Investing Billions - E6: Steve Chasan Head of Investments at the Rothschild Foundation | The Issues With Over-Diversification, How Emerging Managers Will Manage the Reset, and Do Entry Prices Matter?

Starting point is 00:00:00 I mean, over the last few years, I heard a number of VCs say, you know, we don't mind paying, I mean, let's say Series A is now at that point where 2x what they were previously. I heard a number of VCs say that they don't mind paying 2x the historical price because they're aiming for 10x or 20x. I don't think the math works out on that. I think if you're paying 2x more for every single investment, and previously your fund was returning 5x, I mean, now the fund's going to return 2.5x. So I think even if you're aiming for a 10x return on every investment in your portfolio, the entry price matters. You have to be careful about that because as we know, a number of them will be zeros.

Starting point is 00:00:41 Some will be 1 or 2x and only a few will be 10 X, generally speaking. So I think pricing discipline is very important. And also some of the traditional investment criteria, for example, will this company ever make a profit? What's the pathway to that profitability? Will this company survive long enough? Will the cash burn be such that they can survive enough to make a profit? I feel like there was a period in VC where many VC managers didn't want to ask those questions. For today's episode, I to the podcast. and the conversations that LPs have internally that GPs never get to hear. Without further ado, here's Steve.

Starting point is 00:01:51 Steve, welcome to the podcast. It's a pleasure to meet you. Before we get started, we'd love to hear how you came to your current position. Well, actually, I was getting my PhD in philosophy at Columbia University in New York and decided not to pursue the route of becoming a professor. It was quite a struggle, but I managed to get a job on Wall Street at J.P. Morgan, where I was working in proprietary trading. And then I went to a number of hedge funds, Millennium Partners, Moore Capital for a number of years, where I was focused on equity derivatives, equity long short, equity event-driven trading, and global macro. One of the issues about hedge funds, I mean, I really enjoyed my experience there,

Starting point is 00:02:30 and they're great organizations, but the capital base is quite short-term oriented. And I was yearning for an institution where we can both look at short-term trades as well as long-term trades, long-term investments. So on the endowment side, where I am now, it's quite a good balance of that. And what is it like to be an LPN endowment versus other asset manager? So most endowments have the benefit of having long-term capital with pretty minimal spend per year. So they can invest in, as I mentioned before, long-term investments, which include private investments, private equity, venture capital, as well as take advantage of short-term opportunities. So it's a great platform

Starting point is 00:03:10 and mix to take advantage of opportunities in these different asset classes and strategies. Without going into specific investments, I know you get a look at pretty much all the top Dessau funds in every asset class. How do you look at the asset classes today? And how do you do the pros and cons of different asset classes as it compares venture capital versus private equity versus private credit and all these other assets? It is quite challenging. There's a lot of factors to consider. One of the approaches we have, and that many LPs have, is to take sort of a diversified and balanced approach, like a certain portion of the portfolio involved in different asset classes. So it's not choosing one or the other, it's just what kind of a mix

Starting point is 00:03:50 you want between them. The private markets now, particularly venture, I think is a particularly interesting moment because we've had this reset because of the sort of exuberance in the bubble of the last few years. So I think the vintages today will be quite interesting. I think spreads have not widened that much, but over the next 12 to 18 months or 24 months, I expect there to be very good opportunities. I want to highlight something you said on venture, the reset and a good time to invest. A lot of VCs out there are fundraising right now. Famous funds went out to raise $20 billion, came back with $2 billion. It seems to be a terrible fundraising market by any metric. What is the disconnect there?

