Investing Billions - E83: Tax Benefits of Investing in Venture Capital w/ Michael Schulman

Starting point is 00:00:00 Venture is part investment, part psychology. It's exposure to the new, new thing. That has an excitability element, but sometimes has a frustrating patience element. Five years becomes seven years, becomes 12 to 20 years. Institutions are used to such long-range time horizons, but people often have shorter attention spans. Even multi-generational families sometimes have less patience, especially when they are not directly running the business. Because our clients are taxable, we have a preference for early stage venture,

Starting point is 00:00:27 where one can take advantage of QSBS, the Qualified Small Business Stock Tax Benefits. That saves 25% now because capital gains tax federal is 25%. But if you believe that taxes will go up with our ballooning debt, then maybe down the road, QSBS saves you 35% or 45% in taxes when those gains are realized. What leads you to want to do deep diligence on a manager? Across all our private asset classes, I look for three things. We want a manager that is smart because we don't want dummies. We want someone that has a niche or specialty that is distinct from others.

Starting point is 00:00:57 And three, we want someone with systems and processes already in place so that they are not figuring out how to set up and run a fund on our money or our clients' money. Venture capital is known as an access class, whereas the top GPs oftentimes pick the top LPs. How do you gain access to the top venture capital GPs? Michael, Ashley, Shulman, I've been looking forward to having this conversation. Welcome to 10X Capital Podcast. Thank you. Pleasure to be here. Thanks for bringing me on. A pleasure to have you. So Michael, you're the CIO of Running Point Capital Advisors.

Starting point is 00:01:35 What is Running Point Capital Advisors? Simply Running Point's a multifamily office. We tailor financial and investment approach for our clients and families. In other words, David, we can run point on all things financial for our families. So for a family office that doesn't have near-term liquidity needs, how do you advise them to allocate between private and public investments? Often we like to initially guide 20 to 40% of their investment portfolio into privates for most of our families, which means 60 to 80% will be in publics and relatively liquid. And down the road, we can reevaluate as things change. For us, private investments include private real estate, private credit, venture capital, private equity, secondaries, hedge funds, other esoteric investments. And some of the private investments

Starting point is 00:02:18 like private credit and real estate, yes, they're private. Yes, you're locked into it for maybe five years, seven years, 10 years, but they're cash flowing. So even though they are technically illiquid, meaning that they're hard to sell, they can create income that will flow back to you and your portfolio. Income that can be used to meet cash needs or be reinvested into other areas. Well, why not have 60, 80% of your money in privates? Let's say that you don't have any short-term liquidity needs, or maybe you don't even have liquidity needs in the next decade. Why would you have such a small amount in privates? Love that question. I get that question a lot from institutions, because a lot of institutions have less in the publics and more in the privates. There's several answers to that question.

Starting point is 00:02:57 We look at our family's big picture. So many of our families still run their own business or are starting another business. We manage their investable assets while assisting them across their entire financial landscape. They may still have a large part of their wealth tied up in their illiquid assets, including their home, second home, third home, a yacht, and especially in their own business. So when we look at their entire financial picture of assets, liabilities, legacy, so while 20% to 40% of their investment portfolio may be in privates, 60% to 80% of their total wealth may be in illiquid assets. So we look at the whole picture. I mean, there's many large differences between families and institutions, but that's one of them.

Starting point is 00:03:36 So tell me about your venture capital strategy. Venture is part investment, part psychology. It's exposure to the new, new thing. And it has an excitability element, but sometimes has a frustrating patience element. Five years becomes seven years, becomes 12 to 20 years. Institutions are used to such long range time horizons, but people often have shorter attention spans. Even multi-generational families sometimes have less patience, especially when they're not directly running the business. I was speaking to Andy Golden, who's retiring as CIO of Printco. He was there for 29 years.

