Investing Billions - E246: Private Equity in 2025: Fees, Rates, and the Law of Large Numbers

Episode Date: November 20, 2025

Is private equity still worth it — or has the industry scaled its way into mediocre returns? In this episode, I talk with Nolan Bean, CFA, CAIA, Chief Investment Officer and Head of Portfolio Management at FEG Investment Advisors, an independent, employee-owned firm advising on $90+ billion in assets for endowments, foundations, healthcare systems, and mission-driven institutions. We dig into the state of OCIOs, interval funds, private equity, and why Nolan believes the lower middle-market still offers the clearest path to real alpha. Nolan also breaks down the coming wave of 401(k) access to private markets, why large-cap buyout is structurally challenged, and how FEG uses a “crisis playbook” to lean into markets without pretending to time them perfectly.

Give me a sense for the size of FEG investment advisors today. As we sit here today, we advise on over 95 billion in assets, more than 300 clients, and 90% of those are nonprofits. So started in 1988, I joined in 2004, we're at 25 billion, and have that 95, 18 billion is outsourced CIO, where we have full discretion and the balance is traditional consulting. And we've had a lot of RAs and investment advisors on the podcast, and everybody seems to be growing. What's the catalyst behind that growth in the last five to ten years? A lot of the growth in the last five to ten years has been the transition from traditional consulting models to OCIOs.

So that's been a lot of the growth for us. I think that's been one component. Another is it's a mature industry and there's been consolidation. So there's just fewer players and assets are now. consolidating with a smaller number of players. And as you alluded to, there's a convergence of private wealth and institutional OCEM consulting that really wasn't the case when I started 20 years ago. So it's just leading to consolidation of assets and a lot of growth for the players

that have remained and thrived. If you take a step back and take off your FEG hat and just look at it as an industry, whether your endowment or a high net worth individual, how should you go about picking investment advisor. What are some of the criteria? Everyone's going to have their own strengths and weaknesses. So understanding what's going to be a good fit in a good long-term relationship is important. So do they understand your enterprise? You mentioned endowments and foundations are very different than pension plans,

very different than private wealth. So do they understand the enterprise, the nuances, what is your investment style? Most folks have a different area of expertise, be it private equity, hedge funds, you name it. And is that aligned with your organization. And then understanding is it going to be a route? So is this a firm that has concentrated ownership that may be at risk of selling? And then the firm that she thought she partnered with turns into being a very different firm, one, two, three years down the road. One of the main, I think, criticisms of OCIOs is that they're too conservative, is that they're not incentivized to take enough risk. How do you look at that problem set? And is there any way

to operationalize decision-making or culture in a way that avoids this kind of entropy to the most conservative decision? I would first acknowledge that there's some truth to that, meaning it's like any other business, if you're purely trying to maximize the annuity stream, if you will, of the payments, don't get fired, right? Don't look too much with a benchmark. Don't look too different from peers, and you're never going to be bottom quartile, but you're never going to be top quartile. there's some of that inherent risk of conservatism embedded into the mandate. I think it's a couple of ways to try to combat that. People respond to incentives.

So for our team, at least, and I'm sure others, having incentive structures in place for the portfolio management team and the folks managing the capital aligned to performance and have that scale based upon relative outperformance so that, They have an incentive to take thoughtful, calibrated, calculated risk that over time should help drive superior returns or at least the ability to try to get there. And then I think a lot of it's just culture and personality. So some folks are just inherently, that's their approach.

They maybe use more indexing. They don't invest as much in private equity in areas that have more alpha potential. So ensuring that's a part of the DNA and the culture of spending a lot of time and effort in areas that have more alpha potential. I've been going down this rabbit hole of interval funds. I like the idea that if I'm not invested in private credit, I'm not in the private credit space and I want exposure. I don't have to deal with capital calls and things like that.

It seems really nice. What should investors or high net worth investors look out for when they're investing into interval funds? What are the unknown unknowns? It is the easy button. So that's the pro of annual funds. Some asset classes available themselves to being able to do that better than others. I think private credit, there's an argument to be made that that can work.

Some of the risks, I think it's the classic Hotel California that you can just never get out, and there's an asset liability mismatch. So within private equity, you're taking an asset class that's inherently illiquid, long-term in nature, and trying to package it in a wrapper that has more liquidity. So you're either taking a lot of liquidity mismatch in the assets and the terms of the vehicle or you're embedding into that integral fund things that are more liquid that you would almost by definition think would have lower returns. So you're probably either taking some asset liability mismatch or you're baking into a lot

of lower return, more liquid assets to ensure they can actually provide the liquidity per the term. So then it goes to the two real big keys to look out for. I know there's no regulatory numbers, but the industry practice seems to be roughly 5% of liquidity per quarter, so roughly 20% per year. I did some chat GPTing yesterday, so I wanted to get your views on this, that in normal market cycle, so let's say I have a third child. I wasn't expecting a third child. I wasn't expecting a third child, now I want liquidity. It has nothing to do with the market, 75 to 80% of the time. You could take all your money out. Now, I get that. You shouldn't rely on this and that the time that you really need the money, you're not going to be able to take it. I get that. But generally,

is that generally kind of your experience in that for people that are trying to get liquidity under normal market cycles, they're mostly able to do that in any given quarter? I think Chad GPT got it right. Most of the time it's there. But it is that risk of when there is a run on the bank, it's the six-foot man that drowns in a river that's five feet deep on average. There are those periods. And we're calling them integral funds now when it's private equity. But there's been private restructures for decades. And they work 75 to 80% of the time.

