Talk Your Book: Private Investing for Fiduciaries

0:04Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:34On today's show, we're joined by Jake Miller. Jake is a co-founder of Opto Investments, It's a company which I am an advisor to. So I wanted to get that full disclosure slash disclaimer out of the way before we got into this conversation. Ben, one of the bets that a lot of companies like Opto are making is that one of the reasons why institutional investors, and there's a million reasons, but one of the primary reasons why institutional investors have called 30 % of their portfolio in alts and the average high net worth investor has an allocation that runs down to zero is because of access and the pain in the butt that it is to go through this process.

1:23It's a lot. I did this in the past. I always mention this and it was a lot of work and it's operationally inefficient. It's a lot of heavy lifting involved. And especially for advisors that have hundreds, maybe thousands of clients, it's a lot to ask for them to do it. It's a lot. So Opto on that side of the industry is making the bet that if they build it, the advisors and their clients will come. And that is going to be one of the things that I'm most interested in watching unfold over the next decade. Can advisors and their clients get off of zero? And not that they're going to go to 30 % like institutions, but can they get to 2%, can they get to 5 %?

2:03And if they're able to, what are some of the challenges that they're going to face along the way? What are some of the gaps that need to close, not just in terms of technology and access, but really education? Education is the big one. And what does it do to the industry? Does it, because people have talked for years that one of the reasons hedge funds don't work as well anymore is because you get in early to the best ones, but once all the money flows in and there's 11 ,000 hedge funds, there goes all the alpha. Does that seem to happen in private markets? So we had a really good conversation with Jake Miller today about everything that we just discussed from the building to the sourcing, to the diligence, to the education and the explaining and everything in between.

2:41So with that out of the way, here is our conversation with Jake Miller. We're joined today by Jake Miller. Jake is the co-founder of Opto Investments. Welcome to the show, Jake. Thanks for having me. We're going to talk today about private markets, what Opto is doing to bridge the gap, make it easier, private access, all that sort of stuff. But before we get to the meat of it, why don't you tell us briefly about your background? How did you come to co-found the company? Yeah. So I've been a markets junkie since I was very young. I grew up in San Francisco, coming of age during the dot-com boom and bust.

3:17I tell the story a lot. A true nerd. A true nerd, but our next door neighbor went from driving a beat up old Honda to a Ferrari back to, I believe the same beat up old Honda in the span of about 18 months. And eight year old me was like, that looks like a fun game. I should figure out how to play it better than him. So my dad set me up with 50 bucks in a E-Trade account or whatever it was at that point. And sort of never looked back by the time I got to college was mainly focused on bonds, currencies, commodities. Through that, got connected with the folks at Bridgewater, interned there, spent about four years as an investor at Bridgewater, primarily focused on the debt side, which we can get into how that relates to this later.

3:56In late 2019, sort of confluence factors, growth of the private markets, seeing the excitement there, public markets that were, I believe, getting harder to have real alpha in led me to sort of lockpick the golden handcuffs and met Joe Lonsdale, founder of Palantir, Adapar, ABC through a mutual friend. He'd been thinking about the access piece of privates, sort of the other angle of seeing large, sophisticated groups who struggled to do this in a truly scalable, efficient way and needed technology to improve that. And so put our heads together and with a couple other folks, Matt Reed, who's been at Adapar for over eight years, some technical co-founders, put our heads together and decided to found a business to really empower fiduciaries across the country to invest seamlessly in private markets.

4:44So your main focus is on helping advisors get into the private space because it's way harder for them to source this stuff, perform due diligence, handle the operations on it. That's the main idea? Yeah. I mean, even if you, let's say you have a good network in an area, maybe a few of your clients are big PE fund folks or venture capitalists, you probably don't have a network across all the private markets, so venture, private equity, private credit, real estate, infrastructure. and even if you do, which again would be rare, doing diligence on, call it 50 deals a year, doing operations on, let's say you have 100 clients across those, you choose 20 of those deals.