Starting point is 00:04:08 And he said that DPI is the most overrated thing in the market right now in the VC ecosystem. What do you think about that? Had to cough. Yeah, I think IRR can be overrated. I like MOIC, multiple uninvested capital. Why MOIC over IRR? Let's say I look at an investment and it says, geez, we can get you a 16% IRR or better. And I'm like, that's great return. But it's a capital call drawdown fund. I make a million dollar

Starting point is 00:04:34 commitment. It calls that money over four years, then starts giving me the money back. I'm never fully invested. So the GP, the manager played around to get that IRR. Maybe they used a credit line to make the investment before they did the capital call. There's lots of mathematical tricks they can do to boost IRR. And hey, if I'm an investor, that's great. But maybe if I can make a million-dollar investment but fully fund up front and I only get a 12% IRR, over five, 10 years, my multiple-on-invested capital is going to be much better because I'm fully invested. And million dollars working literally at 12% annualized.

Starting point is 00:05:08 What's the best of breed for family offices that have committed capital in terms of how they carry that capital until it's called? A number of different strategies. The best thing is to communicate with a manager, to have an idea of when those capital calls will come in. As I mentioned, we try to create diversification so that we're not short on cash flow. So some of our private or liquid investments like real estate, like private credit, even some secondary funds, they will spit off realizations or income, and then we can use that to fund other capital calls. Also, normally, if we are in a real cash crunch, we can sell something quickly, use T-bills, or maybe go on margin for a week until we can raise the cash. So there's many little levers we can use and pull to fund a capital call and try to stay

Starting point is 00:05:49 fully invested or as fully invested as possible. But overall, right now with T-bills paying 5.3%, a little liquidity there, plus some stocks, plus other diversified investments can help. The best thing is really to communicate with managers that have line of sight as to when those capital calls will happen or when they've stopped doing capital calls. It's unrealistic that they'll do any more. Do you have some kind of liquidity project management software that outlines when you expect different capital calls to happen? Or how do you manage that? We manage it with software that tracks liabilities.

Starting point is 00:06:20 We can track all liabilities and it's financing software. So mortgage payments, paying off a loan finally, factoring in children's college educations. If a client owns a yacht, the salaries for the employees on the yacht, we'll shift things. But yeah, there's financial planning software for that. We're not using something specifically for capital calls. It's just generally for the family's balance sheet. Venture capital is known as an access class, whereas the top GPs oftentimes pick the top LPs. How do you gain access to the top venture capital GPs? I like the bland words there, access class rather than asset class. Several ways. First, it depends on how you define top funds. We have a preference for early stage. What helps is

Starting point is 00:07:09 knowledge of the asset class and finding stuff through our networks. So how do you define top funds? I've happily listened to many of your prior allocators on your show. They're great, their logic is sound, but every LP has their niche. Quite a few LPs need to invest a minimum of $50 to $100 million per fund. That really narrows their field of possible investments to your largest funds. Also, a bunch of them work for tax exempt entities like pension funds, government entities, nonprofits. So taxes are not an issue for them. Taxes are always an issue for our clients. And my apprehension with some of those top call funds is that they are late stage and money into their own previous deals to sustain them and lessen or delay write-offs. I think a bunch of the large

Starting point is 00:07:49 funds are hoping for interest rates or the IPO market to save them. And that's not why invest in venture. Because our clients are taxable, we have a preference for early stage venture, where one can take advantage of QSBS, the Qualified Small Business Stock Tax Benefits. That saves 25% now because capital gains tax federal is 25%. But if you believe that taxes will go up with our ballooning debt, then maybe down the road, QSBS saves you 35% or 45% in taxes when those gains are realized, which as said before, it can be 10, 15 years from now. QSBS can protect up to 10 times an investor's investment from long term capital gains. That's valuable. We try to focus on the early stage. I guess some GPs also appreciate that we understand their

