[REPLAY] David Zorub - The Path to a Hedge Fund Launch (Capital Allocators, EP.96)

25:31Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. As you distill everything you've learned from your career, and now you're on your own and you can set the table as you want, what beliefs do you have about investing that drive the investment philosophy at Parsifal? Yeah. You know, we're all kind of the sum product of our experiences. And at this point in my career, one of my most deeply held convictions and really the cornerstone, one of the couple cornerstones for what we're doing at Parsifal is this. I think the institutionalization of alternatives, it's been great for alternatives.

26:16Let's make no mistake about it. It's been good for me and for many of the people in this room. I don't think it's been good at all for returns. And the reason is, as we've institutionalized, we've put managers in narrower and narrower boxes in terms of what we'll allow them to do. And we've given them very strong financial incentives. And when you put someone in a box and pay them a lot to do something, they're going to do it, and they're going to make bad decisions along the way. So if you think about certain strategies, and I don't want to pick on any one strategy, but there are just certain strategies out there that they're good one or two out of 10 years.

26:52And the rest of the time, they're not to be trifled with. But when you say to someone, hey, you're a dedicated manager in that strategy, they somehow find something to do all the time everywhere in the world. And so one of my deeply held convictions, and when I look at the managers who I identify the most with over my career, They all make money in very different ways, but what they all have in common is this. They took advantage of the inherent flexibility of the hedge fund model to allow them to go to where the best opportunities in the world are in a given market opportunity set and invest with conviction.

27:24And to do so in a manner that was consistent with their process and not force them to make decisions they didn't want to make. And that's really powerful, but there's a paradox at work there. which is our industry, and I think that's a very powerful way to make money, but paradoxically, a strategy that is a very powerful way to make money is the one that our industry is now least willing or capable of underwriting. And that's sobering in many respects. I don't think it's a coincidence, by the way, that if you look at 08, the guys who tended to preserve capital and thrive through that period were really the gray hairs in our industry who'd come up and built those kind of flexible models that allowed them to position, protect, and do something about it.

28:09Because the other thing that happens when someone puts you in a box is you stare at that box, and you lose sight of risks and opportunities that are percolating in different markets, and you also lose sight of really how good or bad your own opportunity set is. So that's why at Parsifal I've really set it up to cut across all these different risk premia. We're never going to be an institutional business. That's okay. We don't want it. when an allocator says to me, Dave, we don't know where to put you in our model. We don't even know who should cover you. I'm like, that's great. That's exactly the point.

28:41Now let's see if we can figure it out or we're just not going to be a good fit for each other. So that's one of the key cornerstones. The other one is everything we're doing at Parsifal is focused around one goal, which is generating outstanding performance and doing it with a like-minded group of partners. It may seem silly for me to say that, or I'm a hedge fund manager, what else am I going to say? Except that my experience over 20-some years is that actually many firms are not set up to focus and prioritize on performance. They're focused on optimizing a bunch of different things, and performance may or may not be at the top of that list.

29:18I get out of bed every day wanting to put up great returns, and so we've literally built our business in every aspect, whether it's the strategy, the team, the incentives, how we choose to partner with people, our AUM, everything is about enabling us to, we think, generate performance. You're now in the thick of talking to prospective investors about investing in Parsifal. And as you said, the challenge of a more flexible model is setting expectations. So if I'm sitting across the table from you, one of the first things I'm going to think is, okay, great, I'm giving you this flexibility and this mandate.

29:53What should I expect? And let's just break that down into what should I expect your portfolio to look like? I should point out that I have sat on the other side of you as an allocator once upon a time, and so I have been on the other side of your grilling. So there's an algorithm for doing this effectively out there. And some of you may be familiar with the work of someone like Martin Kramers at Notre Dame. Mike Mobison, who's sitting here in the front, has written extensively about this. If you want to outperform, you construct your portfolios with high active share, which means your portfolio doesn't look like an index.