And then once a decade, there's a run on the bank. And they get horribly liquid and some bad things can happen. And these run on the banks, are they sustained over? several quarters over several years. In other words, if there's another, let's just call it 2008, global financial crisis. The theoretical maximum that would take for me to get my money out, based on the rules, is five years. But what's practically, is it when there's a market recovery? Give me a sense for, I guess, qualitatively, how many months, how many quarters it takes in those cases? Yeah, I mean, it can be a handful of quarters and a COVID when things snap back

pretty quickly in the GFC, which I hope you and I never have to live through another one of those in our investing careers. It can be several years or the firm shuts it down and it's in wind down mode and you're trying to figure out where's my money, who's actually there to tell me what's going on there. So there can be organizational and systemic risk that can make these things bleed out for a long, long time. I don't know what's worse. That are global financial crisis. Speaking of a difficult part of the market. One of the reasons I want to talk to you is private equity buyouts. You've done a lot of work in this space. What's the state of private equity, specifically large buyouts

today, 2025? It has changed a lot in a decade and changed the time since the 1985 and Barbarians at the gate. So the amount of capital that's coming into that sector is massive. So there's way more capital chasing a similar amount of deals. And my view is there's no asset class that can't be destroyed by too much capital coming in. So that's a risk. The pros, these are some of the smartest folks in the world. So you have that on your side. But I think with capital coming in, interest rates going from being effectively zero to now four or five percent.

That's, there is inherently leverage in these structures and there's more on the large in the market than the small end. So typically five to six times EBITDA and a lot of these transactions, the higher the rates, the lower the return for the equity holders. And then the fees are the fees. And it's still typically two and 20. So in a typical private equity fund that adds up to call it 6%. So a lot of the excess return that I think is actually there. It just accrues to the GP, not the LP, to a point where I think it's hard to see the math work as well for the next decade because of all the things I just referenced.

as it did in the past decade. I don't think it's horrible, by the way, but over the last decade, large by outperform public markets by a couple of percent, just median fund. I think it behooves allocators and LPs to assume the median fund isn't going to beat public markets going forward because purchase prices are higher, cost of capital is higher, there's more dollars chasing it. I think it's just going to be harder going forward. It's interesting because we live in this weird, weird world where large private equity or large buyout has a negative brand, but the actual brands have a positive brand. So KKR has, you know, it's kind of the IBM.

You never lose money and investing into IBM or KKR. But you also have this really negative brand of large buyouts. And people, it's kind of like the same exact asset, but two different takes on it based on how you frame it. Yeah, they've built an amazing brand, attract, amazing talent. and I think they are tying it back to the integral fund and private wealth and institutional investing converging that that brand is selling well in those channels. And I think they're branching out to try to continue to raise assets there where the folks

that have been investing in private equity for the last 20, 30 years appreciate the brand and the brilliance of the folks around the table, but they also understand the law of large numbers. It just makes it hard to generate the same returns out of a $20 billion. fund that they did out of a $2 million fund 10, 15, 20 years ago. Part of your thesis is the high fees, the 2 and 20, the amazing kind of the flow of economics to the GPs from the deals. And part of it is on the interest rate. Is there anything fundamentally that's changed about private equity that if interest rates

did come down, let's say 200 basis points, that it wouldn't suddenly be very attractive? Is there something fundamentally there? Or has something new been realized or back-dusted that makes kind of large buyouts not make as much sense as they want to? So lower rates will help. I don't think it's going to change the dynamics of the amount of capital in the space and the purchase price is being elevated. And you just have limited universe of who do you sell to if you're buying a company that has a billion-dollar enterprise. There's just a limited number of buyers in that universe. I think that structural piece is still in place.

Co-investing to get fees down could also potentially help, which we can dive into more if that's of interest. But I think it helps, but doesn't totally mitigate some of the challenges, in my view, that are facing some of the large buyout mandates. And what are those other challenges? The law of large numbers and the amount of fees that accrue to the GP. That's still structurally in place. If you're paying 13 or 14 times EBIDA for a business today,

and you could have bought that same business for 10 times EBITDA 10, 15 years ago, you've got to grow organically more to make up for, you're not getting that multiple arbitrage that you used to get from the buy. It's hard to get that, just given entrepreneurs, business owners, are smarter about what their company is worth, and there's more people competing for those deals, bidding up asset prices. Many smart LPs agree with this thesis.

is that there's too much capital in large buyouts. And their second order effects are their derivation is that you want to go lower middle market and you want to sell into these large pools of capital that must get deployed. There's this incentive. You're collecting this 2% management fee every year. You need to do something without money. There's this pressure implicitly or explicitly from LPs. What are your thoughts on the middle market, the lower middle market?

And do you buy into this thesis that? it's a great time to sell into these large buyout firms. Yes is the short answer. Our approach, and again, there's different strategies based upon skill sets, pool of capital you're investing. There's different courses for different courses. For us, we like the lower middle market. If you look at the dry powder, the amount of committed capital hasn't been drawn,

80% of it is in the hands of folks that have raised a fund that's $5 billion for greater in size. People will define middle market differently. Let's just call it $1 to $5 billion, a little bit less. And then if you're looking in that sub-billion-dollar funds, there's just a lot less capital. It's still competitive. Don't get me wrong, but still there's more ability to add value through operations. So I think if you go lower middle market and more specialists, be it by sector. You can be a health care expert or a tech expert or a manufacturing industrialist expert.