Starting point is 00:08:30 asset class and that they don't have to explain it to us. So they're willing to reach out to us, talk to us. And occasionally some GPs want access to our families to advise, guide, or coach their companies. How do you build a relationship with GPs without investing in a fund? Meet with them, talk to them. So meet with them, maybe gain access through our networks, including our client families. They know a lot of them, peers, other family offices, MIT alumni, and especially other VCs. So that's a way for us to meet with them, meet their LPs at events they hold. Looking at their co-investments is a great way to get inside the head of a GP and see whether

Starting point is 00:09:05 they are saying what they do and doing what they say. Is it really a great investment or are they just in love with their own cooking? You track hundreds of funds. How often LPs oftentimes say that this kind of magical thing, do you do what you say you're going to do? What percentage of funds on average, not ones that you invest in, but on average do what they say they're going to do? Is it 25%? Is it 50%? Is it 75%? Directionally speaking, how rare of a trade is it to do what you say you're going to do? Most do. Most really do what they say and say what they do. But I've seen enough cases where they don't. And your more institutional funds where it's fund three, fund four, or institutional across private credit, hedge funds and others, they're more likely to stick and stay in their lane.

Starting point is 00:09:50 It's the smaller funds that don't quite have processes or systems in place or may be attracted to the new shiny thing that might step out of their lane. So you have to decide which funds to really double down on. You're not going to do deep diligence on every single fund. What leads you to want to do deep diligence on a manager? Recommendations from peers and references and some sort of track record or niche and process that makes them look attractive. For many that I talk to, references seem to be a last step in a due diligence process, but where possible, I like to bump it up sooner in the process. Across all asset classes, I look across all our private asset classes, I look for three things. We want a manager that is smart because we don't want dummies. We want someone that has a niche or specialty that is

Starting point is 00:10:32 distinct from others. And three, we want someone with systems and processes already in place so that they are not figuring out how to set up and run a fund on our money or our client's money. And that's true across private credit, real estate, hedge funds, and so forth. And I've heard other managers say similar. But for venture capital, I've really added a fourth item to our list in what I look for in a manager. And I look for someone that can choose. I mean, yes, you want a manager that has great access. But I've seen several managers with terrific access make really mediocre investment choices. So I want to know how decisions are made.

Starting point is 00:11:08 It's like going to a buffet at the Wynn Hotel in Vegas. Some people walk into the buffet with a strategy and some don't. Some select the good foods and some stomach the cheap stuff. So what drives the GP to say yes versus no to a deal? And what is their track record with that? Do investment decisions need to be unanimous, majority, or independent? Either way is okay, but I really want to know how the GP makes decisions. You mentioned you talked to references earlier.

Starting point is 00:11:32 Do you do the references before you dig into the data room, or are you doing in parallel? I'll look for some things in the data room, but if I can, I'll do it in parallel. There's some things in a data room that I really want to see, like investor letters. I'll probably read through a see, like investor letters. I'll probably read through a bunch of their investor letters. If they have audited statements, that's great. I may not dive into the audited statements right away, but the investment letters, be they quarterly or monthly, whatever their cadence, tends to share the personality of the GP and their investment case and business case on the various investments over

Starting point is 00:12:06 the years. Sometimes you can see if it panned out. If you read investment letters that are five years old, seven years old, three years old, did what they say become true three, five or seven years later, or did they change topics and subjects? I love reading the Sequoia YouTube memo. So it was during the YouTube lawsuit, it was a part of discovery. So it's out there. It's an interesting memo. So it was during the YouTube lawsuit. It was a part of Discovery. So it's out there. It's an interesting memo. It really played out like Roloff kind of envisioned it, which I think is a pretty impressive thing, given how nascent this space is.