Starting point is 00:04:33 And why is it that it's a good time to invest while people are having trouble fundraising? I think a number of LPs, institutional LPs, got a bit over their skis over the last few years. There was a bit of a bubble in venture, and many of the venture managers were coming back very quickly with new vintages to re-up. So a number of LPs got a bit over-allocated. Additionally, there's what we call the denominator effect in the sense that public markets sold off last year, whereas privates were not adjusted that much. So if someone had a 20% allocation to privates, and that was their target, if their NAV fell 10%, that private market allocation got a bit overweighted. So it's left LPs today still with a denominator problem and still with somewhat restricted ability to invest, which is unfortunate because I really think this vintage today will be much more attractive than the last couple of years because of the change in pricing and many other factors. In business school, I had the good fortune of having a class by Ken French and one entire

Starting point is 00:05:34 class was dedicated to a conversation about how over-diversification is something that a lot of financial advisors do to turn fees. How do you look at diversification and what are you trying to achieve when you build a diversified portfolio? Yeah, so the Swenson model, which many institutional endowments and LPs follow, does strongly emphasize diversification, diversification across asset classes, across strategies. And there are some benefits to this, but there are definitely some costs and some negative aspects. I think sometimes you could say diversification is diversification. Overly diversified, you can end up paying a lot of fees, which can be a large drag, as well as taking a lot of netting risk between different managers. So I do think it's important for LPs and allocators to have diversification, but to do it within a limit and also to not be

Starting point is 00:06:23 afraid to take some concentration risk and to take advantage of certain managers or strategies when there's a dislocation and great opportunity. Talk about that netting effect. My partner likes to tell a story how he gets a letter and he says, congratulations, we just sold this real estate asset. Great return. We're really happy we sold at the top of the market. And then he opens up the next letter and says, congratulations, we just invested in this amazing asset. We got it at a great price. I think one of the big other aspects in the family office endowment is the principal agent problem. And there's a multitude of factors why that's the

Starting point is 00:07:02 case. Do you believe there is a principal agent problem in asset management? I think it is possible for there to be a principal agent problem. You're talking on the LP side. And on the GP side. On the GP side, I think there's definitely, you definitely have to be very cautious about the principal agent problem. I think some GPs, as they've been successful, have become asset gatherers where they're really living off just the management fees rather than the carry. And they've also grown, particularly in venture, some of these managers have grown too big for even their core strategy. They may have been an

Starting point is 00:07:34 early stage venture manager 10 or 15 years ago, but now their size just makes it impossible for them to do early stage VC. So I think it's really important to be alert for that. On the LP side, the principal agent problem can definitely arise, but I think it's just, I don't see it happening that often. I think most institutional LPs are staffed by very professional people. Probably one of the, I would say the higher risk is maybe that institutional LPs are a bit too risk averse, you know, rather than having a standard principal agent problem where they take too many risks for their own benefit. I think a number of institutional LPs tend to be overly cautious about the risk that

Starting point is 00:08:15 they're taking. Let me push back a little bit on that. There would be arguments that a lot of the LP models are a little bit flawed in that there's high salaries, low incentives. So it's as if a VC would have, you know, 10% management fees, 0% carry, which would create its own issues. Why am I wrong in that assertion? From what I've seen, I think the LPs actually have low salaries and low incentives, low carry. And that leads to bias in terms of risk-taking on the GP side, which of course leads to much lower returns,

Starting point is 00:08:49 especially in an industry like venture that's all about the power loss. When LPs ask me what do they look for in an LP, I say that's a high-class problem. But if I was to answer that question, I would say somebody that understands what venture is about and about venture is power law-driven, and venture is not about minimizing loss ratio. It's about maximizing return in a diversified manner. In terms of what you look for as an LP, I think a lot of VCs look at LPs as this like amorphous entity. But of course, there's human beings, you know, what are

Starting point is 00:09:21 some things that you care about? What are some best practices that GPs have done in relationship with you outside of returning 10x? What are some things that are good? And also, what are some things that rub you the wrong way investments. There are some GPs out there that refuse to be transparent. And I think that can be a problem. You know, it makes it harder on the LP side. If you're an institutional investor and you have investment committees to report to and trustees and boards of directors, it's really important that the professional at the institutional investor has knowledge and detailed information about what the manager is doing, what the GP is doing. Plus, style drift. If there's a GP that has had a great track record and success investing in early stage

