Stephen Nesbitt – Innovation in Private Markets for RIAs (EP.410)

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2:31Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators .com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

3:11Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast. My guest on today's show is Stephen Nesbitt. Steve is the CEO and CIO of Cliffwater, an investment consultant and asset management firm specializing in alternatives that oversees a combined $110 billion, including nearly $30 billion in private market interval funds that began just five years ago. Steve founded Cliffwater in 2004 to serve the burgeoning institutional market for alternative investments and bet the farm with a pivot to managing private credit assets for RIAs in 2019. That shift has been one of the most successful initiatives in the industry in the last five years and catapulted Cliffwater to one of the market leaders and brands serving the RIA community.

4:06Our conversation covers Steve's journey as a consultant, formation of Cliffwater, and focus on alternatives. We then discuss his strategic shift to managing assets for RIAs, including the development of a private debt index fund, innovation in fund structures, management of liquidity, distribution in the RIA channel, and new initiatives on the come. Before we get going, I'm excited to tell you about the 13th annual Boston Investment Conference to benefit Boston Children's Hospital in collaboration with the Broad Institute. This year's event takes place on October 24th in Boston and features a ridiculous lineup of speakers, including Boston investment legends Seth Klarman from Baupost, David Fialco from General Catalyst, Nancy Zimmerman from Bracebridge, Will Danoff from Fidelity, Alex Sassardot from Whale Rock, and Gavin Baker from Atreides.

5:02And they may all be upstaged by Brad Stevens, president of basketball operations and former coach of the Boston Celtics, and Roland Fryer Jr. from Equal Opportunity Ventures. My good friends Josh Gold and Matthew Sidman created the Boston Investment Conference to bring together great investment minds for a great cause. It's a fantastic day to do well and do good. Visit bostoninvestmentconference .com to learn more. Please enjoy my conversation with Steve Nesbitt. Steve, thanks so much for joining me. Thanks, Ted. Good to be with you. Why don't you take me back to what got you started in the investment consulting world?

5:44I was very lucky. I've had three jobs in my career. The first coming out of business school was with Wells Fargo Investment Advisors, And they were one of the first to do index funds, if not the first. And I got to work with some very smart people, in particular, Bill Sharp and Bill Faust. He taught the dividend discount model to me. I thought that was fascinating because he had a way to project expected returns on equities rather than just looking retrospectively at historical returns. And that was really important in the evolution of asset allocation. It allowed people to pivot from just looking in the rearview mirror to looking forward.

6:23I got involved in asset allocation along with index funds. Wilshire Associates hired me in 1980 because they thought I knew something about asset allocation and they wanted to start a consulting business. So I went there and at that time, consulting was all about manager selection. And Wilshire stood that on its head and said, no, manager selection is not important. It's asset allocation. I was a consultant there for over 20 years. I ran the consulting group for about 15 years. Success there was on the premise that we spend 90 % of our time on manager selection, but really it's asset allocation that's going to determine returns.

7:02So in the implementation of the asset allocation, how did you reconcile your early experience with index funds with this model of manager selection tied to the asset allocation? It was really a question of where are the markets efficient and where are they not? People hired Wilshire at the time because they liked the idea of efficient markets and provided a pretty simple solution as opposed to hiring 50 managers. And so our philosophy was, hey, we're going to go index where the markets are efficient and we'll hire managers where they're not efficient. We thought the U .S. equity market was efficient.

7:39So we pushed index funds for my tenure there. But in maybe small cap stocks, international, we'd have some mix of passive and active. And it just seems to me the world has basically gravitated slowly to the efficient market thinking, except for private markets, where arguably there are no markets and where the real economy is inefficient and you can take advantage of that. What did you see in those 20 -something years of the evolution of the sophistication of asset management? I think that's two levels. One level, there's been no change. It's amazing to me that investment theory changed radically in the late 50s, early 60s with Markowitz, Bill Sharp, Gene Fama, basically modern portfolio theory.