30:26you concentrate within that, you underwrite medium, longer term horizons, and you take a very fundamental approach. The rub of all that is that I can do all those things and still not succeed because you need to have a capital base that's aligned with you. And that's what the research shows. So for us to be successful, first and foremost, it starts with finding the right partner. Like hands down, setting the expectation of this is what we're trying to do, this is what our return, our volatility objectives are, This is what a good year looks like. This is what a bad year looks like. If we make money, it should be for these reasons.

31:02And by the way, if we make you money for not these reasons, that's as bad as losing you money, et cetera. When you dig down beyond that, our portfolio, it's really the concentration that drives it. So we're only going to be long, say, about 20 securities. The top 10 will be 60 % to 70 % of what we do. And then those will cut across all those different risk premiums. So traditional, long, event-driven, special situations, equity, credit. And so now if you think about my global opportunity set, I have much more raw material to work with. Now I have to filter it. But we're looking for one or two or three really high conviction opportunities.

31:38And that's exciting to me. I think people look at that in two different ways. Some people say, whoa, Dave, that's really daunting. How do you filter your opportunity set? Fair. We think we can do it effectively. I look at it just the opposite. I say my task is to make money, and I have an opportunity set in front of me, and I know the solution to the puzzle is here. I just have to find it. So it's really how you want to look at the puzzle. And when you break down the two sides of your balance sheet, do you have on the long side a hurdle in your mind that if you don't think a prospective investment makes you a 20 % rate of return or 25 or 12, that it's not worth putting in the portfolio?

32:15So we underwrite positions that we think can double over a three-year period with about 25, 30 % downside. So if you back out that IRR, it puts you somewhere closer to 30. Now, we're obviously not annualizing at those rates, so why do I do that? Two reasons. One, we're going to be wrong a lot, as I mentioned earlier, and I have to embed that margin of error in everything we do. If I sent the team and myself out looking for lower returns, we wouldn't compensate for our margin of error. But the second is variant view. So I'm a big believer in the importance of variant view. Expectations drive securities prices.

32:51Revisions to expectations drive revisions to security prices. So we need to be starting in places where we're looking for big variant views. And chances are, if we think that something can double or go down by 50 or 70 percent, that we're starting in the right place. Now there's a whole process that has to come in behind that. But we really want to make that the starting point. And then if you flip, we talked earlier a little bit about your training in short selling. Shorting for a long time now hasn't done much for investors. And there's a lot of competition. Rates are low. how do you think about adding value from shorting?

33:24Yeah, everything about shorting is unfortunately bad most of the time. The risk management, the tax, the trading, the costs. So why do I love it? I love it because it makes me a better investor. You simply just have to be sharper, more objective, more dispassionate. I probably have a bit of a righteous streak in me. And so the idea that you're part of a market mechanism that's creating efficiency, because guess what? Regulators don't find frauds. Auditors don't find frauds. It's the market that finds frauds. And so when I watch, for instance, what's going down with something like Wirecard right now and some other companies, we did a lot of work on Wirecard, and the market hasn't cared for a while, and now it's caring again, and it's caring because you've got some really great, actually, reporters.

34:10There are some great reporters who uncover frauds. But shorting is hard, and it's been really hard this cycle because of where rates are. are when there's no rates, you don't get a short rebate for lending your short book. You'll know, you know, having worked at Yale, in David Swenson's book, I think in his model long short portfolio, this is going back to what, late 90s when he wrote it, I think he was modeling a 4 % short rebate and then stacking another four points of alpha on his short portfolio and getting to something like an 8 % return. Well, like, I wish, like in my, literally in my wildest dreams.

34:43So shorting has been hard this cycle because rates have really distorted the costs and made it very punitive, and then they've distorted price signals fundamentally. As I sit here today, one of the things we're most excited about is the short opportunity set because rates have come up, so the frictional costs have gotten a lot better. Price signals are starting to normalize, or they were, and then as best I can tell about three or four weeks ago, Fed Chair Powell woke up with like the cutoff head of a horse in his bed and someone had clearly made him an offer he couldn't refuse and they got to him.

35:17So the feds put a little bit of a put back in here for the time being. But fundamentals are normalizing again and then there's a lot less competition. This cycle has driven a lot of short sellers out of the market. Guys have retired who are really good or closed. And so even though I'm not that old, I'm 44, I guess that qualifies me for having some gray hair as a short seller and I'm really excited to attack this market. I imagine there are a bunch of people here that one day want to launch their own fund. And you've had a lot of experience leading into this. What's been the most surprising aspect of getting ready to launch?