Starting point is 00:10:20 tech, and then you see them instead starting to invest in real estate, something that's effectively a real estate company, which is real estate development and real estate is a fine asset class. There are firms that have done that for a long time. They make office buildings or residential buildings with various features. But if you see an early stage tech investor start to pivot to real estate because they think it's a large asset class. That's very alarming. And it's not the purpose of investing in with that GP. And likewise

Starting point is 00:10:52 size. If you see a GP start to raise large and larger funds, they're really just changing their strategy. So that can be a problem. But I think the environment rewards it because there are a lot of LPs, sovereign wealth funds and large rewards it because there are a lot of LPs, sovereign wealth funds and large pension funds. They have a lot of money they need to invest. And when they see the track record of some of the top quartile venture managers, I mean, that's quite attractive. The ecosystem is such that if you're a well-established large GP with a good track record, you can raise these large funds. I just think that an astute professional LP should avoid that.

Starting point is 00:11:29 I think a lot of GPs, especially as they scale up their franchises, they become shocked by how many LPs are actually looking for beta and not alpha. And not in a disparaging way, not for adverse selection or anything, but true beta and true exposure at scale. So it's kind of interesting as these funds get larger, they start to hit product market fit. Speaking of product market fit, you mentioned style drift. Is there any appropriate, you know, I would give you an analogy, you know, when startups, you have a top founder and you back them. As a venture capitalist, I give them leeway to go out there and make decisions and adjust to the market. Is there any room for

Starting point is 00:12:05 style drift from a GP? I've had a lot of style drift throughout my career. And I do think that, you know, there are times where a manager could say, let's say, just to pick as an example, B2B SaaS. There could be a manager who is an expert in B2B SaaS, has done very well in it, but comes to the conclusion that the market's getting saturated and there aren't good opportunities there. If there's another area where they can apply their framework and their discipline in terms of investing and their process to something that's slightly different, that can work out fine. I just think the communication has to be there. I mean, LPs need to be consulted and told about this. This is one of the reasons we

Starting point is 00:12:45 created this podcast is to educate people on this process on this magical world of LPs and GPs that few people have any purview into. Going on the other side, going on the LP side, you've had the fortune of being in some of the top funds and you're oftentimes coveted and sought after as an LP. Outside of carrying a large checkbook, what are ways that you've been able to differentiate in the market? And what are some ways that other LPs that you've seen have differentiated? I think on the venture side in particular, there is this element of just access, like it's an access game. It's an access game for the manager to have access to the best founders. And I mean, it's changing today, but for a long time,

Starting point is 00:13:25 only certain LPs could access the best managers because it's been a capacity-constrained strategy, early-stage VC investing. So if the LP is professional and consistent, consistently going into each vintage and co-invests, this can make the LP an attractive partner for the GP. And it's just generally helpful in terms of referrals. It's really the funding. It's really the consistency of the funding that can guarantee the access. Speaking on co-invest is something we talk a lot about on this podcast. What are your views on co-invest and how are they done well? How are they done poorly from an LP perspective? I think co-invests are a bit tricky for LPs.

Starting point is 00:14:12 I always worry about negative selection bias. Why, if this is such a great deal, why am I seeing it? It's not always the case. Sometimes the venture manager, it's a reasonable size deal and he has some excess and it is high quality, but I do worry that I know I might only be seeing the deals that are having trouble getting funded. So that's one element to be careful about.

