I can remember who said it, but somebody said, Patrick, I think this is the first time you've had an Alaskan, quant fixed income trader, longtime Japan liver, now leading endowment investor on the podcast. I thought, yeah, that's probably right. I thought we could take some of those fun points in turn and talk about how each has shaped your investment philosophy for what you're doing now, leading Wash U's very large endowment as I think one of the more innovative endowment investors out there today of not the most. Maybe starting with quant fixed income trading. That seems about as far from, in the investing world, at least, as far from managing an endowment as just about anything could be. What was that experience like?

Starting point is 00:03:31 What did it teach you about markets that carries over to what you do now? I think it's a good background to have. I'm not sure how useful it is managing endowment, but it certainly teaches you a lot. Just running a trading desk, I think teaches you about risk management and teach you about markets, and teach you about how markets react to stress, what happens to bid off or what happens to market participants. For me, my biggest takeaway has probably been more in portfolio construction

Starting point is 00:03:58 then ultimately if you think about running a basket of risk and whether you're sitting on an endowment or in my case, I was trading interest rate derivatives for most of my career. And really what you want is this portfolio of trades or investments that you think have positive expected value, hopefully have positive convexity, mean the capital you have at risk is small relative to the amount you could ultimately make on each trade. And then you want uncorrelated outcomes. If you have a portfolio that's constructed like that, whether it's an endowment or interest rate options, that portfolio is probably going to do reasonably well over long periods of

Starting point is 00:04:37 time. For me, that's probably been the biggest takeaway. I mean, I met great people and learned a ton about various things. But in terms of what we apply today, it's probably more on portfolio construction and risk management than anything. How did that experience shape the degree of your skepticism about the world in general? Most of our big clients were macro hedge funds and other macro type investors. Anybody who knows much about what we do, we do zero macro.

Starting point is 00:05:05 So that probably tells you most of everything. But I think just working for an investment bank for as long as I did, you end up pretty cynical about financial markets in general and market participants and incentives. And I don't want to get into specifics. It's a great place to come from. I'm not sure it's a great place to stay on long term. Could you talk about this story that brought you to Grinnell College? I'm very curious what the system settings were when you first came to the Grinnell Endowment

Starting point is 00:05:32 and then how and why you shaped it the way that you did. Maybe first tell us just what the bridge was like from one part of your career into Grinnell. I had spent my first part of my career in equity research and then moved over into kind of a quant role and then ultimately derivative trading. I was in Tokyo. We had actually just gotten back to Tokyo from London. and essentially got a call out of the blue from Grinnell College's endowment. And they said, hey, we're looking for somebody who checks these boxes.

Starting point is 00:06:02 And ultimately, they wanted someone who had ties to Grinnell in Iowa. So I was at least a reasonable fit on paper, but I had no idea what an endowment really did. I knew someone who worked in the investment office there and obviously had ties to the school. So they reached out and basically asked me if I'd be interested in applying for the job. So I went through the same sort of interview process that everybody else did, but ultimately was offered the job. At the time, it was director of public investments. And this was 2010, shortly after the financial crisis, the investment banks had become not nearly as interesting places to work. They had been defanged. And certainly the upside and compensation. And I'd been steadily thrown more responsibility. So I was getting more away from the trading aspect, which I really enjoyed, to managing trading desks full of people.

Starting point is 00:06:50 which I did not enjoy. It sounds like when you showed up there, maybe you didn't know a ton about what I'll call the traditional endowment model of investing. A lot of people will be acolytes of the Swenson model pioneer at Yale. What was your education like in those early days in 2010? What seemed sensible to you back then and what seemed insane based on what you saw when you arrived? Education-wise, the first thing I did was went out and bought Swenson's book and read that.

Starting point is 00:07:16 There was definitely things that I agreed with and things I didn't agree with. and coming from a Kuan trading background. There's lots of academic things that make a lot of sense, but aren't really practical in the real world. And Grinnell, I think, was probably at an extreme, at that point, relative to Yale and that they already had this Buffett-like model where, hey, we're just trying to find good partners, good investments, put as much capital we can in our highest conviction opportunities,

Starting point is 00:07:43 and then compound with that over super long periods of time. That was probably my main takeaway, and certainly what we do now, I think, is much closer to what Grinnell had originally. And I was super fortunate to work for this guy named David Clay who hired me there and was my mentor, still is a good friend and just a really great person. He took me under his wing and let me make my own mistakes and go out and meet whoever I wanted, travel wherever I wanted. I'd say help me come to the right decision as opposed to force it on me. Maybe you could just level set for everyone listening, the style of investing that you did at Grinnell and employ now at Wash You and, endowment, because I think it stands in pretty sharp contrast to the traditional endowment model,

Starting point is 00:08:24 both in terms of what the portfolio looks like, but also where you and your team spend your time on managers, different geographies, on asset level investments, individual securities. It's all quite a bit different than you might find at a traditional, let's say, Ivy League Endowment or something like that that's mostly allocated to managers in a very broad way. So maybe just level set and talk a bit about the actual investment model, which is quite unique. If you look top down and looked at our asset allocation, it's not going to be significantly different than most of our peers. I would say how we spend our time is probably quite a bit different. Like you said, we probably have 30 close partners in the whole portfolio and probably a group of 50 core partners, we call them.

Starting point is 00:09:04 With that 30 core partners, we're super close to not everything they're doing, but we try and keep really close tabs on what they're looking at, what their portfolio looks like, what they're excited about, not excited about. And we spend over 90% of the team's time just looking at those underlying investments and where we can build our own conviction and have the opportunity to insert ourselves on the cap table. Typically, that's through co-investments, but we've also gone directly on the cap table at times when we've been asked to. It's varied across geography and industry. Basically, we spend a lot of time on the road.