8:28But we've lived with that theory to this day. Maybe I'd throw in their option pricing, but nothing's changed. I still have a couple of textbooks from my MBA days at Wharton, they could be used today. It's amazing. So in one sense, the paradigm hasn't changed. On the other hand, so much has changed in terms of execution and implementation. So the availability of data and data processing is light years ahead. Also, proliferation of asset classes. Back when I started, it was stocks, bonds, and real estate. Institutions loved real estate. Trustees could count the number of parking spots. It seemed to be the only private market that resonated, but it's crowded now.

9:11If you have an asset class, you're competing with arguably 30 or 40 other asset classes. And it comes down to asset allocation portfolio construction. One of my gripes is sometimes people over -diversify. They're not sure, so they end up with godly number of asset classes, which really doesn't do anything from a performance point of view. What led to your founding Cliffwater? A couple of things, investment -wise. I felt at Wilshire, I had accomplished everything I could accomplish. It was getting a little bit routine. I had built in the 90s private equity group, a hedge fund group. Going into the new century, I was convinced that it was going to be alternative investments, that no way 60 -40 was going to meet the actuarial rate.

9:52My feeling was in alternatives, we could add three percentage points net, shift up the efficient frontier. And so I said, hey, we're going to establish a firm that focus 100 % on alternatives. And that was the investment backdrop. Economic backdrop is I didn't have much equity and the other partners that joined me didn't have much equity. So this is a way for us to generate some net worth for ourselves. And how did the business progress in, say, the first 15 years of Cliffwater's experience? Used the same playbook I used at Wilshire. And that playbook was establish your credentials with the highest level people.

10:31So we became advisors to some of the largest pension plans here in the U .S., some abroad. And then we knew there were clients that were interested in discretion. And so the idea was, hey, however long it took, establish your reputation and then move into a more discretionary role. Have a blend of the two. Been successful doing that before. So let's do it again. How did you think about the research process of what types of managers you would recommend across the different asset categories that you were covering at Cliffhunter? It varies by alternative asset class, but there are some alternatives where manager selection is almost everything.

11:10In venture, you can make the right asset allocation decision, but if you can't get the best managers or at least the top quartile managers, it's not going to matter. It's not going to deliver. That's most true in venture, maybe a little less so in buyout and hedge funds. But unlike the public asset classes, where you get 99 % of your return from beta, you get the majority of your return from manager selection or alpha in the case of those asset classes. I think the difference was private debt is different. Most asset classes, there's upside optionality, fixed income and private debt as well. It's downside optionality.

11:46And so there's diversification. And there are a lot of good managers. And so we focus a lot more on beta than we do on alpha, which is limited in the private debt class. Let's go through them one by one. So in venture, there's this notion that you just have to be with the best. How do you figure out who the best are? Track record counts for a lot. The venture industry started in the 70s and there was a lot of persistence in performance, a lot of well -established platforms. Things change, obviously. There are lift outs and splits and so on and so forth. But we have identified others' sustainability in terms of returns on the part of some venture capital firms.

12:28You start with that. You say, looking ahead, do we have the same partners? Do they have the same opportunity set? So on and so forth. We produce these 30, 40 -page due diligence reports with a lot in it, but it comes down to a few things, performance, people, philosophy. That's been a good blueprint for evaluating managers generally. How have you gone about getting access to the ones, if they're so readily identifiable through track records? It can be tough, particularly in the venture capital space where there's a shortage of supply with who you identify the best managers to be. It comes down to relationships and longevity of relationships.

13:07You could also be lucky if you're an institution like University of Michigan, Stanford in the industry that they can get access. We've dealt mostly with public funds on the advisory side. That's a little more difficult. They have special requirements that a lot of venture firms do not like. We've had some success leveraging off our own relationships, helping our clients into them. You can also establish a relationship sometimes in the secondary market. You buy a secondary, all of a sudden you're in the club and that helps. So there are some tricks, but no, it's basically having the GP recognize you as a good and reliable partner.