Starting point is 00:14:32 Another element is just due diligence and timing. A lot of times with co-investments, there's not a lot of lead time. I mean, decisions need to be made in a week or a month. I like to do a proper due diligence on any investment. So I want to know the company and the company's financials well. I like to do a proper due diligence on any investment. So I want to know the company and the company's financials well. I want to know the founders. I want to know the market. I want to know what the competition is like. I want to be able to have some ability to project what the margins will be like and what future competition will be. So if you're

Starting point is 00:15:01 a generalist investor being approached with co-investments in all sorts of sectors, it's quite hard to get that level of confidence. So, I mean, one way to get around it is just ticket size. You could just scale it small enough so that you just have a diversified portfolio. But I prefer on every transaction to do proper due diligence. Going back to your alpha as an LP, you're the first individual I've interviewed that has a PhD in philosophy. Are you able to apply it and gain an advantage in the marketplace via your degree? Well, I just want to point out that I didn't actually finish the PhD. I was writing my

Starting point is 00:15:40 dissertation when I decided to switch to finance. But I do think it's like to respect philosophy and respect the spirit of philosophy, I think it's important not to finish your dissertation. Because this idea of completing it is a little bit... Institutionalization of philosophy is a paradox. Yeah. But I do think... So in terms of like how has philosophy, studying philosophy helped me in investing? I do think, I mean, when you study philosophy, you spend a lot of time analyzing and debating a wide variety of theories or perspectives on an issue. And I do think that training to sort of unemotionally be ready to question your assumptions, look at things

Starting point is 00:16:18 from a different point of view. I think those skills are very helpful in investing because any investment thesis, if you're doing it rationally, you should really examine it from a variety of scenarios and different points of view. That's quite helpful. Also, philosophy with the questioning of assumptions and focused on first principles that can also help with risk management, as well as avoiding bubbles, you know, not being afraid to question the consensus and go against the herd. The Limited Partner Podcast is proudly sponsored by AngelList. If you're a founder or investor, you'll know AngelList builds software that powers the startup economy. AngelList has recently rolled out a suite of new software products for venture capital and private equity

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Starting point is 00:17:38 AngelList, visit www.angelist.com slash TLP. That's AngelList slash TLP to get started. Back to the show. You mentioned first principles thinking there. Venture capital could be an industry where you have some of the highest IQ people making systematic biases and decisions across a wide array of spectrums. Using first principles thinking, which things do you think VCs systematically get wrong and what are some biases and wrong ways of thinking about venture that you see in the industry? I do think, especially over the last few years, I do think it's very important to do due diligence. You know, I'm not in favor of sending out term sheets within a couple of days and having some consultant do the due diligence for you.

Starting point is 00:18:31 I also think pricing, an alertness and a caution about entry price is very important. I mean, over the last few years, I heard a number of VCs say, we don't mind paying, I mean, let's say Series A is now at that point where 2X what they were previously. I heard a number of VCs say that they don't mind paying 2X the historical price because they're aiming for 10X or 20X. I heard a number of VCs say that they don't mind paying 2x the historical price because they're aiming for 10x or 20x. I don't think the math works out on that. I think if you're paying 2x more for every single investment, and previously your fund was returning 5x, I mean, now the fund's going to return 2.5x. So I think even if you're aiming for a 10x return on every investment in your portfolio, the entry price matters. You have to be careful about that because, as we know, a number of them will be zeros.

Starting point is 00:19:12 Some will be 1 or 2x, and only a few will be 10x, generally speaking. So I think pricing discipline is very important. And also, some of the traditional investment criteria. For example, will this company ever make a profit? What's the pathway to that profitability? Will this company survive long enough? Will the cash burn be such that they can survive enough to make a profit? I feel like there was a period in VC where many VC managers didn't want to ask those questions. It was a seller's market. It was a startup market. And individuals like SBS said, take it or leave it. And a lot of people took it and it led to the last bubble. You mentioned something there that I think is interesting to unpack. A lot of VCs will say, well, I don't care if this investment is 2x or zero. It doesn't really move the needle.