Starting point is 00:09:39 But more of that is meeting with individual companies than it is with new potential investment partners. Is it your goal over time to have some ratio of the capital indirect, either co-invest or direct cap table investments versus manager allocations? There was a funny story at Grinnell. I think when you answered a survey on the fees that you were paying compared to your peers actually threw out the Grinnell result because it seemed like too low, your fees were relatively low versus your peers that you were paying to managers. I'm curious whether that's a result of a philosophy to try to have more direct ownership. It's certainly a byproduct of that. Absolutely. Most of those co-investments don't have an associated management fee. They'll have a carry and sometimes a healthy carry. But typically,

Starting point is 00:10:21 if you're already paying for management fee in the main partnership, to add capital to a single name would necessarily increase the management fee. By Grinnell, that was probably 20 plus percent of the portfolio. We're certainly over 20 percent here today. We don't have a hard number. We'd love to see that get to 80%, but that would be organically. All those things quadrupled in value over the next three years, it would certainly explode to 40, 50%, barring any kind of profit taking. But we don't have a hard cap.

Starting point is 00:10:51 We've been fortunate that that part of the portfolio is outperform the rest of the portfolio by a significant margin. But so far, the board has been very accommodative to that. And we break out that performance at every board meeting and are very explicit of where we're adding value and not adding value on those investments. What do you think that says, that's a really interesting stat that your, I'll call it, selection of individual securities underneath the managers that you're allocated to is outperforming the manager bucket? What do you think explains that? Is that because of a problem in portfolio construction at the manager level? Is it because you're doing a better underwriting job and have a big balance sheet and can take big swings?

Starting point is 00:11:28 What explains the fact that the co-invest portion has outperformed the rest? I think it's probably true across any firm. In general, the highest conviction ideas tend to outperform. And we have the luxury of being able to sit atop of 30 different partners and look across all 30 of those portfolios and add capital to the absolute best ideas that come to the top. Some of those are extremely long tails. We had lots of time where we worked on a specific investment for two, three, four years before we were actually able to get on the cap table. But over time, And if you're choosing good partners and your partners are choosing good investments, they generally have a pretty good idea of what they think the best assets in their portfolio are. I'd love to go pretty deep into the process of choosing good partners and what you've learned about doing that effectively over time, not just choosing them, but also then cultivating a good partnership with them over many fund cycles or whatever. You already mentioned at the beginning, the lesson from fixed income may be being build a portfolio of things that have the right kind of asymmetric outcomes, but that are very different from each other. so they're diverse in those outcomes. I assume that the manager philosophy is something kind of like that, that you want a diverse portfolio of people doing different thing

Starting point is 00:12:39 that have potential for delivering that asymmetric return to you in the endowment. How do you identify that kind of manager? If they're all doing very different things, what things do they share in common that you've found useful to look for? It's not easy. And again, we're not bad in a thousand by any means, but we're looking for people who we think have right-size capital base who are operating in a good opportunity set.

Starting point is 00:13:01 I would say being able to get really close to that particular partner and have that dialogue, that takes a lot of time to develop and sometimes it doesn't develop. It's something we work really hard at. I don't think there's a magic bullet that says this is how it's done. Ultimately, we're just out there basic blocking and tackling like, hey, we're interested in what you're doing. Some firms and people are really understanding about that and they actually like it. Like, hey, we'd love to have you guys look at this particular company because we think

Starting point is 00:13:31 there may be an opportunity for us to lead around 12 months from now, and other people are more just naturally protective of those relationships. We always see it as a partnership. We're never trying to step in front of our partners, but certainly if we can get an outsized allocation for whatever reason, that's kind of what we're aiming for, or at least have first opportunity to take a look at the investment if an opportunity arises. It's not an easy process, and it takes a lot of time and effort from the team. What part of that do you, and I guess the team most enjoy as you're doing that hard process?

Starting point is 00:14:04 I know you're not spending a ton of your time on new managers, but when you do, what piece of that is most enjoyable to you? It's probably more on the personal level, just getting to know the people, what they care about, what they like, what their underlying skill set is. We have partners, I think, who have very diverse views of the world and are intellectually curious. It's great for me and the team and our portfolio, quite frankly, to just be able to pick their brains and get their views on either a specific company industry, business model, or just

Starting point is 00:14:31 what's going on in the world. Talk a little bit about the role that travel plays in all that you do. I think in so many ways, a lot of success often is literally just showing up. If there's one thing that I had to say for sure that you and your team are the most different on, it's just the tremendous amount of global travel that you do. The boots on the ground phenomenon, I see your team all the time. And it seems like they're always coming from Singapore or Japan or China or America or Europe or Saudi, they're all over the place all the time. It seems very deliberate. So maybe talk about the importance of boots on the ground in this style of investing, where typically, I would say the norm is a really nicely dressed team in an administrative

Starting point is 00:15:10 building on a college campus or something. It seems kind of the opposite here. Walk us through that strategy. I'm biased. I guess that's where we've structured our process, but I just don't think there's a substitute for having boots on the ground. There's a bifurcation between perception and reality, when you actually spend time on the ground in some of these markets. I think it's really tough to build a real relationship or even do real diligence on a company. If you're not there touring the factory, looking at the process, talking to various levels of management,

Starting point is 00:15:39 I think it's hard to build real conviction in an investment. And you just can't replicate that over a 45-hour, even an hour and a half Zoom call, which is probably the max of most people's tolerance. Anything beyond an hour and a half on Zoom gets pretty painful. and I think people start getting distracted, but you can go and spend two, three, full days with one company and spend half a day with head of sales,

Starting point is 00:16:02 half a day with the product team, half the day with IR and CEO, and half a day touring the factories, and you're going to have a much better understanding of that company and the team than you will over countless Zoom calls. Personally, I think there's not a real substitute. For the team being together in person, that's in the office on the road and spending time with our partners and our potential investments in person.