13:42Sometimes there are significant drawdowns in the market and having a willingness to step in, that counts for a lot. How about private equity and the buyout side? Basically the same thing. You don't really have the capacity problem. In a few instances, over the last 10, 15 years, it's been middle market buyouts that seem to have produced the greatest value add. And again, it's relationship building, being a good partner, them knowing you can count on capital when they're ready to launch a new fund. So just that consistency. We've been doing private equity since the beginning. I remember my eyes opened.

14:17I was at an Oregon Investment Council meeting back in 81 or 82. George Roberts was there talking about what he does. And I was just, as someone who was efficient markets, quant, blah, blah, blah, this guy making a lot of money for the state of Oregon, it was completely different. So being a witness to success and failure, lessons learned over a long period of time has really been useful to me in judging private equity, who are the winners and who are the losers. So we met a long time ago in and around the hedge fund space, and probably more so than venture and private equity. It's changed quite a lot in that period of time, last two decades.

14:56We'd love to get your thoughts on how you've participated and how that's evolved. The holy grail in our industry is that Northwest Quadrant, high return, low risk. When we launched 20 years ago, traditional low risk asset classes, publicly traded fixed income, yields had come way down. No new math was going to get you to the actuarial interest rate. There's been this look for strategies that could get you in the Northwest quadrant. Coming out of the 90s and early part of 2000s, hedge funds look pretty good. And some of the strategies, mostly arbitrage strategies, look to be sustainable, so on and so forth.

15:35So you could earn an equity -like return at a bond -like level of risk. That looked attractive. Unfortunately, that industry got very crowded, very fast. The reliable arbitrage opportunities just didn't seem to be there, or at least not at the level to get you an equity -like return. I think the watershed year was 2008 financial crisis, where hedge funds are down 20%. They were supposed to protect capital and didn't meet that standard. And we've gone through the last 15 years since the financial crisis, where people have ratcheted down their hedge fund allocations. And I don't know, at least in my opinion, maybe a dozen hedge funds that really matter today.

16:15I'd love to ask about how you thought about the changes and the state of your business leading into what's been this very significant shift over the last four or five years. The consulting business, in a sense, from a business perspective, has gotten very concentrated and virtually zero growth, where you probably have five, maybe 10, but not much more than that, really sharing the pie amongst themselves. Sometimes it seems to be a zero -sum game there, and it competes on fees. All these top firms, very qualified, very good, have very good people, But the problem is they're not very differentiated.

16:54And it's questionable whether they're really adding a lot of value other than education and check the box on fiduciary oversight. It's a very tough business. Margins are very low, single digit, zero growth. It's hard to attract really good people in that type of business environment. I think all of them, like us, have been interested in finding a clientele that values execution, can't execute themselves so they can differentiate themselves so they can charge higher fees, attract better people, and add value. For us, I think we had the right idea in consulting. We were just undersized and we focused on alternatives.

17:33But then after the financial crisis, the general consultants decided to do alternatives as well at a much lower price. So we were getting squeezed. So you have your business, you're undersized and you see this consolidation. There's no growth, low margins. You got a bunch of people, you got a bunch of clients. That's a tough position to be in. What did you do? It's very tough. We had some options. We could merge with another bigger firm. We looked at that, a firm that might have global offices, whether that mattered or not. Their headcount was in the hundreds and not the tens. That would have been a logical option for us.

18:09And there were a number that didn't have alternative capabilities. So that was interesting. And we did look at that, honestly, to solve our growth problem. But it just so happened that the emergence of private debt caught my eye early on. And going back to this idea of the Northwest Quadrant, the yield curve had basically gone to zero. And it was like, is this an asset class that has growth itself? Can we manage it? How do we manage it? Could it be big? Could it be the new thing? And I thought it was the new thing. And basically, arguably, we bet the company on that asset class. And what was your base case for why you wanted to make that bet?

18:47The private debt we were interested in wasn't distressed. You didn't need to be a rocket scientist. All you needed was access to senior secured loans backed by viable companies. The yields were extremely attractive. And the question became, hey, can you hire managers that can underwrite those loans to close to a 0 % default rate? I felt that was the answer. We'd still do hedge funds, but I saw this as a more simple and more elegant answer to that North -Northwest quadrant. And it just so happened there were a few, not many, that had done this through the 90s into the 2000s that I knew they performed very well during the financial crisis, hedge funds for the most part.