5:21You're talking about reams and reams of paper. It probably looks something like that famous photo of Bill Gates where he's got the CD-ROM in his hand and a stack of paper underneath him. That's how many subdocs you've got and K-1s. The paperwork really is immense for a private book. I used to work in the endowment space And we had, I don't know, 10 % sleeve of hedge funds and a 15 % sleeve in private equity and venture. And this is kind of the pre-cloud days. And we had just file cabinets full of the docs. Yeah, and that was one holder of those positions and a non-taxable investor. And so multiply that by 50, 100, 200 families, a bunch of different underlying accounts, taxable, non-taxable, mix of those.

6:04Yeah, that's not as scalable for an RA trying to grow their business. and at the same time, you need private markets today to differentiate. And there's also a lot to be said about what actually differentiates you now that their access is increasing. It's just not across the board. There are certain products that everyone has access to now. That's not going to help you win an ultra high net worth individual. But there's still parts of privates that are inaccessible and can help differentiate practices. So before we get into some of the exciting stuff, the investment, let's just start backwards and talk about, okay, operationally.

6:35So there are stacks of paper. It's a pain in the butt. What did you all create in order to make this easier for both the advisor and the end client? Yeah, so it starts in the decision-making step. And so we are not product pushers. We're not here to sell one fund. And so we started agnostically and said, how do we help map financial planning and goal setting onto the private space? Not something that's done super commonly. And so ability to import and integrate with your planning software, with your reporting provider, pull in portfolios and goals, and help say, this mix of private markets is likely to help this book of clients.

7:15So already you've cut out a lot of work of copying and pasting into Excel, doing a bunch of your own research, having to go through a bunch of PDFs. From there, the ability to seamlessly create proposals. So take that information plus a recommendation that you build with us and turn that into a compliance-ready, easily shareable thing that you can bring to a client meeting as a PDF that you can send as a hyperlink that's white-labeled for your firm. And so cut down on the need to make decks and spend hours in PowerPoint adjusting logos of these underlying managers. From there is where I think the efficiency really starts to kick in.

7:50Once you're ready to invest, say, for 10 families, you just enter amounts. We've imported that client list. You just enter the amounts. And we've basically automated the subscription document process where there's a simple sort of form field. Most of that's pre-populated from CRM, reporting, custody. So that by the time you get to the subdocs, 90 % to 95 % is filled out. Usually you still have to upload an ID or something. You just click generate. You get a DocuSign packet. You can be subscribed in seven minutes. We had one client for one of their funds do$20 million across 11 clients in 33 minutes.

8:29And then once you've done that once, that investor profile is stored in a secure server. So the next time you want to invest on them, it's 100 % filled out. I would imagine that you're integrated with all of the performance reporting pieces of software, all of the custodians. And one of the magical things that you do, which we'll get to later, is the portfolio aspect of these private placements. Talk about how that process works. Yeah, so definitely integrated with reporting, custody, CRM. That was table stakes for us. We talked to a lot of advisors before we wrote a line of code, and it just has to work, and it can't be a copy-paste exercise.

9:05But yeah, the portfolio side felt really untapped to us when we looked at the market. I think that's because so much backward-looking has been focused on distribution of specific products, and you would never build a tool that wouldn't recommend the product you're trying to sell. And not every product is going to be right for every investor, And so you would avoid a portfolio approach because you might not be able to sell the thing that's your job to sell. Because we sit on the same side of the table as our clients, we didn't have that problem. And so I wanted to approach this with the same rigor, analytics, and sort of holistic goal-oriented view that most people approach for their public markets allocations.

9:40So these private investments have historically been reserved for institutional investors. And the best have not just been reserved for institutional investors, but the largest ones. right? If you have a$90 million or whatever, good luck getting into some of the best deals. Over time, as more capital has come into the space, they've gone downstream. You don't need a billion dollars anymore to get in. Wealth management has been a hot space. The price that has been paid for some of these deals has risen commensurately such that a lot of the, I'm using air quote alpha, which was really just the illiquidity premium.

