Muthu Muthiah - Inefficiency and Innovation at CHOA (EP. 339)

26:16I'd say one difference that I've noticed is that people on the hospital side of things have to react to economic realities a lot quicker given what they do and how complex it is and pushing costs through and reimbursement. The conversations around volatility are a lot different. They inherently understand volatility because they go through operation volatility so much, which was different from the other places that I'd worked. But I think the nature of the capital is pretty similar. So how we put it to work is pretty similar. What did you find when you showed up in terms of the structure of the portfolio?

26:50So we had more sub-asset classes. And so the first notion we did is work on those three buckets of philosophy, process, and people. And we worked on collapsing our asset class buckets. So we did that to mirror the notion of an allocation to equity-like and an allocation to fixed income-like. And the second part of that, when the buckets go away, there's certain investments that go away. So second part of that was consolidating the portfolio, which 12 months in, we took our liquid equity-like portfolio from somewhere around 35 managers to 12. So we're running a fairly concentrated portfolio now, and then structuring the team from being siloed to being generalist so that they could focus on a smaller number of managers, but also focus across asset classes.

27:36How did you do that manager pruning process from 35 to 12 on the public side? The first thing I'll say is all the managers that we were invested in have done tremendous things for children. So we're all grateful for what they've done for the organization, but it started with philosophy. So our equity benchmark is MSCI Acquity. So we say, look, at the end of the day, for us to outperform that, we need to take risks that big buckets of risk that aren't in it. And so looking at that, we say, look, the big buckets of risk to take are concentration, illiquidity, leverage, and timing. So on the concentration part, that for us evolved into portfolio construction, having a more concentrated portfolio, and also being in places where we see inefficiency.

28:19On the illiquidity side was where a lot of cross-asset class thinking happened. We like illiquidity with control. And so markets where small cap US equities, for example, are very small cap, deep distress, deep value stuff that was in the portfolio had a place in the portfolio if you weren't doing buyouts. And the buyout allocation, because we don't have the buckets, consumed some of that more deep value, small cap stuff. So those are the two things that we use to concentrate the portfolio at the top-down level. And then the bottom-up level, it was the same thing that we applied to ourselves, which is, what is the manager's philosophy?

28:56What are their processes? What do their people look like? And re-underwriting all of them. I want to pull apart each of those four levers. You start with concentration. There's the pruning that leads to a more concentrated number of managers. that may or may not be the same as what you own. How did you think about concentration as it relates to what assets you own? The concentration took us to places thematically where we thought there was an efficiency and innovation. So we went more concentrated into China, more into India, more into technology disruption per se, and then more into life sciences.

29:36That was the top-down thematic concentration. and then focusing on measures themselves that were fairly concentrated. And did you do that across public and private markets? We did on the private markets, did not much movement, but I classified folks as to legacy and core. So in each of those, there's different dynamics. I'd love to pull apart. You start in India, your home country. What did you find when you decided you want to have some concentrated investments in India? Getting concentrated on the public equity side because of valuation. in terms of where we started that concentration process was a challenge to say, no, do we want to, at this point in the cycle, put more money into India?

30:17And how that evolved for us was to spend time in places or in pockets of India where we thought valuations were somewhat more reasonable. So early stage VC was probably one of those areas where we spent a little bit more time. But we had two investment managers that are already focused on India going into the portfolio, which we have kept and tried to size up, given we think they hold some stuff that's a little different from others. What did you find about the community of managers focusing in India when you looked? Yeah, on the public market side, there was a lot of ownership of the same things.

30:54Not a lot of differentiation in people's portfolios, except on the margins. And on the private side, we thought about what are we trying to do in the Indian context. We didn't spend a lot of time in the buyout world at all, mostly because we think Western developed markets are a great place to be in the buyout world. And in the venture world, we did spend a lot of time and it felt to us that there's been really good evolution in the type of manager in India, in venture, which looks like the US a lot now in terms of the type of person who finds himself at a venture fund. And it used to be investment bankers or transaction experience, and it became consultants with business experience.

31:32And now you see former founders at firms, which feels like it's evolving the same way the US evolved. So up down the three big buckets, that's what we noticed. How did you think about concentrating in China? China does offer inefficiency and innovation, but then you also have to layer on top of that, the risks of binary capital loss or regulation and all of those things. So where we came to was to say, let's concentrate with managers who we think are good at navigating the regulatory environment, who are aware of it, who know where the backwind is and where it's not. So when we had confidence that managers on the ground were better at navigating that, we allocated more to them.