Starting point is 00:16:24 You talk a bit about frontier and emerging markets specifically as it relates to all this travel. It seems like there's a huge amount of time that the team has devoted to those markets specifically. I don't know if that's a point in time thing or just a more general view on the potential for opportunity in those places relative to the developed world. Why so much time in frontier and emerging markets? We've found that it's generally been pretty fertile hunting grounds. It's probably changed a little bit in the last six months, but over the last five years, just the quality of the company. company's quality of the management teams relative to the valuation you can invest in. You find companies that are trading at four times earnings growing 30%, but 40, 50% return on equity,

Starting point is 00:17:06 just really great companies that you can buy in at prices that don't exist in the developed markets. There's obviously risk associated with that. What I tell the team is, like, all investing involves risk. The question is, is it correlated risk or uncorrelated risk and are you being well compensated for it? We've generally had quite a bit of success. in EM and frontier markets across the portfolio. Is there a market, even country or even company within a country that stands out in memory as an exemplar of this idea to you? We've had lots of great investments in these markets, public and private, looking at

Starting point is 00:17:41 like a captive power plant in Nigeria, that ended up being just a really great transaction. And it was a super simple thesis. It was a product that was hugely in demand. The hardest part was just basic execution risk of importing the required equipment. and running power lines. But even after the investment had mostly been de-risk, you could still buy in it at such a great price. And it was a business that wasn't like it was going to be a 3x.

Starting point is 00:18:05 It was going to be a 30-X type transaction. There was a Southeast Asian gaming and e-commerce company that we invested in very early on. We thought a big chunk of the thesis had already been de-rists. Ended up being a really great transaction for us. I don't think we would have gotten the same sort of conviction or been able to size it like we did in the portfolio without actually spending time on the ground

Starting point is 00:18:26 with the management team there. What do you think is interesting in terms of the East right now? Maybe China's the most obvious big question mark. You've seen lots of, I think, very talented Western-based managers say this is just in the too hard pile, it's sort of uninvestable for us because there's too much uncertainty. What do you think of investing in China and somewhere? I know you spend a bunch of time, a huge part of the world.

Starting point is 00:18:48 What have you learned there? We would probably take the view that anybody who thinks investing in China it today is any different than it was 10 years ago. It hasn't been paying attention over the same time period, and we have lots of people who lived in Asia. So for us, it's becoming much more investable because you have the same assets trading at significantly discounted values. And that geopolitical tension may have bubbled to the surface. I don't want to downplay the world slightly different than it was 10 years ago. But in terms of investing in things that the government there prioritizes, I don't think that's really changed.

Starting point is 00:19:23 we've actually, if anything, increased our exposure to China over the last six months and have spent more and more time in that area. Now, it's tough. Fortunately, we have a small office in Shanghai. We do have boots on the ground there all the time. We've been able to diligence some of these investments better than we otherwise would have during the pandemic. Implicitly, when you buy stock or own part of a company, you're making this assumption that

Starting point is 00:19:47 you have some sort of fundamental claim to the economic earnings of the business as a shareholder. And I think in China and a lot of these places that we invest, that exists as long as that's what's in the best interest of the Chinese people and the Chinese government, you have to go in with a very clear view, hey, here's the risk. And are we being compensated for that risk? We generally like geopolitical risk because it tends to be uncorrelated to other broader macroeconomic risks in the portfolio. What about Asia outside of China? I know you lived in and have spent a ton of time in Japan and also, where in the region. What else have you learned that's interesting in Asia X China? Every market there is its own little sandbox. Broader takeaways would be, hey, we want to invest with locals in local market. I think it's really tough to invest in Asia from New York, whether that's Japan or Vietnam or Malaysia or Indonesia. Some of these markets are super

Starting point is 00:20:44 interesting markets with huge populations and growing economies. But you want to make sure you're invested with partners who can navigate this situation. on the ground and deal with political and economic reality on the ground. I would never invest in Japan with someone who was in New York. Yeah, someone who probably grew up in New York. We would have a super strong preference for local people. I'd love to do an asset class tour knowing that you've got allocations with partners in all sorts of different asset classes and geographies.

Starting point is 00:21:15 And maybe take, we'll call it the skeptical, slightly cynical lens and talk about what you you as crazy things or downsides to each asset classes or things that you might look to avoid. Maybe we'll start with venture. That's the world I know best. You've obviously met tons of the greatest investors in this category through your career. What is interesting to you about the category and what are the sorts of, I guess I'll call them red flags or things that raise your cynicism a bit in that asset class? Venture is kind of unique.