And you're typically buying family-owned and founder-led business. businesses that in many cases are lifestyle businesses. Somebody started a business. They're doing pretty well, made more money than they ever thought they would. And they don't really want to take it the next leg. They're pretty happy. And they're at a point in their career where they're ready to slow down. Maybe they don't have children they want to, they want to hand the business off to private equity can step in and figure out how do you take it to the next level. So let's say It has $5 million of EBITDA. How do you take it to $10 or $15 or has $10 million?

How to turn into $20 or $25 million of EBITDA. Professionalize that business scale. Maybe there's some tuck in acquisitions you can do. And you can typically buy those cheaper than the large buyout funds. And you can get that multiple arbitrage. And you have a large universe of buyers. The larger private equity funds need those companies, strategics. and you can get that arbitrage, and they tend to use less debt.

And they're not saints. Banks typically or private credit just won't lend them as much. So now you're at a point where maybe it's three turns of debt, which you're less reliant on predicting which way interest rates are going. It's less about financial engineering. It's much more about adding operational value add and then selling it up to the food chain to that next buyer that wants to take it to the next level. At the risk of saying something extremely obvious, the reason less debt is better is you're essentially, the two deals have the same kind of return mandate.

One is using more leverage than the other. The main reason the one using less leverage is better is because it's not taking that additional risk. So if you think about you have all the risks of the business and now you add interest rate risk, it's going to have lower alpha because it has more risk than the deal without interest rate risk. That's absolutely right. Now, we'll say leverage cuts both ways. If you don't default or go bankrupt, more leverage, you can make more money. It's just inherently riskier. And in our view, is we'd rather take operational risk of how to improve the business and improve margins and grow.

We feel like that's a better risk to take than making levered calls on sectors and markets and companies and hope that they can pay it off before something bad happens. if you had to make an argument against lower middle market and investing into that space what's the main argument today against investing to lower middle market the biggest argument i hear that i think has elements of truth that's very fair is these are smaller fragile riskier businesses if you have a business that's has $5 million of earnings or EBITDA. There's probably some client concentration risk. The CEO and the founder is probably the head of sales.

They may or may not have a truly professionalized CFO. So these are smaller, more fragile businesses that if there is a downturn and we have a recession, I think they're at more risk than a bigger, more stable, more diversified business. So I think that is, you have to be willing. to bear that risk and partner with good GPs that are good operators to know how to manage a business through good times and bad. Yesterday, I taped with the CIA of Aberdeen, a former CIA of Aberde. He mentioned this criticism, which is people are using the wrong benchmarks when you put in

the Fama French three-factor model, which is size, obviously beta, but also size, and whether it's value or growth, they end up not having as much alpha as it. seems on the surface. So to your point, lower middle market, smaller, smaller companies should have higher returns because they're higher risk and the market rewards for that. Why does that matter if these returns are there over long term? Or is it just a commentary on the fact that there's more volatility in that strategy? Why should I care that there's a model that would predict that higher return. If you could replicate the return stream with less fees and more liquidity, you should. There's no points for difficulty. So if that factor, the Fom and French factor predicted

and you could capture all the returns of private equity, you should do it. So there are elements of truth of those factors do kind of load, if you will, on some of the characteristics of lower middle market buyout, but the last decade is a wonderful case study that it's not it's not perfect by any stress. Small cap value has been a horrific place to invest in public equities for the last decade. If you go back to 1926 at the beginning of the data said, yeah, it looks great, but most investors and most investment committees don't want to wait 80 years for something to pay off. And lower middle market buyout has beaten small cap value and beating the S&P 500 for the last decade if, when done right, and, you know,

SP 500 is compounded at 15% annualized for the last decade. So it's not predicting all of it. There's elements of truth, but there's elements that you're just not capturing that operational value add in the alpha. There's a lot more of that to be had in the lower metal market buyout, in my view, than publicly traded small capitalized stuff. The best cases I've heard, CIO of Hurtle Callahan, Rat Conger, and he said that the fundamental small company has changed in the public markets.

Most of them, if you look just through the actual underlying companies, because these are real businesses, these are not just stocks. They're either fallen, fallen large-cap companies. So there are companies that are at once large and now small, not something you necessarily want to want to own. There's a bunch of SPAC and direct listings, so quality is lower. And the reason for that is that the companies, the true great small companies, kind of the mini-large companies, that are high-quality, have good earnings. recurring revenue, all these things, have more capital in the private markets to stay private. So the true small caps are either, some would argue, depending on their book, that the large buyouts, some would argue there are small bouts. But essentially, these are still in the private

markets and what you're getting in the public markets is adversely selected on average. What do you think about that? There's certainly elements of truth to that argument. If you look today in the U.S., there's roughly 3,500 publicly traded stocks. So the Walshirt 5,000 has 3,500 stocks. It had 7,000 in the early 2000s. So there are fewer companies going public. Companies are staying private longer. And just in the U.S. alone, there's almost 200,000 privately owned businesses that have at least 10 million in revenue or more. So it's just a much larger universe. Companies are staying private longer. The regulatory burden of going public is more severe today than it was

in the past. So you certainly have some of that adverse selection and smallness being thrust upon companies that used to be large, that are the fallen angels and just fewer IPOs. So the universe has shrunk that I buy that argument. I will also say, because we invest in all asset classes, small cap value publicly trade stocks have been out of favor for so long. I do think they're going to have a run. They kind of seem to be trading with rates and with the first rate cut. They're showing some signs of life for the first time in a while, but you're not truly capturing the, the, full universe of that opportunity. So just given it's so much larger if you look at privately traded or privately owned businesses versus publicly traded companies.