Starting point is 00:12:34 I will look that up. Are you always waiting for this last close? And what gets you to accelerate your diligence process? Tell me about some of the signals and some of the game theory around being an LP and investing into a new GP. It's interesting because I think we played that a couple of years ago without really calling it game theory. You're right. Normally, it's great if the fund's already 60, 70, 80% invested. You're some of the last money in. You have a look back. There's been gains. But in 2022, 2023, that was the stuff you wanted to avoid because anyone that was fully invested or nearly fully invested, you just assume that most of the

Starting point is 00:13:12 investments they'd made in 2020, 21, 22 are overpriced. Normally, you want them to be somewhat invested and you want to be last money in. And lately, I've been looking more at funds where I want to be the first money in because there's been quite a correction in 2022, 2023. I mean, not as much as maybe I hoped for, but there's been a correction. So I think this is a better time to invest. And therefore, I want funds that have a lot of cash available to take advantage of the opportunities in the pricing and valuation right now. For GPs that don't have a first close incentive, how would you counsel GPs to get LPs to invest in the first close in today's market? I think part of it is you want previous investors

Starting point is 00:13:49 to invest early into your fund, even if you don't have incentives. That shows great continuity and trust amongst your previous LPs. And I think part of it is also just telling a really good story about the opportunities now and being able to show the opportunities that one can take advantage of by investing now, be it pricing or market or technology or searching founders. When do you as an LP, when do you want your GPs to tell you about their fundraising schedules? If it's a GP that I'm following or care about, I want to hedge up as far as possible. Tell me 12 months in advance. Remind me six months in advance. Remind me again three months in advance. Send me some materials. I get an avalanche of emails. So I don't notice everything. I don't see everything. There's managers that know I like them or I care about

Starting point is 00:14:41 them or I want to talk to them. They have the right to pick up the phone and call me and cut through the clutter with a phone call. Congratulations, 10X Capital podcast listeners. We have officially cracked the top 10 rankings in the United States for investing. Please help this podcast continue climbing up in the rankings by clicking the follow button above. This helps our podcast rank higher, which brings more revenue to the show and helps us bring in the very highest quality guests and to produce the very highest quality content. Thank you for your support. What are the benefits and what are the potential risks of investing in spinouts? We try to be selective. Did they spin out from a Lightspeed, NEA, or some other notable top name firm? And did they spin out because they were not going to make partner or they weren't moving up the corporate ladder, so to speak,

Starting point is 00:15:25 or were they the rising star, but just wanted to go in a different direction? You need to differentiate between that. I like a spin-out manager, especially if they've been there at least five or 10 years and they've had time to develop a track record, a real track record, and at least see a few of their investments go full cycle. That way they can develop a sense of pattern recognition for what will go right and what can go wrong. I get a little bit concerned about some spin-out managers that, yeah, they may have made some great investments, but they've not actually seen a company go full cycle. Additionally, when a spin-out manager actually has funding from their prior firm or the partners of their prior firm, that's a very positive signal. Love to see that.

Starting point is 00:16:03 What are some risk factors that are unique to spinouts? I think with spinout managers, the risks are similar to any new manager, whether they're spinout or not, whether or not they have the systems and processes in place. Was there something about their old firm, be it Lightspeed or A16 or Goldman, that allowed them to be successful, that allowed them to develop a great track record. And now that they are independent, will they have their systems and processes in place? Maybe there was some boss at their old firm that they really disliked, practically hated. But that boss just happened to nix two of their ideas that would have blown up

Starting point is 00:16:42 their fund or blown up their strategy or nixed two investments that would have torpedoed everything. So you just don't know what transfers over to their new firm and what doesn't and what saved them at that last firm and may not save them in their new setup. Absolutely. You mentioned systems and processes. What are some best in class systems and processes in the venture space? I like to see people that have actually invested money in the past that have communicated with investors that understand fiduciary responsibility. There's a lot of brilliant people out there. They were operators. Some of them are good or can be good at running a fund, but some aren't necessarily used to that and used to the fiduciary responsibility. And a lot of them are not

Starting point is 00:17:23 used to communicating monthly or quarterly with letters to their investors on what's going on and what's happening with the portfolio. Some are very good at the marketing and the speaking, and some are good at networking with other VCs, but not necessarily with investors. There's a difference. Prior to becoming CIO of Running Point Capital, you spent 14 years as a manager at an RIA called Hollencrest, and also you're a VP at Deutsche Bank. What do you wish you knew before starting as CIO of Running Point Capital? You know, the knowledge has been cumulative.