32:17But any of our allocations don't grow top down, they grow bottom up. So as far as we can get comfortable finding more people like that, we'll do more things in China. How do you consider the changes in the geopolitical context between the US and China with those investments? We think about a lot. And where it's come out for us is that we've gotten a lot more liquid in China. So we've not really spent a lot of time on illiquid investments. We're not quite sure the illiquidity premium is there for all the risks that we're bearing, but we're still confident that there's equity premium in the market.

32:50So we've just gotten a lot more liquid. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? Partner with a company that's been defining the future of dealmaking for nearly two decades instead. When it comes to M &A innovation, SRS Aquium has reshaped the way that deals get done, streamlining processes for maximum efficiency and minimum headaches. Professional shareholder representation, online M &A payments, digital stockholder solicitation, SRS Aquium pioneered each and continues to set the bar for game-changing innovation.

33:34So leave the days of disjointed deal management behind and define your future with SRS Aquium, the smartest way to run a deal. Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. So when you turn to healthcare and technology, you've had very different dynamics, particularly in the public markets over the last couple of years. How have you thought about investing in both of those sectors? On the tech side of things, we think most of our exposure will come from the venture portfolio. And on the life science side of things, we spent a lot of time thinking about private versus public.

34:18And so where we're expressing the life science view now is in the public markets. And the reason for that is when we look at venture in life sciences, and there's a broad statement, this doesn't cover everybody, but the strategy seems to be to invest in a platform that has multi-molecule outcomes. And in that construct, dollar that goes to a company, it seems like 60 cents goes to building infrastructure and 40 cents goes to R &D. So not super capital efficient in terms of what they're building. And then by the time liquidity comes, it's based on the success of one molecule, which the private fund gets to participate in.

34:59And then the other four molecules are up for grabs for public equity investors, who seem to be doing a great job at that. When we thought about those dynamics, it didn't feel to us that we needed to take a liquidity in the life science market. So we ended up and are a lot more public in life sciences than we are private. And in that market where there's lots of winners and losers, how have you thought about long-only versus hedge funds? We've done mostly long-short in the space. And our notion on long-short generally has been that we want to be in long-short managers where we think that they're operating in a fertile shorting market, where there's clear catalysts and there's clear dispersion in stock performance, and science is a clear catalyst.

35:40In tech, you mentioned mostly in venture, and yet any investment you have in the public markets in the US, if it's benchmarked, it's seven tech companies that are driving the index. So how have you thought about balancing those two, your public market exposure that may not fit into these themes, but ultimately today is going to be benchmarked against technology. There's a mismatch for us on the public side, which we are comfortable with. And so we have global managers that have exposure to US tech and tech broadly, where they think the inefficient windows have opened up and they're able to get in.

36:13We do have some exposure. I wouldn't say it matches the public index, so we are mismatched. So the way we think about it is to say on the growth spectrum of things, especially in tech, let's take the exposure in our private market portfolio, which means that our portfolio won't keep up with big rallies in the market and won't have as much momentum. But we think over market cycles, if we get the private stuff right, we'll outperform the benchmark. In the context of everything you're doing, how big can each of these themes get relative to your total assets? We think about sizing on these themes in different matrices.

36:50So if you thought about China, it's about 16 % of global GDP right now. So that feels like a number to think about for us, not to target, but to think about in terms of our exposures in general. Within tech, it is a bottoms-up portfolio. Most of it for us will come from our venture side of things. And we think venture will be about 50 % of our private portfolio, which is a target of 40, so probably about 20 % in the venture portfolio. And then on India, I think we're about 5 % now in Indian exposure. And again, if you thought about GDP, it could get a little bigger than where it is right now, but it really is dependent on the entry point and finding the right managers.

37:30And then when life sciences completely bottoms up, we've got, I think, 6 % or so of the book in life sciences right now. If you move on to liquidity and illiquidity, how do you think about your budget for how much you can lock up? So when we decided on the 40 % number on the 10 plus year illiquid type structures, it came from thinking about our ability to rebalance. So we didn't want more than 40 would not allow us to rebalance when we wanted to. And then we thought about unfunded liabilities. So saying, look, at the end of the day, unfunded liabilities and the commitments you make are contractual and callable, so they're leverage, and we don't want too much leverage in the portfolio.