You're dealing with tens of billions of dollars. So you have to make macro level decisions. You can't just make investment decisions or manager decisions. And you have to follow all these like different trends going on and recalibating the markets. You just gave a great example, small cap value. Everything has. a value to it. So if something's oversold by definition, at some point, it'll become a great investment. One of the big trends going on is this democratization of the private markets, but also I think one thing that people don't talk enough about is this executive order to allow people to invest their 401k into private assets. How do you think that's going to affect the

market having this 401k? Or is it kind of just this moot point that's, you know, in theory, people could do it, but no one's going to execute? How do you look at that along with this kind of ultra-high net worth trend going into alternatives? How is that going to change the market in five, ten years? I think it will happen. If you look at the distribution channel that the KKRs and the Blackstones of the world have to build product, that they can move into that channel, I think they will succeed. So I think you have to contemplate how that's going to change the market dynamics. I can't imagine the dynamics will stay the same. So if you think, how could that play out, more integral funds, what are the types of assets that you can build product and

distribute in that channel, integral funds doing private credit, secondaries, that's another now large buyer of secondaries where you're buying more mature funds raised five, six, seven years ago, you get the discount that then can accrue the NAV quickly, cash should be coming back quicker so that you can manage the asset liability. And then pockets of large buyout, I think, will come into that market as well. I think venture is harder. So I don't know that you'll see venture integral funds anytime soon. If you do, I would be very suspicious of those.

So that will be a new buyer with more capital coming in that should push up asset prices. So that's going to make it harder to generate the types of returns that you would want. In our view, we're trying to get at least a three to five percent premium over public markets for investing in private markets. The asset price is getting pushed up, I think it becomes harder. So can you sell into that? That's the way that you can mitigate the risk. And we need to sell into it. Just to simplify it, let's say that all alternatives was Bitcoin.

And now you have $100 trillion in IRA money and 401K money going to buy this one asset. Even if nothing else happened, the demand would just push up the pricing. So the same is happening across thousands of not tens of thousands of private assets as well. Just the mere demand without necessarily the change in intrinsic value into the asset, you believe could increase value. We all studied economics 101 in the supply demand curve. And with more demand of capital coming in, that should push up asset prices. So you can determine how you want to try to play that. Do you want to try to get in front of it and capture some of the appreciation?

Do you sell into it? There's a lot of different ways to think about it. And it'll be very interesting to see how it plays out. To borrow from kind of event-driven hedge funds, That's almost like a one-time catalyst. Yes, it's going to keep on going in. But this surge in demand is something that's going to reprice assets over a short period of time. That's right.

That's right. So I think that the concept of an illiquidity premium is likely going away because illiquidity, when I started 20 years ago, was seen as a bug. Now it's almost a feature. and it's a shade, it's a continuum now of liquidity versus private equity is illiquid. Public trade stocks are liquid. Now there's this continuum of secondary purchasing dollars out there has grown tremendously. You have continuation vehicles. You have large venture back companies like Stripe and others that don't really want to go public,

but there's almost a public-like market where you can buy and sell. So there's this continuing shade of gray where you've had this push up in asset prices. That's this one-time phenomenon of money coming in, and 401K in integral funds is the latest wave of that. I don't think there's really any liquidity premium anymore because it's not seen as negative like it was. And markets are creative and innovative, and it found ways to create liquidity. Let's fast forward five years from now, this, you know, trillions and trillions and trillions of dollars is now in the private. markets, doesn't that hurt kind of traditional, institutional, and OCIO firms like FEG? And how do you react to that?

What do you need to get better at in order to generate alpha under those market conditions? That makes it harder. It makes it harder. So the returns, I think you should expect to come down largely. So, again, I think assume there's no illiquidity, illiquidity premium writ large for an asset class. but there will be rolling droughts that hit different asset classes or sectors that become out of favor, where you have to try to find those pockets is how we're thinking about it to get the types of returns you want. Think energy in 2020 when oil went negative 37, no one wanted to invest in energy.

There's pockets of real estate today. Real estate's been a really tough place for the last 15 years that no one wants to touch it, other ways to extract value. So that's on the contrarian play. And then the other is gross is a wonderful thing. If you can find innovative fast-growing sectors and companies, even if you have to pay a little bit more, if you have a five to 10-year time horizon, you can still make pretty good money.

So making sure there's sufficient growth opportunity to overpay and then look for these rolling droughts, as I'm calling where liquidity dries up in an asset class or a sector where you can take advantage of them. Yeah, there's this reflexivity to markets. that's it's almost so basic that people don't talk about it we had a good example small cap value for 30 years everybody knew that small cap value outperformed and now there's this countermeam in the last 10 years that everybody knows that's called small cap value underperforms and there's

these kind of memes that start to spread and over time they just become people buy into them so much that they don't even look at the underlying investments and that that's where the health opportunity is. There's a narrative violation. There's an opportunity to capture an asset that's intrinsically valuable. That maybe you never have to sell. Who cares what people think if you're never to sell and it's cash flowing? It's a good business. Absolutely right. So I think when you're trying to capture those things, ensuring that the fundamental characteristics are still sound and having changed. Some things get cheap for a reason. As long as those fundamental characteristics are still in place and it's more of the reflexivity and the meme and becomes a known, even though the facts

don't, don't bear it out. I think that's where opportunity lies. And it can go on longer than you think is the other thing that I've found out the hard way many times is you don't want to pile in, you know this is the bottom, but lean in a little. And if you're too early, make sure you have a second, third bite at the apple, because it's hard to know when those means can change very quickly, but it's really hard to predict the exact point. I want to get to kind of timeless principles and portfolio construction. Somebody comes to you, they just exited their company for a billion dollars post-tax. They have to invest their money.