35:53I think the most surprising thing, having built a business over eight years, is I knew exactly how hard it would be and prepared for it. And it's been even that much harder. The demands to start a business today and a hedge fund today are, I think, just harder than it's ever been. I think what's changed is a few things. One, the institutional demands on the business side. So the days of just kind of hanging a shingle, investing, making money, and kind of pulling your business behind you, those days are over. Today, we're putting in place a best-in-class infrastructure day one. And so we have to have amazing partners, which we do.

36:33my partner, Luke Orford, who came over from Bridger, he spent seven years as a best-in-class chief operating officer. We've partnered with Blackstone on the institutional side to leverage their experience in starting a fund. Right now, I'm the choke point. I have to wear so many different hats, whether it's the team, the research, the marketing, all these things have to come together, and it's very demanding. One of the things that probably doesn't get enough discussion also in that it takes a real commitment in your personal life as well. And it's something in general that I think people don't appreciate about investing over long careers.

37:11It's a seven-day-a-week job. You don't turn this job off ever. That's your fiduciary. And so you have to have a very stable personal life. And I'm lucky, and if you'll indulge me for a minute, my wife is here today, Katie. I've spoken a lot of times over the years. She's never come to see me speak. This is the first time. But I won the wife lottery, literally like Super Bowl, not like scratch off Super Bowl. And we have four awesome kids. But she creates that stability in my personal life that allows me to then make this kind of commitment professionally. All right, Dave, I want to ask you one more question before we open it up a little bit.

37:47For someone as calm, patient, and mild-mannered as you, what's your biggest pet peeve? I have a lot of pet peeves, for sure. I have very low tolerance for bad manners and behavior. I just think that we all should have a real basic respect for each other. And so when people fail to respect each other, that gets me upset. I put things like bullying in that category and professional and personal bullying. You know, I've been known to sort of stand my ground on principle in the investing world with a company or something, just because they've ruffled that pet peeve. And sometimes maybe to my own detriment.

38:27So those are a couple things I'd probably put at the top of the list. What's your biggest investment pet peeve? Gosh, I have a lot of these. So probably my biggest one and something we really work hard to weed out is this is going to sound like kind of an overblown generalization. Most people don't know how to properly use valuation multiples. And the idea that multiples flow from proper valuation and DCF technique and are not a driver of it. And And therefore what happens is people make a lot of mistakes. They do maybe good quantitative or qualitative analysis of a situation and then they just kind of blow the valuation badly.

39:03And it's because they haven't really internalized what those valuation scenarios and implications are. It's a little bit like if you think back to your grade school algebra days, you know, you get these word problems and they say, you know, train A leaves town going west and train B doing this. And you have to solve that problem. But then the question was, is if your teacher gave you that problem in a different construct where it wasn't train A and train B, did you understand it and could you solve it? And that's really what I'm talking about in terms of an understanding. So that's a big one. When I hear about a management team's buying back stock to offset dilution, it almost gives me an aneurysm and I want to reach through the phone or across the table and choke someone.

39:44And so, you know, I have a whole list of things like that, but those are some of the big ones. Well, we have a few minutes for questions. So I think there's a microphone there. and over there if anyone wants to hop up to the mic. Morning. Thanks for the talk. I was curious to just drill down more on your comments about portfolio concentration. I think you said you like 20 stocks and maybe the top 10 would be at 60 to 70. So just curious as to what the utility of the second 10 stocks are to you and perhaps maybe your 20th weighting is like 1 % or something like that. So what is the utility of the bottom half of your portfolio for you?

40:21Not to get overly technical, but it bears on the answer. So I construct our portfolios to be about 100 % long when we're fully invested and 60 to 70 % short. The reason I do that is I'm not a big fan of leverage, and so I kind of cap it at where I wouldn't have to borrow over 100%. We're also shorting to make money, and I think if anyone's being honest with you, it's really hard to populate a portfolio at much more than 60 to 70%. And so that construction is kind of what falls out. but the implication is that we're not going to generate excess returns through leverage or beta to the market, and so we have to do it through concentration.