Starting point is 00:17:52 One of my happiest moments at my very first job when I was 21 years old and I was modeling bonds, the pricing was based on the second derivative. And I'm like, I smiled to myself. I'm like, yes, there's a use for calculus. Because when you're in high school- I still haven't found one. When you're in high school and college and you're learning calculus, you're like, when am I ever going to use this? And boom, my first real professional job, 21, I'm using calculus to price bonds. And what I realized is that a lot of the knowledge is cumulative. Yes, I work in the investment industry. Yes, it's very numbers oriented, but I mean a lot on my writing skills, my creative writing skills to communicate with

Starting point is 00:18:28 clients, to talk to reporters, to give up my take on what's going on. Is there anything that I wish I knew? All of it. I'd say the most important thing is to maintain bridges, maintain contacts with people. A lot of us, including me in the investment world, are a little bit of an introvert. And I realize I really like a lot of my peers. I love talking to them, communicating with them, sharing ideas with them. And I need to put myself out there more because it's not my natural tendency to keep up the communication, to keep the lines open, to reach out to them and say hi and talk about family or talk about investments or talk about the economy. And those are often the conversations I enjoy most.

Starting point is 00:19:08 Yeah. Being an LP is an interesting blend of quantitative and qualitative people skills and heavy quant skills. What would you like our audience to know about you, about Running Point Capital or anything else you'd like to shine a light on? Thank you, David. As you know, by listening to this conversation, we invest across all asset classes and help our families with all things financial under one roof, financial advice, trust and estate planning, tax optimization, family guidance. So I want people to just remember that, that we're still growing and selectively adding families as clients.

Starting point is 00:19:37 So if anything I said or this conversation resonated with you, it may be worthwhile to ask some questions and reach out. And what's your minimum? It depends. Again, that answer, it depends. We like to see a minimum of $8 to $10 million. But if someone has $2 million of investable assets, but they have their own business, that business is going to have a liquidity event down the road, maybe sold for $20, $30, $40 million.

Starting point is 00:20:02 That's actually a perfect client. And you can help them more ahead of liquidity. Exactly. What are some things kind of at a high level that people should be thinking about pre-liquidity? What are some tax strategies? Yeah, I like that question. So, you know, we recently met an individual, has a family, walked away with 40 million, could have walked away with 48 million. Had they just written the sales contract a little bit differently?

Starting point is 00:20:23 So the actual M&A deal? Yeah, they needed six months longer to qualify for QSBS. So they could have just delayed the purchase, saved a bunch on taxes. Had they moved some of the stock out of California, they could have saved in advance a couple years ahead of time, could have saved a lot on state taxes, things like that. How is the company incorporated? If you have children or grandchildren and you want to pass on that wealth, maybe you pass it on as a gift in stock before you sell the company. When the 498 valuation is essentially a wealth. Yes, exactly. And that way it doesn't count as much against your

Starting point is 00:20:56 individual $13.5 million lifetime gifting exemption. This has been a very illuminating conversation. Thanks for jumping on the podcast and look forward to meeting up in California or New York City very soon. David, it's been a pleasure. I look forward to meeting you in person also. Thank you. Thank you, Michael. Thanks for listening to the audio version of this podcast. Come on over to 10xCabell Podcast on YouTube by typing in 10xCabell Podcast into youtube.com and clicking the subscribe button. On the YouTube version of this podcast, you could see the graphs, visuals, and key takeaways that accompany every episode.

Investing Billions - E83: Tax Benefits of Investing in Venture Capital w/ Michael Schulman

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