They're not looking to buy a super yacht or a super mansion or a jet. So this is essentially an evergreen pool of capital. What are some first principles on how somebody should go about investing that capital? Yep. First principles for us are start with risk, not return, and you can boil it down to four key risks that you want to identify in the front end. And by the way, risk is good. It's just how much and where do you want to take those risks?

So those risks are first, what are you trying to achieve? It fits the enterprise. Your example is a more capital preservation, is that I want to get double-digit returns, whatever it is. There's no generically good portfolio construction. you must actually have a purpose for the capital. What are you trying to achieve? And be very clear on what are you trying to achieve?

So what's the goal of the enterprise or the pool of capital? Be clear on that in the front end. And then once you've determined that, how much market risk are you willing to bear volatility? If, again, that, if 08 repeats and that portfolio is down 20, can you stick with a strategy? The best strategy is one you can stick with over the long run is that a 10% draw down 20,

30. And again, we're not going to get it right down to the basis point, but understand we're going to build a portfolio to achieve your goals that when bad things happen, it can be down in the range of X or Y. The next risk is illiquidity. How much of the portfolio can we accept the liquidity with? Is that 10%? Is it 30%? What's that number? What's our illiquidity budget? And then the last one is less scientific, but I think incredibly important. I call it an average risk. How willing to be different are you, be it? to market benchmarks or other peers or pools of capital that you may compare yourselves to. And the classic example I give there is we work with a lot of university endowments.

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And a lot of them compare themselves to the schools they play football against on Saturday afternoon. And if they look too different, they want to beat them just like they want to beat them in football. So is there some concept of maverick risk and how different are you willing to be? Some people have a high tolerance for that. Some have a lower tolerance. And if you can't stick with it, it's not going to work. So what are you trying to achieve market risk, illiquidity risk, MAGRAC, get those right, and you're setting yourself up for success over the long term.

Your tolerance for variability and your tolerance for being, having different and being outside of the herd, I think most investors start out with a lack of self-awareness, including myself. I'm putting myself into this. Everybody thinks they're able to take as much risk as possible to maximize their turn. and everybody thinks that they're willing to go as outside of the pack as possible in order to maximize their return. And yet, when they run the simulation, when they go through a market cycle, behavior says otherwise. Absolutely. It's the Mike Tyson line. Everyone has a plan until they get punched in the face.

So this now billionaire comes to you. They say, okay, I want to maximize growth. I'm willing to take as much volatility. I'm willing to be different. I'm willing to be illiquid and now they get punched in the face is there like a second okay basically you sit down with them and you say look let's talk about what your tolerances are at this level and kind of recalibrate the portfolio

or how do you deal with that? Yeah so it comes back to that first blank are we still on the same has anything fundamentally changed on what we're trying to achieve? Usually it's no. That's upstream of everything. That's the most important consideration.

That's the most important. And then if so, come in and say, this is when fortunes are made. You've got punched in the face. People are panicking. Like, we should go on the offensive. We all agree this was a portfolio that when this bad thing happened, we knew we were going to be down. We want to actually lean in and be like a kid in the candy store and go finding opportunities, not panicking. So that's where that preparation on the front end of this is our risk tolerance.

And then remind them, like, it just happened. The risk came to bear. And we knew this was going to happen. We're not going to panic. We're not going to go to cash. We're going to say we still have the same risk budget. And now asset prices just went on sale by 30%. Where can we deploy capital?

And on the back end of this, we should be in a good place. Not everyone says, yes, that's a great idea. at least you've set yourself up to try to minimize the behavioral risk of panic when you get punched in the face. Don't you have to set those expectations before the market drought down and basically do these mental exercises before? Given that this is behavioral finance and AI would not have to deal with these existential issues. Absolutely right. You got to do it beforehand and you got to remind folks. This is not a one-time exercise. And I think that's one of the things that I've learned over my career is that the behavioral economics is just as, if not more important than the true fundamentals and DCFs and all of that

because we're all human beings and subject to our own biases and emotions. And you can whipside yourself and you take the pain and then you lock it in and then you miss the upside. So setting those expectations on the front end, reminding folks in good times. Right now is a great time. S&P keeps hitting new all-time highs to remind folks, bad things do happen. This is our risk tolerance. When it happens, we're not going to panic. We're actually going to say, we knew this was going to happen. How can we go on the offensive now when, when animal spirits aren't in the same place that they were a couple years ago? It's the coaching mindset. When you're winning, beat everybody down. When you're losing, pick them up. So make sure that they're always