10:17You were able to buy these companies at four times whatever your cash flow metric is, lever it up and get a really juicy return. Over time, there's been a compression between public markets and private markets such that I don't know if there's any alpha at all anymore, broadly speaking. So talk about what you're doing to address what I just said. Yeah, to start by saying there should never be alpha, broadly speaking. Alpha is hard. And for every, well, we can get into this, but usually for every winner, there needs to be a loser. That's a little bit more complicated in privates, but usually the average should be average.

10:56And then you add fees and you're below average. I guess just the premise that the reason why you would even invest in these products at all, because they are a pain in the ass historically, is because you're trying to outperform what you could very easily get in the liquid markets paying three basis points for. That's the deal? Well, and so what I'd say is the illiquidity premium, I actually think of more as a beta-like return. It's a return for risk that I agree has basically been competed away. There are still pockets of it where it is still truly liquid, like outside of the larger private credit, private equity space.

11:27But that's a return for risk, and it's one that you should expect to pay you over time, but should be very inconsistent at any point in time. Sorry to cut in here. But so do you think for something private equity, it is just you have this more illiquid asset that forces you to hold for the long term, plus you had some leverage on it, and just getting the beta there might be enough? Or do you think that you need to actually perform to? Historically, yes. And forward-looking, no. And this is, I think, true across beta assets. You're coming off of a decade of very easy capital. looking at, call it yield space.

12:01So residential real estate yields and equity earnings yields, which are the two primary mechanisms of American saving, are at basically their peak overvaluedness versus the short rate. And that same dynamic is at play in private markets, at play at all markets. What you have in private markets is, and this is based off of seeing the inside of a hedge fund as well on the liquid side, more sustainable sources of actual alpha. What I mean by actual alpha is the illiquidity premium, that's not skill. That's just do you have a longer horizon than the average investor? I break it down into four buckets.

12:33If you need to have unique information, unique access, unique insight, or luck. Those are the four ways you outperform the average. The first two are illegal in public markets. So you've got to be really insightful, which is hard, and you've got to hope you're lucky. But the lifeblood of privates is unique information and access. What's your network? What deals do you see? What information do you have that others don't? And that's actually a more sustainable edge to measure in the diligence process. And so when you look at the serial correlation of outperformance, unless people are growing way too fast, and so like doubling fund size or a little bit less, it is much more likely that a top quartile fund is top quartile the next time than the average fund.

13:12Because it's a relationship business and they have the relationships? Exactly. And these things compound, right? If I'm a startup founder and I'm hearing all this news that this venture capitalist is the best in the business because they picked a lot of great companies. I'm going to want them to pick my company because now it's a stamp for me. It's almost self-fulfilling. Yeah. All right, before we get back into how Opto is doing, I just want to stick with the broad landscape of private. So private equity, I guess it was like, it was hedge funds in the 90s. They got their faces ripped off in the GFC.

13:45And then it was private equity and venture. And now it's gone from, okay, let's take ownership positions in these private companies to, hey, wait a minute, what if we lend these companies money? I'm talking about private credit. And to say that that has become betafied, for lack of a better word, very quickly, and I don't pretend to be an expert on the space, but just the headlines, I can't help but notice that it's reached a fever pitch. I'd love to get your take on what's going on in the private credit space. No, you're absolutely right. And my view is by the time someone is telling you something's in a golden age, it's usually in the dark age.

14:24If you have to say it's in a golden age, probably not. That dynamic has definitely reached a fever pitch, and that's on the back of, if we look back over the last 18 months, obviously inflation impulse, Fed responds in ways that you'd expect the Fed to respond, maybe a little bit late, but responded. On the back of that, some banks break, particularly around the venture space, SVB, FRB. Regionals come under pressure on the real estate side, and that tightens bank standards. So the percentage of banks tightening to businesses and consumers was at a cyclical high, and private credit stepped in to fill the breach.

14:59And they did this at rates that we don't think make sense by and large. Now, of course, these markets are varied. There are still folks who have, I think, the right covenants in place. I have a question on that. Sorry to interrupt, but when you say at rates that don't make sense, are you saying that they're not being compensated for the risk? or perhaps worse, that they're putting too much of a burden on the companies that they're lending you to and the companies won't be able to pay them back? It's a great question. I think it's mostly the former, but there are pockets of the latter, particularly in spaces that are kind of under pressure like technology.