Starting point is 00:21:43 It's been one of the best performing asset classes, at least on paper over the last two decades. We do like venture. We like disruption and investing in disruption and new markets. It's tough for a large pool of capital in that early stage investing doesn't really scale. But it's tough for us. We really have to be in early and be really close to our partners to get access to, I would say, interesting deals, interesting prices. There's lots of great companies. But if they're fully priced or overpriced, it becomes very difficult. And I also think venture is probably, going to suffer from an overhang of excess capital for quite some time. If you look at entry level valuations 10 years ago or 20 years ago to be extreme, and look at what the industry has done, and if you say the industry has produced a multiple of 5-8x over that time period, and maybe it's done even better, that's an amazing return. But now you're looking at a situation, and they may have normalized here a little bit recently, but you're looking at a situation where entry-level multiples are now 5-8X. So in order for the industry as a whole to produce the same kind of returns

Starting point is 00:22:51 it did over the last two decades, that doesn't look very rosy to me. Something's got to give. It just seems very tough to me when you play it out because public market multiples change over time, but if your entry-level multiple starts at a 5 or 10x, and you've seen that in these national champion type companies, like if Google went public today or Amazon, they wouldn't have gone public at the same sort of valuations they did go public at just more. It would happen. They'd be very, very fully priced in the private markets and probably would have stayed private for much longer than they did. What's the worst thing or things that you see from venture investors? Where do you think they're the naughtiest? Venture investing is hard,

Starting point is 00:23:31 and I think people who are really good at venturing investing have very open mind, and it's really tough to see who would want to get in a stranger's car and get a ride home from the airport. if you could call it on an app, they had illegal cabs in New York and London for as long as I can remember, and no one wanted to get in a car with them. I think it's hard to see that kind of disruption and say, yeah, this could be a really successful company. Where most venture investors break down is having some sort of rational framework around valuation and business model. And you just see so much value put on top line growth and so little value put on ultimately what the economics of this business look like. So you've seen industries that I think will

Starting point is 00:24:12 just be really, really tough to ultimately make much money in. And that could be the scooter companies that were valued at billions of dollars for food delivery platforms. It's not that these aren't a great product and a great service and there's a market for it, but it's an industry where ultimately it's really tough to make money in this. And those specific examples, there's not huge barriers to entry. There's no switching costs for going from Uber Eats to DoorDash. For the customer, it's a very, very tough business that I think ultimately have a hard time generating significant profits for equity holders. I'm curious what you think about an interesting counterpoint. Two things come to mind. And the question is, should venture investors care? Because very often

Starting point is 00:24:54 they're exiting and earning their carry and returning capital to their LPs before that's all sorted out, typically by public markets. The one famous example would be something like Tumblr, which sold, I think, for a billion dollars for its early investors. It was a phenomenal investment. and they did their job. On paper, they did their job. And then there was some famous, very famous VC who made the comment, I think, privately that they had never invested in a company that was yet profitable and yet they had delivered phenomenal returns to their LPs. Do you think that maybe you are both right and VC as an industry maybe shouldn't care as much? To me, I would separate a trade from an investment. If I'm just buying this to sell it three years from now at a much higher price,

Starting point is 00:25:38 ultimately I don't even care what the final thing is worth. That's to me a trade, not an investment. Ultimately, we're investing in something and we think it's compounding intrinsic value, and the company is definitely worth more three years from now than what it is today. That shows up in lots of things, not just earnings or free cash flow. But if you're just trying to make a trade, we bought Tumblr at X and sold it for 5X. Yeah, that's the great trade. I would say us just because of our time horizon and wanting this to compound over decades

Starting point is 00:26:13 ideally and not be forced to sell something, we are certainly looking for investors and not traders. You can be successful doing that, but it's tough. The strangest thing for me coming from the quant world where obviously it's the opposite side of the coin and everything boils back to free cash-help per share growth, the craziest thing is how little mind is given to that early on. And obviously some of these companies are so young, it's hard to know where the free cash flow is going to come from. And it is much more about product traction and overall growth. It's a really interesting dynamic that I think you've laid out well.

Starting point is 00:26:46 How does all that same stuff play out in the more traditional private equity space? And I'm curious in the same questions here of what the virtues and what the vices are and what the bad behavior might be. In the private equity model, where the businesses tend to be much more established, much more analyzable. There's a lot more quantitative work typically going on. Give us your impression of managers. and investing in the private equity space. It's been a great space. If I'm looking at the pitfalls, certainly over the last 10 years, it's through financial engineering. And I think there's all kinds of agency problems with those large private equity firms. And most of the deals have become so disintermediated that it's tough to get proprietary deal flow,

Starting point is 00:27:24 proprietary pricing. So ultimately the deal goes to either somebody who has a very unique differentiated view on how to realize value with the business or whoever has, the lowest cost of capital. I think there's been for sure a race to the bottom in terms of who has the lowest cost of capital and stuff they used to trade it six to eight times EBITDA with reasonable free cash for per share and growth and return on invested capital probably now trades it 10 to 12. And they're trying to justify that with twice as much leverage to get a fairly respectable ultimate net return to LPs. It's probably a very hard question to answer, but I'll try the question anyway. What percent of that industry measured by capital

Starting point is 00:28:09 base or something do you think are truly investors versus, I'll call it rather than traders, financial engineers that are trying to engineer returns? Our general view has been, certainly most of the large players are generating returns through financial engineering. Companies get stagnant. Maybe I'm dodging your question. I would say over half for sure. the large players are through financial engineering. They're good players and the players we tend to gravitate towards do come in and you see where these large companies

Starting point is 00:28:40 get very stagnant. They're unwilling to make hard decisions and cut unprofitable units and reduce staff and sell off portions of the business that don't make sense, don't provide any sort of economic synergies. There are good players out there still, but it's

Starting point is 00:28:56 tough. Ultimately, if the deal is just being sold to whoever has the lowest cost to capital, it's tough to execute a value add strategy within that. You don't end up winning that many deals. Continuing on our tour, I'm curious what your impression of the world of hedge funds has become. I think people think of hedge funds as two parts.

Starting point is 00:29:15 You've got the sort of asset selection long and short. And then you've got a different version of portfolio engineering, I'll call it, with managing gross and net exposures. What's your impression of the evolution of the hedge fund model? What parts do you find appealing as partners? What parts wouldn't you touch with a 10-foot pole? We don't do a lot of hedge funds. I think we currently have four in the portfolio.