Starting point is 00:19:58 I have a $2 billion fund. It's a $20 million investment. Well, if you do the math, an extra $20 million isn't going to move the needle. But that's assuming you have $20 million investment. Well, if you do the math, an extra $20 million isn't going to move the needle, but that's assuming you have $120 million investments. It's an error that if you systematically made it through your entire portfolio, it would make a big difference. So I think just picking one investment and saying it doesn't matter and that, I think that's a bias. The other thing, the big one that I see over and over, the smartest VCs will say this is every single investment has to return the entire fund. And then you ask them why, and they say, because we have 15 to 20

Starting point is 00:20:29 investments. And then you ask the next question is, so if you have 30 to 40 investments, does every investment have to return half the fund? And of course, that's kind of lost on a lot of VCs, but that's the same math somehow that the sum is different than the part is a preposterous kind of mathematical premise. So speaking of, you know, we're now in mid 2023. And we see some interesting things in the market. What are you what's your prognostication for venture over the next five to 10 years? And what do you think probabilistically is likely to happen? I do think we're in a very good time because there has been this reset, there's a return of focus on important traditional financial metrics like cash burn and pathway to profitability.

Starting point is 00:21:08 Pricing is better. Also, I think there's a lot of sectors besides the obvious ones, such as AI or others, where I think there's some really interesting developments, for example, in deep tech and in particular hard tech. In other words, focused on atoms rather than bits. I think there's some really interesting developments happening in material science and other areas of sort of clean tech, but very upstream. There's some interesting IP coming out of universities where a lot of venture has not looked as much. In other words, a lot of ventures focused on software and consumer-facing companies. But some of these upstream materials spinouts can have great TAMs, and they can also have a very solid moat because of the IP. And the downside on some of these companies, if they can't commercialize, is often greater than one. So that's an area I think is quite interesting. In terms of resets and assets, so you have the benefit of several decades as an investor,

Starting point is 00:22:10 and you've seen, you know, you mentioned hedge funds. I think it's not controversial to say hedge funds are not the hottest asset right now. Even though you're at Millennium, you're at a top fund. You know, I'm sure you saw a reset around that industry. What should VC and GPs really, how should they prepare themselves? I think VC will manage fine through this reset. I mean, there's going to be some victims. Some of the smaller managers, emerging managers can have difficulty, but I still think many of them can make it. I think there's a lot of investors around the world that have an interest

Starting point is 00:22:42 in this, not only from a financial point of view, but also from a societal point of view, because VCs are often funding companies that are really trying to improve the world and innovate in very important ways. So I think there's a lot of support for the VC ecosystem. Despite the turbulence of the last few years, I see, you know, the U.S., which has been great for VC and for startups for many years, I see that attitude spreading to other parts of the world, to Asia and to Europe. So a lot of the benefits of the U.S. ecosystem are starting to go to other areas. So it's a healthy thing. You mentioned a couple of technologies or you alluded to them that a couple of industries that you're interested in. What are some technologies that you're interested in that you're keeping an eye on? has focused on, this is very upstream, on sort of a new material for clean hydrogen electrolyzers. So for a clean hydrogen electrolyzer to work, you need a catalyst.

Starting point is 00:23:51 And traditionally, that catalyst is made up of iridium, which is a very rare and very expensive metal. There's a company that has done, this is spinning out from university, where they've spent 10 years testing different metals and compounds. And they're using, sorry to say it to be cliche, but they've been using machine learning and AI to optimize the mix to come up with an alternate compound, an alternate mix besides iridium that can work as a catalyst in the hydrogen electrolyzer. And as clean hydrogen gets deployed and gets built out, this represents a cost reduction of about 60% for the electrolyzer. And as clean hydrogen gets deployed and gets built out, this represents a cost reduction of about 60% for the electrolyzer. So I think these areas are very interesting, and there's not a lot of capital focused on it. There's some great venture capital managers

Starting point is 00:24:36 with engineers and scientists focused on these areas, but its valuations are still quite attractive. And then in a similar vein in agriculture, there's some managers and there's a company that is focused on alternatives to chemical fertilizers. So they've found microbes that can transport nitrogen to the roots of a plant as an alternative for chemical nitrogen in a fertilizer. And this can have really transformative effects on agriculture in the sense of avoiding some of the negative effects of chemical fertilizers in terms of runoff into the water system. So I think these are sort of niche areas that are a bit off the beaten path