15:31I don't want to be told that I could get 15%. That seems like you're heading down a dangerous road. And I'm not saying that anybody's saying that, but just as an example. We see that right all the time. And that is burdensome. You need to believe that there's something material will change or that that is going to, you know, that's, you need to believe your business is going to grow faster than that. That's going to fund in an environment where growth overall is two, 3%, maybe nominally a little bit higher. Like that's a pretty high bar. I saw, I saw Bob Elliott, who, you know, poking about private credit that these are, he was joking that, uh, you know, these are the, the, the best, uh, bond managers or whatever lenders and they do it at sustainable rates and there's alpha and all that sort of stuff.

16:13But what happens if the private piece of it, because these are loans, right? They're not bonds. They don't trade. What happens if and when? So there was an article like JP Morgan might be trying to bring liquidity to some of these loans. What happens at the next phase of it when they're no longer really, where the illiquidity premium to the extent that exists just goes away actually? Yeah. And so I think it's helpful to put some numbers around this. So round numbers here, direct lending space, which is where we see a lot of the froth. Call it 10-ish percent, 9%, 10 % is what a lot of loans we see being written at.

16:52And when you look at that versus kind of how geared these companies are either to sales or margins and their ability to make that payment, it looks a lot more like equity risk to us than normal debt-like risk. There's not a margin of safety. And then when I think about, okay, short rates at 5%, equity excess return should be somewhere in the 3 % to 4 % range. I'm getting equity-like return with equity-like risk. And I'm usually paying more for it because I'm going through one of these active managers. And so there's probably even a bit of overvaluedness, which we can get to in a second. But even just from a raw deal perspective, I can get very cheap equity-like return for equity-like risk in the equity market.

17:33or I can get expensive equity-like returns or equity-like risk in the private credit markets. But do you think that people are lying to themselves about the risk that they're taking because it doesn't get marked? Forget about daily. It doesn't get marked at all. It doesn't get marked at all. And that's where bringing more liquidity to the space could be a rude awakening. Right. If I have to see this get remarked every day. No, no, no. Don't show me. Don't show me. Yeah, I mean, I think if you asked a lot of active investors, how much would you pay to only be marked quarterly? A lot. They'd probably pay a lot.

17:59Yeah. So private credit is the hot dot right now. Now, Michael's description of the different ways that it's changed over the time, I think is pretty accurate. It's so funny that I know hedge funds still manage a ton of money, but you don't hear about hedge funds as much anymore as you did in the 2010s. Do you at Opto have to have an opinion on this stuff, or do you take a more diversified approach where we want to get you into each of these different asset classes and diversify by vintage year and have a more static bucket? Or do you have to have more opinion and analysis based of this whole sector here is kind of tapped out.

18:32We think you should be moving this way. How do you view that approach to the wider landscape of alts? Because there are so many options. You have to be selective in private markets. Great question, Ben. Great question. You basically, you know, that's the reason we exist. You have to be selective in these markets. The difference between a top quartile and bottom quartile long short equity manager, depending on the year, let's call it an average four to five percent. The difference between top quartile and bottom quartile private equity, more like 15 to 20%. And that story is repeated a little less on private credit, but still call it like 12 to 15%.

19:07So you, you know, if you choose wrong, all of that yield you just got goes away and you're negative. You have to be selective. You also do have to be diversified. And so, you know, one of the things we don't like about some of these semi-liquid strategies is you're buying into existing portfolio. And so these loans were written at a different time. There's some cross liability across these loans, i.e. if loans stop coming into these large books or people start trying to withdraw, all of these companies can be affected. It's a lot less diversified than true vintage approach where I write loans to a company in 2024 and then I do more in 2025.