Starting point is 00:29:38 It's not a big part of our portfolio. I think in general, it's an expensive way to mitigate volatility in the short term. It costs you a lot and expected returns over long periods of time. And there's other portfolio construction issues that I've talked about before and basically ultimately, if you put a big basket of longshore hedge funds and you look at your underlying exposures, you end up with an index fund on both sides of the market with this massive active management fee structure and the nature of the carry there is you're short of basket of options on performance, which means you're essentially long correlation and that you get

Starting point is 00:30:12 no offsetting benefit for firms that do well versus firms that do poorly. We've gone away from that. I do think individually there's some really great investors, but even take Warren Buffett, if you put a two and 20 fee structure on top of his performance, it's not going to look that great either. It's a tough asset class fee adjusted, I think, just to produce not even good, but reasonable returns over a long periods of time. And you've seen that. There's one broader trend in institutional flows. I think you're seeing it out of hedge funds and into private equity and venture. And that's across endowments and foundations, particularly pension funds over the last couple of years, have cut their hedge fund allocations. And that's, hey, this asset class has performed really well,

Starting point is 00:31:00 This one has performed really poorly. You're probably doing it at the worst absolute time. We do think there's a place for hedge funds in the market, but it's a tough place to generate returns. So most of our hedge funds, we have really great relationships to, and we use them as research partners to either size up the individual names in their portfolio that we think are super attractive and help us diligence, other investments that we're looking at across the portfolio.

Starting point is 00:31:25 Maybe two more pit stops on the tour. First being credit, obviously you had tons of personal experience, in the fixed income world as a trader, what is the role that credit can play in a portfolio like the one that you manage now? And what is interesting about the managers that you have or might consider partnering with? Because it seems to be a totally different game. That's sort of what could go wrong game versus the what could go right on the equity side. What role do you think that plays and similar questions in the world of credit? If you think like the most simple asset allocation like fixed income equity, 6040, 70, 30,

Starting point is 00:31:56 whatever your broader benchmark is, that asset allocation or those ratios should be a function of your time horizon. So if you have a 100-year time horizon, you'd probably be in 100% equities. Or if you have a two-year time horizon or five-year time horizon, your allocation of credit and fixed income is going to be way higher. In general, I think the role of credit in a portfolio is really small. If we say we have a 20-plus-year time horizon, why would we put something that we know has a significantly lower expected return over that 20-year time frame in the portfolio. And the reason people do that is to mitigate short-term volatility, but you have to calculate the cost of that. Ultimately, we basket our risk in two main buckets. We have the risks of

Starting point is 00:32:39 short-term liquidity. We can't fund our obligations to the university. And our other big risk is we can't generate returns that cover inflation plus our payout, plus a little bit of real growth in the portfolio. And that the next thing, the next thing, the next thing. next generation is worse off than the current generation. Those are the two ways we think about risk. For us, credit has to compete for capital with any other asset class, and we haven't found a ton of investments, but we have found a handful of people doing interesting things in credit, but the returns ultimately more look like risk. And probably if you looked at the beta, the risk exposure, it looks more like equity risk. What is great in that world in terms of

Starting point is 00:33:20 the manager attributes? What do the people that you've seen do something truly interesting in that world, tend to be strong in personally. Credit is probably unique relative to equities. And I think if you look at the best people in equity, we don't really distinguish between public equity, private equity inventory for us is just all equity exposure. I think in the equity portfolio, the best investors have some sort of unique insight on a business. Now, whether that's the size of the market or ability to capture market share or what margins

Starting point is 00:33:50 ultimately look like, could be anything. but they have some sort of unique insight that they see that the market doesn't value properly, that allows them to generate great returns on that specific investment. And credit, it's that unique insight, but in this case, here is why this paper is worth more than what we're paying for it. So if it's trading it 50, 60, 70 cents on the dollar, or they have a unique distribution process that allows them to generate returns and sell debt or make loans at a interest rate that's significantly higher than the market would bear if circumstances were different for that specific

Starting point is 00:34:26 company. For the last of our pit stops, I have in mind the Nigerian power plant, which is, I guess I'll just call it other. The thing I'm most curious about here is how you think about the source of return and the risk associated with that source. So equity and credit have some pretty aligned risk profiles, I guess. Like you said, you consider everything and venture all the way through public equity to be equity. And there's lots of things that are risk factors for equity beta. What? is in this other bucket that I'm assuming something like a Nigerian power plant, or maybe that is equity like, what is other to you and why is it relevant? When we build up the portfolio and we think about diversification, we're looking to put capital into investments that we think have a

Starting point is 00:35:08 high expected return, hopefully have positive convexity or that asymmetric payout, and then also have independent outcomes over some reasonable investment time horizon. That's real diversification. And it doesn't mean that if the cost of capital goes up for everyone tomorrow, the value isn't going to fall. But over some reasonable investment timeframe, we think those things are going to have completely independent outcomes. So we would put the Nigerian power plant there. It was an investment that started with a group of people in a wealthy neighborhood in Lagos.

Starting point is 00:35:39 Power generation is a problem in a lot of these frontier markets. Ultimately, they got to take a pay contract that government was supporting because they didn't have the capital to buy generators and make investments and run power lines, it was more beneficial for them to outsource that. They actually had a take or pay contract from the government, so the whole thing was as long as they could import the materials. And because it was supported by the government, I think the execution risk was minimized there. Now, it's not without risk because governments can easily change your mind and governments change frequently in some of these markets. but because it was supported by the government, what we thought was a very attractive implied valuation.