38:13And so about 20 % was what we were comfortable with in terms of leverage, which if you think about the ratio of unfunded to NAV results in about a 40 % illiquid investment. And then on a yearly basis, we try to commit no more than 6 % of the AUM to the liquids, so that we don't bust through that 20 % unfunded. You mentioned leverage. How do you think about using leverage as a tool in your portfolio? We don't at the portfolio level, but I think the way it's expressed in the portfolio with leverage and timing is private equity and hedge funds. How do you think about timing? We don't think about timing, but we do have managers that think about timing and that's delegated timing, I'd put it as, in the private equity portfolio with the five-year commitment period and being able to time that and then with the net exposures on the hedge fund side.

39:02How do you work in some of the other assets we haven't talked about that are available, certain real assets, real estate, timber, in this framework of equity-like and fixed-income-like? When you think about the equity side of things and the illiquid equity side of things, we're saying, hey, we want an equity premium, we want an illiquidity premium, and we want diversification if we can get it. So when you think about real estate within the realm of competing against venture and buyout, it's hard for us to get there. And given our liability streams, et cetera, we don't need a lot of yield, I think, at this point in time.

39:38So we don't do core. If real estate does make it into the portfolio, it's usually opportunistic. It's usually small, high vacancy development things. Right now, we don't have any. And then on the real asset exposure, given we do have 70 % of our assets in equity-like investments, we're comfortable with that serving as protection for long-term inflation. So even in the real asset world, I think we need to see real equity premiums evolve and strategies that are less dependent on just price, which is hard for us to come by. How do you fill the exposures to the fixed income and credit-like exposures?

40:16So given our duration, we want to be as much in equity as possible, but to solve for short-term volatility. And so right now, that portfolio has exposure to distressed credit, which we've built slowly over the last couple of months and waiting, I'd say, for lack of a better term. And then it has more of our very low net long short folks, fixed income and cash. So it's a pretty simple portfolio I define it as and serves that function again of providing us both illiquidity and defensiveness. So in that portfolio, we don't tend to do a lot of illiquid stuff. When you roll up the exposures you've picked up bottom up, somewhat top down from your themes.

40:56How do you think about the overall risk? The risks that we control for are really three, market risk, illiquidity, and manager risk. So on the market risk side, we simplistically pay attention to equity beta. So moving equity beta up and down through redemptions and allocations on the portfolio. So on the illiquidity side, again, the regulator being not more than 6 % of the portfolio in illiquid investments in any given year. And then on the manager selection side, hopefully doing great deep due diligence. What does your due diligence process look like for a manager? I don't think it looks dissimilar from a lot of our peers.

41:34We've all been doing manager selection for a long time, but we tend to focus on unpacking the three pillars. What is your philosophy? And definitionally, is it the same as ours? So if you're saying you run a concentrated portfolio, but you have 50 names, we might have a definitional mismatch on what it means to be concentrated. So it's things like that on the philosophy to say, does their philosophy align with our philosophy? And do we define things the same way? Process-wise, really looking for repeatability, rigor, collaboratives among the team. And then on the people side, looking first and foremost for alignment.

42:14I think our folks aligned with us and then spending time on culture. So I think those are the broad strokes of what we look for. Alignment's a funny one, and people can define it in different ways with a very, very similar concept. What have you found has worked best in the weeds of what makes a manager aligned with you? I think economic alignment is an easy one to get to. How much are they invested alongside you is an easy one and a box that we check. And besides that, it's spending time with folks trying to figure out what drives them because are they motivated to keep performing? And we like to say, do they think about this as a sport?

42:51And do they want to be the best at that sport? And then thirdly, that our mission is important to them, that they care about what we care about. And they're aligned to care about the kids of Georgia as we do. And if those three things match up, I think that's what we look for. What are the aspects of culture that you've found conducive to success for a manager? Debate is critical to be able to get to the right decisions. That implies more collaboration amongst team members. And then I also think culture feels like what people talk about. And when you spend time with people and they're talking about investments, even when you're at dinner with them and just obsessing over the portfolio, that's a clear indication for us of what matters at the firm versus having dinner and talking about a whole lot of other things.

43:33And I know that's a very fuzzy thing to say, but it's a combination of those things. And also for us, it feels like thinking about the attributes of the folks in the team and the values they share together. And we generally try to tease out, is there humility? Are they curious? Values wise, do they operate as a team? Do they care about excellence? If you think about a recent decision you made, either to include someone in your portfolio or do not include them, what were the toughest aspects of that one decision that you have in mind? That's a good question. It's actually a decision we haven't made yet that's still rolling around with the team in that the dissonance between what people say and what they do.