19:45And each time I'm capturing the market dynamic of that day rather than this book of some existing loans, I'd probably rather not hold. And also across sectors, like for every private credit in the technology space, I should do something in commodities or in financials. And I should also have other sleeves. This is just like the public markets where you wouldn't say, hey, I should go buy this one slice of BAA. That'd be kind of a weird fixed income approach. Same thing applies here. All right. So at Opto, talk about the landscape before you guys got on the scene. So you're not the first platform company to try to bring better access with technology, with diligence, with fund selection.

20:32You're not the first to do this. What is the opportunity? What is different about what you are doing, how you're working with advisors versus what had been on the market before you came to it? Yeah. So the big thing we saw was who were the companies built for? And so we're coming out of a period, honestly a very similar timeline to the hedge funds, another collateral damage in that hedge fund blow up was all the brokers who'd been selling hedge funds. And you saw the BD model really losing steam and wires losing steam and the growth of the independent RIA market. And various platforms have tried to pivot to go from being largely wire house-based shops with wholesalers and large deals and large funds to servicing the RIAs.

21:15But their DNA is still on that transaction-based comp model. Now, that's not how most independent RIAs work. They're fiduciaries and they're fee-only. And so you have a mismatch in how these companies are operating. We wanted to undo that mismatch. And so we are fiduciaries alongside our clients. We take fiduciary risk on all the funds we do. We're often taking our own balance sheet and investing alongside our clients. And what this does is it opens up a lot more in the market. The best managers don't need to pay to raise capital. Why would I pay a placement agent 5 % if I'm oversubscribed? And so because we're not going in and saying, the way we get paid is we charge you to raise your next fund, we can talk to anyone, not just the mega funds that are trying to raise 20 billion this time and so are willing to pay a little bit to get that raised.

22:01We can talk to the really unique issues that are consistently oversubscribed, that have stayed true to their strategy, not grown too fast, and have been consistent generators of alpha. One of the things that you mentioned in terms of generating alpha is unique access. Where is that unique access at Opto coming from? So it comes from our founder and chairman, Joe Lonsdale, and the networks of our founders and investors. We have a lot of top family offices, some large institutions, folks who are deep private markets investors. We stuck to pretty strategic players for our fundraise, where we can go to them once a month and say, what's the most exciting thing you've done?

22:34It's usually pretty cool stuff. we still have a low pass rate even given that, but it gets us into some of the best conversations about allocation in the country rather than the stuff that is actively trying to be sold. All right. So walk us through that process. You get a deal that you think is interesting. What does that look like? How does it go through the filter? Yeah. So we look at strategy, structure, and sponsor. And on the structure and sponsor side, a lot of that is more on the operational due diligence, though we really see it all as one thing. So that's things like, are there conflicts between the manager and the fund?

23:09Are they paid in a way that is client aligned? How could there be a conflict between the sponsor and the fund? So for example, a common thing you see is deal fees being paid to the manager, but not accruing to the fund. And so if you have a fund who's just incentivized to do a ton of deals because the manager gets paid, but that doesn't necessarily accrue benefit to the investors in the fund. Or are there sort of funky relationships between different fund entities? Are they lending to companies they previously did equity rounds in at rates that don't make a ton of sense? And then on the structure side, are leverage levels appropriate?

23:43Is the management team solid? Do they have good continuity? This stuff can make or break a fund over a fund life, and these can be five to ten plus years. And so you want to be really sure about the longevity of these organizations. So the longevity piece is something I've been thinking about. So to Michael's point about institutional investors, I was in the endowments and foundation space, and that's just way more money even than in the RIA space in a lot of ways. And you would think that a lot of these private funds would say, why do I need an RIA if I have access to these big, huge pensions and endowments and sovereign wealth funds?

24:18But my experience there is those funds are very fickle, and they look at quarterly performance, and they put a lot of pressure because they're dealing with boards and investment committees and alumni and donors and all these things. and they may not be the best long-term partner, even though they should have a very long time horizon. So do you think that this space with RAs can actually be a better long-term partner than those institutions because they're more willing to stick with a fund over the long term than jumping in and out as much as some of those institutions do? Yeah, we deeply believe that.