kind of at the rational headspace to maximize performance. I had the former CIO of Northern Trust Thomas Sweeney. And one of the things that you talked about, which was I thought really interesting is he really focuses on the fixed income market. That's what he spent his entire career on. So he had a really interesting first principles approach to it. So why do you have bonds in your portfolio? You have bonds to be negatively correlated to stocks. So first of all, you want to make sure that your bonds are negatively correlated to stocks. Unfortunately, things like junk bonds are not negatively correlated to stocks or have not been. So a lot of people make the fundamental first error, which is you should never even have bonds in your portfolio

if they're positively correlated because then you rather just have more stocks because they have a higher expect of return. Secondly, he had an interesting point in that he wanted to make sure that not only are they negatively correlated the bond portfolio, but also that they're liquid because that way, if you have it in these interval funds that we talked about earlier or some illiquid structure, when the market's down 30%, which usually doesn't last long if you look historically, there's been a lot of, especially recently, a lot of these V-shaped recoveries versus these kind of slow recoveries. You want to make sure that you're liquid or else, why are you, again, there's no value in having

liquidity during difficult times if you can't use it. If you think about those principles, those are good ones. I think that's a helpful reminder to all of us. And in 2020 and rates are at zero, we saw the correlation isn't always negative. So there's times where you're getting more of that correlation. benefit than others. And then that liquidity piece is critical because if you can't sell it to redeploy, you're minimizing your ability to be countercyclical and contrarian. So if you think about hedge fund portfolios as an example of another diversifier that folks use and we use

to diversify away from equity risk, which is the dominant risk in almost every long-term portfolio, there are great hedge fund strategies that aren't correlated to equities, but you can't rebalance whenever you want. You don't have that liquidity feature. So you need a higher return out of that portfolio to make up for that lack of liquidity in the ability to redeploy capital in times of stress. So it doesn't mean hedge funds are inherently bad, but if you think bonds are going to do 5% over the next decade, if you're investing, and there's different flavors of hedge funds, it's like Baskin Robbins. If you're using them as a bond proxy and stay rich money, you should command some sort

of premium over bonds, pick your number, 3%, 5%. If you're not getting that out of hedge funds, if you're just getting a percent over bonds, it's probably not worth it because you don't have that ability because you're going to have a 60-day lockup with a 90-day notice. So in nine months, I can- And rest assured during our- And rest to sure, there would be no gate during a market correction. That is the one time you're guaranteed not to get your money back. Exactly right.

Exactly right. His model strategy was, let's say, your 60-40 is when there's a market correction, you overweight equity. So you might go, you might sell off some of those bonds. And now you're 75, 25. So you're not at your long-term portfolio diversification on purpose because you believe that there's basically a panic discount to stocks that you're able to capture. How do you buy into a downturn?

So usually downturns are not a day, although the Liberation Day was a very quick turnaround. I think it was less than 30 days from Trough to to where they were before. How do you play a crisis? So take me step by step because it's certainly better to talk about this today than when the crisis hits. So while I have a rational mind, how do you, how do you, how? How do you play that a crisis? What's the best practices? Yeah.

So you want to have a game plan in advance. I think a couple of things that are helpful in that prepared mind is build a discipline processing and be different for different organizations, different groups. And also some semblance of humility that you're not going to time it right. So I love the Cliffazness line, the founder of AQR, that market timing is to send, and you should send a lot. little. Don't think you're going to get it right. So calibrate your bets accordingly, and you can move incrementally so that if you're wrong, you can lean in and have another bite at the apple. And we've created a process that we call it VFS, stands for valuations, fundamentals, and sentiment. And we track every major asset class on those three characteristics. And it's not a black box.

This isn't Renaissance or D.E shot or some quant shot. But it just gives us an opportunity to calibrate based upon valuation levels, various fundamental characteristics, earnings growth, profit, margin, debt on the balance sheet, and the like. And then sentiments, it's a real thing. So is there is there momentum? Trying to avoid catching the falling night for coming in too early or conversely taking chips off the table too quickly when things are running. Having that discipline process you can fall back to of this is who we are, this is how we invest, and this is our framework and our mental model. So that you're not just sticking your thumb in the, in the to try to determine what you're going to do, building that game plan up front and saying,

stick to the process, play baseball in college. My baseball coach used to say, don't be fast, be good. So be good, know your process, execute it. Don't try to rush anything and stick to it in good times and bad. I think having that process, whatever it is for different investors and sticking with it increases the odds of success and not panicking in those times of stress. Every crisis is a different flavor. History doesn't repeat, but it rhymes. The way that I would approach this very rough and I want you to improve my model is you want to look at how long the average crisis lasts in terms of how long it takes for stocks to go down before they start going down, like from beginning to trough. And then essentially dollar costs average over that period of time with some kind of standard deviation so that you're on average, buying all the way down, and then that's kind of where you're at. So what am I missing, and how would you improve that model? That's the right model in our view high level, and then I think you can approve it by looking

at not just price, but price relative to free cash flow earnings to determine the relative attractiveness or riskiness of any asset. So price action is helpful, but if you're. It's the equity market. You're trading at 50 times earnings and you go to 40 times. You may not want to be as aggressive if it went from trading at 20 times earnings down to 10. So there's also a historical context. There's a relative context.

That's right. So I think the overlay of the fundamental component, I think, is the way to improve on that model. It's just pure price action. You've been at FEG for 21 years. You've seen a lot of market cycles. I've been more in the private side, so I don't check the stock market as often as probably you do. Do stock prices, when they go down, they're essentially always rebounding regardless of these qualitative metrics? At the market level, not individual companies necessarily.