Starting point is 00:36:19 And then you also had this optionality to expand to not only that neighborhood, but 30 other neighborhoods in and around where the power was being generated. Pretty interesting, the risk's initial investment with the ability to scale up capital and reinvest profits at a super high return over a 10-plus year time period was a pretty interesting investment. I'd love to talk about everything you've learned about asset managers as asset gatherers. This is a phenomenon that I think is as old as the industry has existed. The incentive structure, because there's management fees, is that one way to earn a lot more is to raise more money. And I think also you've seen this interesting trend of the biggest businesses measured by something like enterprise value that have been created in the world of asset management.

Starting point is 00:37:05 I'm thinking BlackRock or Blackstone or Vanguard, maybe if its model was different, come from ways of selling beta. The steady business is really selling data, not alpha, and that's an asset gathering game. And I'm just curious what you've learned about that. The incentive structures that you've observed in the asset management industry, how and when you can effectively fight them and actually deliver real alpha, this just seems like an under-discussed and really important feature or bug, I guess, of asset management is the tendency of all companies in the space to trend towards asset gathering. People respond to incentives.

Starting point is 00:37:37 Ultimately, the incentives are there, and even firms that's start off, I think, well-intentioned. They have teams. They tend to be self-replicating organizations and that they just get bigger and larger over time. And the opportunity sets change over time. So I don't think you can have a rigid, hey, this is the right-sized capital-based for our opportunity set. Opportunity set changes in capital-sized and capital-based needs to change with that. We have seen interesting structures. We have one hedge fund in the portfolio, whose total collected management fee actually starts to tick down after a certain asset size. You see a lot of people limiting asset size or the amount of capital raised in the docks,

Starting point is 00:38:16 but it's more the norm. We have a big redemption coming in over the next couple months, and it was a public equity manager that started out small and was going to close at a very reasonable level, and now at 5x that level and haven't returned the time of capital. The opportunity said, just get so small once you get to a certain size, and then if you're not investing in the $20, $30 billion plus enterprise value companies, you just don't have enough liquidity to get in and out without really impacting the market. Is that the most common reason you would say that you redeem from a manager is size growth?

Starting point is 00:38:52 Yeah. Redemptions on the private side are a little different and that you just choose to not invest in the latest fund, but we had quite a few partners who we thought got completely undisciplined. They were also doubling and tripling the size of their funds, so that was part of it. but they're also deploying capital at just a rapid pace, and we're just completely undisciplined about valuation. And you'll see those funds, I think, reflect that. And I'd say it was mostly in the growth equity space.

Starting point is 00:39:21 You see these small venture firms, they start off. Fund one is X. Fund two is two X, and that's probably still a reasonable size. And then by Fund three, they have a small fund and a growth fund, and then ultimately that growth fund becomes the vast majority of deployed capital. I think the returns on all of those growth funds are going to be very mediocre or worse. I'd love to talk about my favorite and in my opinion the most important investing question as it applies to the Washington Dowement specifically, but also just other large pools of capital,

Starting point is 00:39:53 which is the way I promote the question is, why not SPY? If the S&P 500 or a total equity market or whatever the simple, broad exposure is the opportunity cost for most investors, managing for you a double-digit billions pool of capital, how do you fight that same problem? I mean, you've talked a lot about it to some extent with the hedge fund example, but how do you fight convergence and keep tracking error in the portfolio at that size? Because it seems like the more successful you are, the harder your job becomes for the same reasons you just outlined for asset managers because the opportunity set shrinks with size. For a lot of people, SPY is a reasonable solution or MSCI.

Starting point is 00:40:36 SPY has outperformed the broader global markets for the last 10 years, so you're seeing more and more of that. But what I predict that the SPY is going to have that same outperformance over the next 10 years, I wouldn't bet on that. Certainly, U.S. domestic beta has been one of the best performing asset classes for a long period of time. If you have a small team or don't have the resources to do a full investment office, that's probably not a bad bet. The reason people try is the reason people have always tried. And

Starting point is 00:41:03 if you can just create a little bit of outperformance and compound that over 34 years, the difference is just so massive. It's worth it. We don't compare ourselves to the SPY and the global allocation come down from the board. Even over the last five years, I think we're ahead of SPY, which is the timeframe that I've been at Washu, and we're significantly ahead of the MSCI. If you look at the benefit to the university, over that 30, 40-year time horizon, just 100 basis points, 200 base points of outperformance ends up being $20 plus billion for a pool like ours, even bigger if I recalculated on today's basis. But we did that analysis for the board. Last year, this was over a 20-year timeframe. So the difference between a 7% return over 20 years

Starting point is 00:41:53 and an 8% return is $12 billion. Tracking year is one of those things. Obviously, to do that, you need some sort of tracking error versus the underlying benchmark. And tracking error is lovely when it's on the right side and painful when it's on the wrong side. Given that you run a very different portfolio, I'm even thinking back to the Grinnell days. I'm just curious to hear about what it's like to go through the bad side of tracking error. The results are public. You can go look at Washington return last year and it's insanely good, 65 or 70%.