44:14And on paper, this manager says all the right things. We're long-term oriented. We do deep work. We don't play momentum, all of these things. And then you look at the results and they don't quite stack up to the behavior that they purport to. So that's been a tough decision, I think, and it's a decision in the works still. As you built out the structure of this portfolio in your image and then look to enhance on the margin, I'm curious, what are the things beyond a roster of managers that you're implementing or would like to? As we define our objectives to deliver on top of the benchmark, to make sure that we're providing for today's spending, compounding capital.

44:54One thing that we try to think about is being the best manager in our portfolio of managers. And I think we will never get there and we shouldn't ever get there, but it's an element of learning from the folks that we're invested with and seeing what we could bring over. It translates into working on our processes and making sure that we refine them over and over and over again and going back and doing analyses on what worked, what didn't, what was skill, what was luck, where should we go, where shouldn't we go? And it's taking a page from Alpine Investors out in San Francisco, Graham Weaver, where he says, we try consistently to water the flowers and take out the weeds.

45:33And that's a part of what we try to do too, to look back and say, what could have we done better? What didn't we get right? What did we get right process-wise? And then people-wise, it's about growth for everybody. We've all been in places where people want to grow. And so constantly thinking about where people can grow within the team. I think the generalist model works very well for that in terms of people have their bias and they've spent time in one place, but they grow and learn more in another place. How have you thought about internal capabilities? You've got manager selection. Now you have a whole world of co-invest.

46:07Sometimes people do some passive strategies internally. We're aware of what our skill sets are and our skill sets are picking managers. And then we try to think about how do we leverage the other things we can do, but coming from our core competency, which is manager selection. So how that translates is into co-investments. We've been thinking a lot about fundless sponsors in today's market, mostly because it solves for private equity exposure without the unfunded commitment leverage, and as does co-investments. So for us, it's more driven by solving for unfunded fees. Our skill sets are analyzing managers.

46:44Our skill sets are figuring out what a core investment looks like for a manager and what their strike zone is. So when we look at co-investments, we think about it as a, does this asset fit the manager analysis? So coming from knowing the manager first, we have a four-tier process where we say, hey, is this allocation to the sector or country something that we're interested in? Does it fit the strike zone of the manager? Are the models reasonable? How do we size it? Pull the thread a bit on fundless sponsors and how you're thinking about that. When you look at new funds that are formed in the private equity space, there's a period of time where fundraising was a lot easier than it is today.

47:25And in that period, you could come from a very big brand name private equity firm and raise your first fund without much of a problem that might not be available in today's market. So as people think about proving their track record, it feels like there's a place for us to participate there. And we went back and looked at successful fundless sponsor track records pre-Fund1. So we're invested with Diverses, which came out of Marlin. The deals that they did between Marlin and forming Diverses were extraordinary, honestly. So there's just so much alignment. Somebody who's in mid-career willing to put that career progression at a great firm on pause to prove their own thing, has an amount of hunger that doesn't exist in other places, especially when you're a fundless sponsor and you have to raise it deal by deal.

48:11And what we noticed then was that because people don't have this unfunded commitment clock ticking on them, they wait for pretty fat pitches because if they don't get the fat pitch, then they don't raise fund one. So as we look at that, it feels like a good place to look for returns, but what are we looking for specifically, or at least what's our first level screen before we get to defining strike zone. And the way we think about it is folks that have been at a firm where they were deal leads cradle to grave, so they had real impact on the portfolio. They have returns that we can somehow triangulate through reference calls or whatever it might be.

48:49And they want to build a firm at some point in time, not remain fundless sponsors for the rest of their careers. If you put on your cap of thinking about inefficiency and innovation in your portfolio, I'm wondering if you could turn that to your investment efforts with your team and the market that you're participating in. And maybe first, where do you see the potential to take advantage of what you perceive as inefficiencies in the way capital gets allocated to managers? One thing that seems sexy, I guess, but is hard to figure out is how tech plays a part in all of this and all of what we do.

49:26How can tech enable us to just be better manager selectors? And some of the things that come to mind are APIs into LinkedIn so that we're not waiting to hear from a manager if somebody left and we can actually figure out if somebody's leaving. It feels like there's a lot you could do tech enabled wise. And I think the LP community maybe has been slower at it. It also is a matter of attracting the right talent to get it done. I'm not sure the best data science person or AI person is going to want to come and work for an alligator. And then on the innovation side, everyone's always looking for the next frontier of investing.