40:59Now, when I think about taking a 20-security portfolio, the question is if I equal-weighted it, okay, let's just say 5 % each, can I do better than that for making active decisions off of that equal weighting? And I think it's a really fair question for most people. But the way I think about it is we then take every IRR and we weight it for a variety of factors that would move us above or beyond that weighting. And it's a non-stationary analysis. So my top ten are not always going to be my top ten. We want to flex up at points in time when we think it's most attractive and then kind of revert to that equal weighting.

41:34And we want to flex down at points in time where we think there's still an attractive skew, but maybe there are reasons around timing or other factors. So that's why you have a distribution. The second issue is you don't always know what your best ideas are going to be. And so you have to, at times, live with these and make sure they are what you think you are. We have a process that's basically three things. We have to be able to identify opportunities. We have to be able to analyze them. We have to be able to monetize them. And it turns out that those are three very, very different skill sets.

42:04And so just because something goes through each sub-discrete process in those areas and gets through to the end, it doesn't stop there. It just starts all over again continuously, and that's kind of how I think about a portfolio in that sense. Awesome. Thanks. Thank you, David. Can you talk a little bit about global exposure, some of the different parts of the world, China, India, Africa, what's happening in those different regions of the globe? Does that influence your thinking about where you want to invest? So we're very bottoms up, and so the way we filter our global opportunity set is we are screening for very specific fact patterns on a global basis, and if our bottoms-up takes us into these markets, we're happy to go there, but if it doesn't, we don't have, like, a top-down view of, hey, I want to be this global.

42:49When I think about the global opportunity set in general, I filter it a little more precisely. So there are some markets I just don't do. Like, we don't do Russia. It's just the property, law, rights, et cetera, are too difficult. Generally don't do heavy lift EM, but we will do developed EM, particularly during dislocations because you can usually buy best-in-class or quasi-monopoly businesses at bargain prices when you have a dislocation in developed EM. India is a very interesting market, but it's also set up in a market structure that is set up to advantage local investors at the expense of the foreign, and so that's very tricky.

43:24China, I think, is similar in certain respects. So for us, our global is North America, South America, Western Europe, aspects of China. Japan is probably where we ply our trade. When I think about the global outlook today, there's a real tension. You saw last year that most global indices sold off and were somewhere between correction and bear market. The U.S. was the outlier for most of the year. And what global markets were telegraphing very clearly is that growth is slowing. And I've seen nothing anywhere to suggest that that's not, in fact, still the case. As I said, I think we've gotten a bit of a put here from the U.S.

43:59I think China's probably followed, even if it hasn't been announced formally. It wouldn't shock me if the Europeans got on board if Mario on his way out reduces the pace of the balance sheet reduction. So we might get one more shot of stimulus, but again, we're just so late in the cycle here that I do think global growth is slowing, and so we need to be careful. Thank you. And I think we have time for one more. Thank you for being here. You mentioned that institutionals tend to pigeonhole managers, and that has been very detrimental for returns. Do you have any suggestions on how managers can push back on institutionals so that you maintain that flexibility that you just mentioned before?

44:42I have to tell you, it's really, really hard. The only obvious way to me is to not actually push back, is to say this is how I'm going to set up my business and see if you can find a handful of like-minded allocators and build your business that way. The institutions are tremendously powerful gatekeepers. And by the way, that system works for a lot of their end constituencies. It exists for a reason. That's where the efficient market has taken it. But it's a very significant barrier to overcome. It's not obvious. I think what it takes is a leadership at the top of an institutional allocator who recognizes this issue and is willing to organize their setup in a way that can take advantage of it.

45:24And by the way, they do exist. there are a significant number of super thoughtful allocators across all the different, whether it's pension, endowment, fund-to-funds, family office. There are people, you just have to find them. But by and large, the industry itself has gravitated to a model of highly specialization. So long-short and within long-short sectors and even within sectors, you know, there are front-of-the-eye biotech specialists and there are back-of-the-eye biotech specialists. So, So, I mean, we're talking about very meaningful segregation here. It's challenging. Just a follow-up.