Starting point is 00:42:21 And on the other side of the ledger, what's it like and what is it important for you to do, you personally and your team, to behave well in the negative tracking error periods? If you think about our mandate from the board, they want us to outperform the 70, 30, our incentive compensation stuff is the more you outperform the better your incentive compensation is. So we're targeting a thousand basis points of tracking error. And I would say on our portfolio as big as ours, that's a lot of tracking error. And we measured over rolling two-year periods, a natural byproduct of that, if you're going to run with that much tracking areas, you are going to have really good years and really bad years. And it makes short-term performance measurement. You can still do it, but it's not very meaningful. So just like last year's high return is not meaningful. I think the only way to properly measure these endowment performances over multi-year timeframes. And if you talk to all of our peers, no one's going to have a one-year strategy. Everybody's. going to have a different basket of core investments that they think will pay off over some

Starting point is 00:43:24 certain timeframe, but I don't think anybody's going to say our one-year returns are meaningful at all. And ultimately, that's not how we look at the world. It's not how we're compensated. We look at rolling three-year and five-year returns for the team's incentive plan. It has nothing to do with the one-year return. Is it fair to assume then that a time like this is actually maybe your favorite kind of market environment in which to operate when maybe trailing returns aren't nearly as good, but the opportunity set is just, there's just a lot more chaos and uncertainty in the world today than there was a year ago. Absolutely. I think if you really like investing, you can't have a good time investing when there's this much uncertainty in the world. This is

Starting point is 00:44:03 the absolute best time to put capital to work. And we've been fortunate over the last five years that I've been at Wash U. We had the fourth quarter of 2018. We had the pandemic. And now you've seen significant drawdown. And certainly some sectors have drawn down 70, 80, 90 percent. And they may take decades to go back to where they were or they may never get there. But this is a really interesting time to be kicking over rocks and looking for interesting places to put capital. If you can't have fun investing in this type of market, I think you're probably in the wrong seat.

Starting point is 00:44:33 There's something else. In some ways in a market like this, you're sort of an allocator of team time and resources. And when there's a blowup and uncertainty like there has been recently, especially once so global with lots of geopolitical type stuff happening and energy stuff happening, it does feel like chaos in certain regions. You see those power charts in Germany or something, and it's really nuts. As an allocator of people's time, which then will lead to the investments, how do you think about that?

Starting point is 00:45:00 Are you sitting and saying, we need to spend more time in Europe because of X, Y, or Z? How does the macro uncertainty stuff figure into how you allocate your team's time in a market like this? We're going mostly where the real run into the fire. Yeah, that's kind of how we allocate the team's time. So we've been looking a lot more at Asia and China in particular. We've been looking at Europe. Some of these frontier markets has gotten less interesting on a relative basis.

Starting point is 00:45:28 Those stocks have held up relatively well, and a lot of them are natural resource-based economies, and they're doing fine. So we're spending more time in Dubai and less time in Bangladesh, more time in London. We haven't made that many investments recently, but it's, if you look at the travel schedule for myself and the team over the next three, four months, it is absolutely brutal. it's as busy as I've ever been. If you think about that thousand basis points of tracking error and then start to shift ears into lots of these same questions I've asked you about asset classes to the endowment level or the foundation level, the allocator level, what do you see in terms of tracking error, like as normal? Like a thousand basis points seems, especially on a big pool of capital,

Starting point is 00:46:08 extremely high. I mean, that would be extremely high for a long-only manager or something. Do you think that most endowments and foundations have been squeezed in the same way hedge funds have? And so they may have a couple hundred basis points of tracking error, but functionally they've got high fees on beta. Is that your assessment of the Endowment and Foundation world generally? In general, I think, yeah, historically, if you've had 200 base points of tracking error, that's much more common. I would say the vast majority of endowments would fall into that, relative to the peer group for sure, a couple hundred base points of tracking error would be high. And that if you look at, it's not only that a lot of the foundations and endowments are investing in the same asset classes, the same subset of managers.

Starting point is 00:46:52 If you look at the overlap across that portfolio, I think it would be super high for a lot of foundation endowments. And that's not even including everything that's consulting led. That tends to be just super ubiquitous across people's portfolios. Yeah, there's that term for stocks that they call hedge fund hotels where all the same funds are invested. It sounds like it's the same phenomenon at the manager level. Maybe talk about incentives. My guess is your answer to why anything exists the way it is, is incentives. Why do such big pools of institutional capital allocators tend to end up looking so similar?

Starting point is 00:47:25 Is it the governance structures? Is it career risk? Is it the boards? Why does this the outcome? What are the incentives that drive this outcome? It's career risk and career longevity. Nobody ever got fired for investing in BlackRock or Bain or Blackstone. it's an easy thing to do.

Starting point is 00:47:42 And if you're sitting on a really large pool of capital, it's also easy. It's efficient. Hey, I can get five products from the same firm. Are those the best five products across those different subsectors? But if I can invest in their real estate, their life science is fun, their venture firm, their buyout, private equity, they have it in Asia, they have it in Europe, they have it in the U.S., they're all reasonable. Those firms are good firms. they're not going to keep underperforming teams around for long periods of time. They produce reasonable results, but it's the guarantee of mediocrity.

Starting point is 00:48:17 I totally forgot to ask you about real estate. Do you think of real estate as sitting between stocks and bonds in terms of like risk reward profile? What do you think about real estate as an opportunity? It's been a tough place for us to invest. We do have a couple partners in real estate. It tends to be more redevelopment or greenfield type development projects for that stuff to compete for capital with other asset classes, you can't buy core real estate at a 4% cap rate

Starting point is 00:48:44 and expect that you're going to generate our cost of capital over long periods of time. It's kind of like private equity, and it's not necessarily remarked that often. Those cap rates don't change that quickly, even relative to broader interest rates. We haven't seen cap rates fluctuate that much in the really good markets. I would think it's always going to be a relatively small part of the portfolio. So we have found great co-investments there as well. One of our best investments last year was a co-investment in a real estate project in Asheville. Another one of my obsessions is the cultivation of a talented investment team.