50:01I would love to hear any thoughts you have of where you're considering poking around. For us, fundless sponsors seems like some part of the next frontier. That's where we've concentrated most, if not all of our work in terms of things that we don't do today. Okay. So you're one year in, if we sat down again a year or two or three from now, what are you hoping to accomplish over these next couple of years within your portfolio? Yeah, I think it's just refinement and getting the paces and building the culture. There's a transition that happens when you go from a siloed world to a generalist world.

50:35And that transition happens better if you can build a climate of trust, that you can build a climate of collaboration. So I hope when we talk a year from now, I can say we built that culture that works. And when I think about the whole construct of philosophy, process, and people, it feels like philosophy and process is hardware and people is software. And if you're running the wrong operating system, it just doesn't matter. So in a year, hopefully you'll get the operating system right. I want to make sure I have a little time to ask you a couple of closing questions. What is your favorite hobby or activity outside of work and family?

51:09Probably about five years ago, I bought a motorbike. So I do that, which I really love. And so spending my college days in India, motorbikes are a part of what you do. But I was riding 150cc small bikes. They were probably mopeds. And I got myself a little bit of a bigger bike and I love doing that. What's your biggest pet peeve? With people in general and with investors, more specifically too, it's a lack of humility and it's dismissiveness. All of us have a skill set. Sometimes the market cooperates and sometimes you get lucky, sometimes you get unlucky. People are good at talking about when they were unlucky, but not great about talking about when they were lucky.

51:44So that humility to say, hey, I got this right, but it could have gone the other way, keeps you evolving. And the dismissiveness part of it really gets to me too. If there's an idea, give it some consideration before you blow it off. What investment mistake have you made that you'll never make again? I made plenty. The one that I got the most learning from was when I was at Spider, we made an investment in an Indian infrastructure private equity fund, which didn't work out so well. And when I went back and thought about my analysis, I was just like dead sure this thing would work because there was a power investments in the fund.

52:18And thematically, it felt like, oh, look, demand-wise, India has a lot of demand for power, but there doesn't seem to be a lot of infrastructure to provide it. Oh, great theme. And the second step was, well, they have purchasing power, purchasing contracts, prices are set in, how could this go wrong? And then it all went wrong. And so... How did it go wrong? The contracts ended up being an Achilles heel because tariffs on co went up and they were caught in the middle there. Then the team started to leave and all the things that you don't want to happen, happened. And as I think back on that, the lessons for me are themes are great, but you got to still pick investments.

52:53Which two people have had the biggest impact on your professional life? Honestly, I thought about this one and there's just so many people that have had, so I'm going to basically give you all of them. So people that stand out for me, like Jim Traynor, who hired me at the state of Florida, it was my first allocated investment job. He was such an example of just how to be a person in this world. Good, decent person, thoughtful. And then Rob Blanford at Spider, because Rob was willing to help me get from being a siloed person to a generalist person and willing to sit down and talk to me about how to think about those things.

53:26And the next transition for me was going from being an asset class person to a chief investment officer and trying to figure out how governance works and all of those things. I was really lucky because InnaTai Foundation, our IC chair, Peter Van Oppen, really helped me with that, as did our CEO, Nicole Maher. And then when I thought about this question, I first thought about people that I reported to, but there's a bunch of people that reported to me that I've learned a ton from. And Pong at InnaTai really stands out. He's one of the brightest people I've worked with. What teaching from your parents has most stayed with you?

53:58So my parents aren't the type to sit you down and teach you. And so it was all looking at how they acted as people. And what I know about my parents as I was growing up, they treated people well and they stood up for what they believed in. And for me, the teaching from that was to say, be kind would also have a backbone. All right. With the last one, what life lesson have you learned that you wish you knew a lot earlier in life. This is also from five years ago. So five years is a pivotal point for me in my history. But in that month that I took off and I was doing all the reading, I kept running into the concept again of your circle of competence.

54:34And it got me thinking about there's more circles in life. There's a circle of competence, which is what you know. There's a circle of skill, which is what you know how to do. And there's a circle of joy, which is what you actually enjoy. And it felt to me that life was about making those three circles as big as possible and as concentric as possible. So I said, hey, taking all that together, what I want to do in life is I want to do something meaningful with people I care about. And that was a realization I had five years ago. And I wish I'd had that many, many years ago. Ruth, thanks so much for sharing your path and exciting new seat at CHOA.

55:12Thank you, Ted. I really enjoyed it. Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one, and see you next time.