45:58Can you properly scale without the institutionals? It depends on what your objectives are. Again, I think if you're prioritizing performance, you recognize that asset growth is the enemy of performance. There's no question about that. But if you can get to a proper level of scale to ensure business stability and being able to stay competitive with the evolution of talent, data, compliance, the business costs, you can absolutely scale through natural returns and having a group of like-minded partners. All right, Dave. Well, it's a week later and now we're sitting in your offices. So we said we should sit down and finish up some of the closing questions.

46:35So we'll do that while we're going to tack that on. Dave, what's your favorite hobby or activity outside of work and family? I grew up in a sporting family. My father was a sportsman from a young age. And so he took me out into the woods and nature from a pretty young age. And so when I can sneak away, I like to get out into the woods, take a walk, take a walk with the dog, have some fun, particularly in the winter months. It's a great way to be outside and have made some really nice friendships because when you're walking around in the woods all day, you tend to find some interesting things to talk about.

47:07And it's very meditative too. It's quite restorative. Yeah. Great. What reading do you almost never miss? so reading is just truly one of my passions i'm one of these people that at any given point in time is reading five or six different books you know there's something on my nightstand something in my office at home on my kindle for when i'm commuting that kind of thing when i think about our business really the one thing that i try not to miss is mike semblist at jp morgan's private bank they put out a piece when they feel like it so it's not on a regular interval called eye on the market. And I just think he and his team do a really great job in five or six pages of distilling key issues and making it very accessible.

47:47I actually really try to make time in my reading for fiction because I find that it relaxes me and it accesses a different part of my brain. And so a lot of my creativity and insights come from when I'm reading fiction. And then I also just love to read, kind of going back to some of the comments earlier about Coach K or David McCullough. Anytime you can find someone who's willing to talk about their craft, I love it. And so right now, for instance, I'm reading, Stephen King has a book that he wrote called On Writing a number of years ago, where he really talks through his development of a writer and then how he applies his craft.

48:22And it's just fascinating. Cool. What teaching from your parents has most stayed with you? I'm really blessed when it comes to kind of the family thing. My parents are by far my role models in life. I'm sort of the classic first generation. Both my parents came to this country from different parts of the world, very modest origins, and have had a really blessed family experience. And when I think about my parents and what they taught us, it was be humble, help others, work hard, the value of work ethic, and just be willing to stand up for what you believe in. You know, be willing to stand on one side of the room, even if everyone is standing on the other side of the room, which is not an easy thing, but they imparted that to us very young.

49:06And in particular, you know, as I've gotten a little bit older, they've also imparted something else on me, which I didn't really appreciate many years ago. My father is going to be 75. Actually, both my parents will be 75 this year, but my father still, he's a neurosurgeon in Pittsburgh, and he still practices full-time, 60-some hours a week, full caseload. There was a time when we all wanted him to pull back even as much as 20 years ago. And what I came to realize is that actually that work, that engagement, that passion is like the fountain of youth for him. And it's shown me the value of staying engaged and doing something I love for a very, very long time.

49:43And so when I think about investing in particular, this is something I can do for a very, very long time. All right. One more. What life lesson have you learned that you wish you knew a lot earlier in your life? As you get into sort of the middle part of your life, you really start to appreciate when all the people who told you along the way, you know, hey, slow down, enjoy the moment, it won't last. And all these key moments that happen in your life, whether it's your first job, or when you get married, or the birth of each of your children, you know, I'm coming through a phase now where the youngest of my four is no longer a young child, she's getting on.

50:19And all of a sudden that phase of our life is over and I'm quite nostalgic about it. So not that I have any regrets, but if I had to do it over again, really just trying to be as much in the moment at these key points in your life. Great. Dave, thanks so much. Well, thank you. Really enjoyed it. Thanks for listening to this episode. I hope you found a nugget or two to take away and apply in your investing and your life. If you'd like what you heard, please tell a friend and maybe even write a review on iTunes. You'll help others discover the show, and I thank you for it. Have a good one, and see you next time.