Starting point is 00:25:17 in terms of VC, but have great upside and you can get in at good valuations. I think people are always shocked by the TAM of agriculture. Even in the state of California, it's greater than most countries' tech TAM. I think that those are two great examples. You mentioned VC's two favorite word of 2023, I guess 2021 was machine learning, 2023 was AI. You're having a lot of meetings with the top fund managers and venture capital, and they're all giving you different narratives and different examples of AI. What is your view on AI today? I think it's important to remember that AI has been around for a long time. I think it was 2004 in the biotech industry where AI was used for the first time in drug discovery. So it's been used for a while.

Starting point is 00:26:06 Chatbots have been around. Tesla has been using AI for a while. So I think there's been step changes along the way. I also think it's interesting, every time you hear the word AI, replace it with the word computer, and it probably makes just as much sense. At the same time, even though I think it can get overhyped, I do think the step changes that we've had, even though there have been many along the way, it is getting to a very exciting point in terms of the developments. There's this confluence of events that we're seeing now in terms of big data, processing speed, and an improvement in the algorithms and the models. But at the same time, this is very well known. And I also feel like it's very well priced into both some of the public equities and also on the private side.

Starting point is 00:26:52 So from an investment point of view, I do encourage people who are making direct investments in AI-specific companies to be very careful. Because I do think pricing has gotten a bit out of control. I guess you would remind people that in order for Power law returns to exist, you need a 100x plus potential if that's already been taken out, even if it's going to be quote-unquote big.

Starting point is 00:27:13 Because the risk at the early stages is still there. We have a lot of emerging managers that listen to this podcast, and I'm a big believer in solo GPs and emerging managers. What would be some of your advice and best practices that you've seen in some of your top, I guess, emerged managers that you would recommend to emerging managers? A lot of institutional LPs, it can be hard for them to invest in an emerging manager because of the conservatism and the emphasis to avoid sort of any investment that could go wrong. But there are some institutional LPs that have recognized that a lot of the value in funds, whether it's a hedge fund or a venture capital fund, often comes in the emerging manager because

Starting point is 00:27:55 of the size and the care with which they're focused on generating alpha. So I would just encourage emerging managers to be tenacious in terms of don't give up. It's a numbers game. Like you just have to keep working at it, keep trying. Family offices oftentimes have more leeway and more flexibility to invest in an emerging manager. So I would encourage maybe a little bit more focus on the family office side. Yeah, there's more, less conservatism.

Starting point is 00:28:24 Sometimes it's their own money. So sometimes there's more, less conservatism. Sometimes it's their own money. So sometimes there's more alignment between principal and agents. And of course, anything that you want to accomplish is difficult, especially in a difficult market. One other piece of advice I would give actually on the LP side is VCs are the best narrative dealers in the world.

Starting point is 00:28:41 I think probably the asset class with the best narrative, the way to be a first principles thinkers to go that what the data says and to go different sources, anybody from AngelList to Silicon Valley Bank, First Republic to Cambridge, etc. So seek the data first, and then listen to a narrative second. And I think in that order. Well, Steve, I really appreciate it. I know, I know you're very busy. I really appreciate you taking a half an hour out of your day to talk to myself and our listeners. And thank you and look forward to continuing this conversation very soon. My pleasure. Thank you very much. Thanks for listening to Limited Partner Podcast. If you like this conversation,

Starting point is 00:29:17 please like, subscribe and review on YouTube, Spotify or Apple. Thank you for your support.

Investing Billions - E6: Steve Chasan Head of Investments at the Rothschild Foundation | The Issues With Over-Diversification, How Emerging Managers Will Manage the Reset, and Do Entry Prices Matter?

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