And some markets have been down for long periods of time. So there are value traps are real. There was a point a year or two ago where the 30-year return for the Chinese equity market was flat. 30 years is a long time to wait. So diversification is your friend. So if you can look at those markets in different pockets by region, sector, you name it. And then take that same approach at the macro level of, am I more risk on, risk off of just how much is it? and equities and then slice and dice and use that risk budget under the hood at that next

level, it will smooth out the ride. And if when you're too early or you're wrong in an area, you have something else that's going to be working in your portfolio. My personal view slash bias is that public market investors understudy politics. They kind of see it almost as exogenous, not as playing an active role in the stock market. And one of the views out there is that the government, because there's so many stockholders with S&P 500, the government and Congress, the president, will never allow the stock market to go down for a long period of time. They rather cause inflation in the market. Is there any truth to this?

And what are your thoughts on kind of the public policy aspect of the government having one of these levers? So the Fed doesn't control all the levers, the government does. And if there's this bipartisan incumbent view that you can't. let the stock market go down, they're going to pull one of those levers. What do you think about this theory? There are certainly elements of truth to that. If you study public market returns and cycles based upon presidential cycles as an example, and they're coming into a reelection, there's an incentive if you want to get reelected and most politicians do to have more pro-growth, pro-market policies. So if you're going to do something,

you know the market's not going to like do it early after you got elected and they do more pro-growth and the stock market not always but kind of rhymes with that approach i think you need to be aware of it i think it's also tough to make huge bets and be successful predicting what policy will be but i think policy and interest rates have a massive in the fed have a massive impact on the markets so you have to at a minimum be aware um and recognize is people have incentives and what are those incentives? And if they have more influence, be it through policy or a level of interest rates, that's going to have an impact.

I got some numbers, by the way, to back up this theory. In 2022, the rate of incumbents running for re-election was 94%, 2024, 95%. And for Congress, House and Senate, one of the estimates is that 24 incumbents' win rate was 97%. And if you want to think about the most rational and calculated people on the planet, it might be quant traders and politicians. Exactly right. Exactly right. Going back to 2004 when you started at FEG, what one piece of timeless advice would you give younger Nolan there that would have either accelerated your success or helped you avoid key mistakes? Yeah.

I'm going to give you two. One is from a macroan investing perspective, don't fight the Fed. It's the classic Warren Buffett that interest rates are to asset prices, what gravity is to the Apple. And don't get in the way of the Fed. the other is I was more relationships matter. I did not appreciate that as much. I was more of an introvert math geek as a kid and relationships are essential in this business to investing, finding the right partners to invest with, finding the right folks to work with. And I got there eventually, but if I would have known that and appreciated the impact of that earlier,

I think it would have helped accelerate my career. Don't fight the Fed. It sounds obvious, but I would argue isn't the Fed interest rates and the policy priced into the assets? So what does it mean to fight the Fed? And what do you want to avoid exactly? Yeah. So when interest rates went to zero after the GFC, cost to capital, incredibly low for businesses. If you took the approach, this is inherently risky. the Fed's balance sheets ballooning, the world's coming to an end. We don't want to ask risk. We don't want to own risk assets. You missed out on an amazing bull run in public markets. There was a lot of risk appetite in private markets to create new businesses because it didn't take a lot of capital to start a company. So when interest rates are low, it's typically good for asset prices writ large.

And conversely, when asset prices, when interest rates are high, that's tough for most asset prices. when look at 2022, rates go up, stocks and bonds are both down double digits. So I think everyone knows it, but there's always a reason and a narrative and a story of why this could be the inverse and don't overthink or underappreciate the impact of the level of interest rates and the cost of capital. I think it's something that is, it's easy to forget because there's always a reason to think this time may be different. And I don't know if you'll admit it, but it seems like the strategy under something like

that where you believe that you're right about interest rates being too low and the Fed's still keeping them at that point. It's basically to ride the wave knowing that you're going to get more on the upside than you're going to lose on the downside. So you might be up 3x and then you go down 20%. And there's no way to really time that. Is that the correct predisposition or could you somehow hedge yourself in a cost effective way? And how do you play that kind of, I would call it a cognitive dissonance in that you believe one thing, but the market believes another thing. And you've now learned not to fight the fad, not to fight the market. Yeah, you have this kind of dual conflict in your brain.

And on the one hand, when that's happening, valuations prior, aren't cheap. So it isn't this contrary. It's hard, heady balance, not overpaying for assets in this contrarian instinct with appreciating markets do cycle. And there are these trends. And if you, if you jump off the, the bus too early, you just give up a lot of that upside. So I think I started in 2004 coming out of the tech bubble. And it's like, yeah, you just, you know, that was obviously a bubble. Like I didn't live through it.

I didn't have to have the pain of being wrong early. It just seemed obvious that you used to be contrarian. And yeah, contrarian instincts are good, but you can take any good idea too far. Markets also trend, whether it's stock prices or the fundamentals of a business. If a company has 60% margins and is growing 20% or 30% a year, they typically don't just crater in a quarter for six months. They tend to look at invidia's growth over the last handful of years. There are reasons why things trend and cycle and trying to balance a contrarian instinct, but also have an appreciation for that component of cyclicality and trends is the

tension that you have to try to balance in investing and you never get it perfect, but appreciating both exist and are real. And don't lean too far one way or the other. I think helps you avoid massive mistakes, which I think is half the battle in investing. Being in the market is very positive in those cases because you get the run-up, you get all the benefit. And then I do believe in this not Fed put, but essentially politicians put, and that politicians will not allow the market to go down more than 20%, more than two years election cycle.