Starting point is 00:49:19 Obviously, you've got a big and very talented team that's going all over the world, evaluating things. Tell me what you've learned about teaching investing and investing mentorship as a leader of an investment team. How have you personally gotten better at that over time? what has worked for you in training other investors? It's a pretty organic process. It was really hard at first when I first started. It helped that Andrew on my team came over from Grinnell and we'd already worked together for quite some time so we could mentor the team together.

Starting point is 00:49:49 But just changing this focus from funds to what's inside the funds was a big change and the process is obviously very different. For the most part, the team is really taken to it. And we generally are traveling in teams. We have a generalist model, so I don't know what the biggest meeting we've done with you is, but we're not afraid to gang up on somebody and put 12 people on a Zoom call. But I think everybody learns organically through that process. And then after our call like that, we dissect a company like Prefect and just say, like,

Starting point is 00:50:19 what did you guys think about it? What do you think of the business model, the marketplace, and generally talk about the investment as a team. And we do that every if you were to sit in on one of our Monday meetings, which you're welcome to do at some point. We spend just as much time talking about the merits plus and minuses of an individual company or potential investment than we do talking about research projects and diligence on new funds. And I think that's really the only way to do it. Some people take to it.

Starting point is 00:50:45 Some people don't. I think the more shots on goal, the more time you get to spend doing it. And we're super fortunate because we get to talk to a lot of the best investors in the world and ask, what is your thesis on this specific company? why do you like it? What's the work that? How do you verify that? How do you think about risk? How do you think about reward? Competitive landscape, industry, chance of disruption. It's an open book. And you can talk to three great investors who have different views on the same company. That's super helpful for us to triangulate our internal thesis on the same company.

Starting point is 00:51:18 One of the interesting things that I've seen you do is collide your managers. I've sat in on manager meetings that you've had with other managers. That can't happen very often. And it ends up being such a fun. spirited thing. Do you do that intentionally or is that just a fun thing that you like to do? And if it is intentional, why do you do it like that? Well, I wish it was more intentional. I wish we had the opportunity to do that more. Hey, this is a really smart guy. And these are good people too who like talking to other really smart, good people. We had two of our managers became really, really good friends with this other manager we had in Hong Kong. So this New York guy was probably spending more time talking to our manager in Hong Kong than we were.

Starting point is 00:51:59 the manager of Hong Kong shut down, but we've had lots of situations like that. We'll deliberately connect people who are talking about the same companies or same industries. Most people are super appreciative of that. Just like the manager meetings done with you, I didn't think that was awkward at all. It's an interesting dichotomy. Like, hey, here's what we're concerned about and want to talk about. And we don't really keep secrets. We're a pretty open book.

Starting point is 00:52:24 As we sort of start to wind down, this beautiful idea of just boots on the ground. It's just not complicated, hard work, get out there, get to the edges, don't sit in a chair and think all the time, get out there and see the world. Is there a investing trip that you've taken in your career that is most memorable just to really drive home this point of why this is worth doing, even though it's a lot of work? There's lots of interesting places where, like, hey, we never would have had access to this investment or been able to build the kind of conviction that we had and double or triple down on the investment if we had not spent. the time on the ground that we did. In terms of specific investments, we've taken trips to like Pakistan and Bangladesh and found some super interesting companies there. You just wouldn't have had access if you didn't spend time with the management team on the ground. It was helpful to build a relationship with the management teams there because they were successful enough

Starting point is 00:53:18 that they could choose their cap table. Just being willing to go out and spend time on the ground with the company, gave us preferential access to the deal. I assume it's the same venture for you, if you're going to go out and meet a company doing an hour over Zoom call is probably not going to be the first call when it comes to raise money. If you're not actually on the ground with the team and building that relationship, it's a harder game. As you look forward over the next 10 years, you've got 10 years behind you now, or 12, I guess, since the start of Grinnell doing this style of investing, do you think that the things that will sort the winners from losers in the next 10 years

Starting point is 00:53:54 are any different than what's happened in the last 10? When you think of the portfolios that will perform well over the next 10 years, my guess is that those portfolios look quite a bit different than the portfolios that performed well over the last 10 years. I think a lot of asset classes have matured and have just gotten harder and there's been more institutional capital. In terms of investment process and firms, I think a lot of the good endowments and good investment teams that have seen that, will see that, and are adjusting their portfolios or But I think people who are playing catch up and trying to add billions of dollars of venture to the portfolio and cutting billions of dollars of hedge funds, that's probably going to be tough.

Starting point is 00:54:38 As always, Scott, when we talk, I've come to rely on you and wash you team a lot for a clear-eyed allocator's view of the world writ large. That's been really fun to do this on record with you for once. Really appreciate your time. I think, as you know, I ask the same traditional closing question of everybody. what is the kindest thing that anyone's ever done for you? Career-wise, so many people have done so many great things for me over the course of my career. I've been blessed with some of the great opportunities and great mentors. I would say if I have to think even career-wise, the kindest thing anybody's ever done for me,

Starting point is 00:55:09 I would have to go back to my wife if you think of where my career's taken me. And we've been married 21 years in November. When we got married, we were basically kids. We started in San Francisco and then went to Chicago to Chicago to Tokyo, to, to London, back to Tokyo to to London, back to Tokyo, to Des Moines. And I've been blessed with all these great career opportunities and being able to work with all these great people.

Starting point is 00:55:32 But her willingness to allow me to do that is definitely probably the kindest thing anybody's ever done for me. I collect the categories of these responses. I think that's the first of that type that I've had, which is really, really cool. It's rare these days, having done hundreds of these. Scott, thank you so much for the insight and for your time. Yeah, great to see you.

Starting point is 00:55:50 Thanks a lot, Patrick. Thanks for having me. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Scott Wilson - Non-Traditional Endowment Investing - [Invest Like the Best, EP.297]

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