That's my own personal belief. We'd love to hear if you agree or not. but so you get all the upside on the on the up and then you have a temporary pain but probably it's not going to be long lived because politicians want to win back and presidents want to win elections and politicians want to win back their seats why is that wrong i think it's more right than than wrong during the initial tariff tantrum in the beginning of April, it was a little nerve-wracking and my standard line that many of our clients heard from me is a wonderful quote from Winston Churchill that you can always count on Americans

to do the right thing after they try everything else first. So when there's a bad policy in markets puk, they tend to find the right path. So you do have these little setbacks and then we'll do the right thing after we've tried everything else first because no one wants to mark it down for an extended period of times, least of which politicians they need to then run again. The general reaction function of thinking that way, I think is healthy. And then you just have to worry about the downward spiral of negative. Like tariffs could have gone horribly wrong if we stuck with it and then people react because they view tariffs are going to be negative and you can have this horrible downward spiral. So once every couple of cycles, you get these extreme

pullbacks so you don't want to just be polyanish and assume it can never happen but on average you tend to have pullbacks and then go back off to the races versus these horrible downwards downwards finals and the market the world can only end once so betting on the world the time that was i made a big bet on robin hood during covid in the sequoia round that was exactly my thesis was if we end up if everyone dies it doesn't matter and if we don't it's going to be a good investment. And I don't control either outcome, but this is the highly rational thing to do. And I talked to so many family offices for many years. They're like, well, obviously, if Sequoia's investing, I want exposure to this. We had more allocation than we could fill. And they said,

well, yeah, but now it's COVID. Or yeah, now it's tariffs. Not understanding that that event in the market is the reason this is a once-in-a-generation opportunity. People kind of miss this, the cause and effect. Yeah, for sure. The second thing that you said, relationships matter. What does that mean exactly? And what is a source of relationship alpha as a CIO managing tens of billions of dollars? You can't know everything.

So you can speed up your learning curve, your ability to understand what's going on in markets, your ability to access great managers by right. recognizing that fact and building relationships with other folks that if you need help in an area, you have someone that you can call on and you just expedited that growth curve 10x, 100x. And you can't do it just by asking for favors all the time. You actually have to do it by being genuine and helping other people out and asking for nothing in return. So how do you build relationships, try to be a good, partner a good actor in the community it's a small world at the end of the day in the investing

community so get to know folks that you like trust respect admire try to understand what they're grappling with if you can help them out do it ask for nothing in return and when you're struggling with something whatever it is what's going on in markets i'm trying to get any more lower middle market managers or early stage venture managers who's a smart person in that community that you can call um to try to get up to speed can they provide an intro to someone, that connectivity is hugely powerful. And I didn't fully appreciate that when I was younger. There's a great book called The Storyteller Secret that interviews different entrepreneurs and business centers.

And one of them made the point that I love that a lot of people in business and in sales in particular talk about ABC, always be closing. He's like, I hate that. No one likes to be closed. I don't want to close people. His mantra was ABCD, always be connecting the dots. Figure out what's going on, what dots can I connect? Who can I help? If I'm trying to figure something out, who can I call?

And if you build that Rolodex, if you will, no one only has Rolodexes anymore. You just increase the odds of success. If you know someone that can help you out with whatever the challenges that you're facing at that point. The way that I like to think about it is, how do you provide so much value that would be unreasonable for other people to help you down the road?

and to provide value for that. And there's actually evolutionary backing on it. So one of the reasons there's not many truly selfish people, and we have this reciprocity bias. So if somebody's done a lot for you, you feel the need to do that. It actually goes back to evolutionary times where we were in a tribe,

and the people that just took and didn't give, they were ostracized, and either they literally died out. And then, you know, the people that stayed, so our ancestors, the people are still alive, they had this reciprocity gene, more or less, most of them. So it's literally hardwired in people to be reciprocal, which is if you go around and help people and are very generous, you can't even control it.

People will feel this like, almost like this fight or flight feeling to help you. Like they're going to die if they don't help you back. So it's like a cool way to live the world, it's live your life. It's like, how do I provide so much value that it becomes unreasonable for somebody not to help me or just in general for the market for the network not to help me back it's amazing it's it's it's it's absolutely a real thing and i think it's just a better way to go through life if you're wrong you help people out and that's not a that's not a terrible thing and i think venture capitalists are some of the masters of this like the concept of lead with value i've heard many

venture capitalists talk about they are there's some of the best folks in the universe i've seen at this concept of how do you build those relationships help people out and have that A lot of the firms operationalize that's the answer to how do you be in a multi-stage firm. You give it, give and give enough value. And then when the time comes and Sequoia comes in to raise the round, the founder is going to pound their table for one or two investors. You want to be one of those two investors. And you do that through giving, not through positioning, not through marketing, not through saying that how can I help or how much value can I bring, but actually bringing real live value that improves the value of the company. Makes sense.

On that note, Nolan, thanks so much for taking your time. Looking forward, I'm from the Midwest, so I need to make it back to the Midwest sometime soon and sit down and continue this conversation. We'd love to. Let's hope the Reds make the playoffs. You can come and watch them. We're tied right now with the Mets. So the little guy, the little guy is.

Don't threaten me with a good time. Awesome. Thanks, Nolan. That's it for today's episode of How I Invest. if this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.