19:32And I felt, hey, let's do our due diligence on this asset class, on these managers, and start recommending them. So that's what we did. When we got interested in private debt, I was amazed. There was really no data. There was no index. So I felt that it's like any asset class. It's not going to take off until it has an index. I often say it's in the Wizard of Oz, the scarecrow. He wants to be recognized and smart. He is smart, but Wizard says, all you need is a diploma. And then everybody will think you're smart. I've discovered in the consulting business, in the institutional business, you need an index before you fit into asset allocation.

20:08So we spent an incredible amount of time, like five years, building a database and creating an index, Cliffwater Drug Lending Index, engineering that back to 2004 so people could have a good idea of what this could do. I thought people, they're not going to hire a specialty private debt consultant, too many consultants. So I said, hey, this is new. Why don't we do a kind of a fund of funds? I thought that was a simple solution, charge low fees. funded funds weren't particularly popular, but I thought we could, the value add proposition was huge. We ran into the problem that we couldn't sell this to our existing client base because you have a fiduciary problem.

20:46No, can't recommend ourselves. So started to talk to other funds and the problem was we couldn't get through their consultants. The other consultant didn't want to recommend us, quickly discovered raising capital was going to be a problem. Here I have, I thought, really great idea, but I can't sell it into the market. So I'd love to dive through different aspects of that process. The index creation, what are some of the complexities that you walked into as you started thinking about creating what became the direct lending index? I've been familiar with indexes my whole career. I've learned about them, actually implementing them at Wells Fargo Investment Advisors.

21:22So created a couple of indices, two or three at Wilshire Associates. When it came to private debt, once I had the data, I knew how to create the index. And fortunately, the BDC market, not many people knew about it. These are 40 -act vehicles, so they're SEC registered. And the SEC requires disclosure on a quarterly basis, including holdings. If you can manipulate SEC data, you can create an index. People can replicate our index if they're now willing to spend an incredible amount of time and resources doing it. We scrub, slice and dice SEC data to create this index. It's an asset -weighted index of the underlying collateral.

22:04I analogize it to NACREF, the real estate index, where it's an index not of properties, but actual loans. And it's actually better than NACREF because it's not populated by managers voluntarily giving their property values. But this is all SEC mandated information. Once you got conviction in the area, you look today and you've had this incredible growth on the asset management side of your business through this debt asset class in a completely different market. You often find people with a good idea that you had that are long the concept and short distribution. Really curious how you made that pivot from serving mostly public pension funds in consulting to creating a product and then figuring out how to bring that into a completely different channel.

22:55Kind of like the, if you build it, they will come. When investment business, they don't come. I was just lucky enough, a young professional, maybe he was 30 years old, who had been following my research, who came to me and said, hey, you ought to meet with a bunch of people I sell to. He was selling BDCs to individual investors and to RIAs and said, you got to spend some time with this RIA channel because I think you could be very successful in it. And so I spent a year meeting with the RIAs he recommended. I said, hey, let's switch the RIA channel. And that was it. We figured out, hey, what's the best fund structure to make it easy for these RIAs?

23:33So we selected this interval fund structure. Others use BDC and offering yields closer to 10 than the zero. That got us started. We took advantage of a market that was severely underserved, this RIA channel, that was gaining in size and sophistication. sales into that channel or product pitches and substandard products with high fees. Phil Hasbrook was working in that channel. I think he was somewhat successful on that channel, but I had the idea of cold calling me. And part of this is just listening to people and even young people and being willing to take business risks. That's how it all got started.

24:15And I quickly determined that these RIAs, generally they manage between one and maybe 20 billion. They are very smart business people. They have some investment skill, but they don't have the resources, particularly the resources to do alternative investments. They really needed advice as well as good product. I think we've been successful because we have great product, but we also can give them institutional advice that single product salesmen can't give them. So, for example, maybe you have an RIA gets a new client. They've got some venture fund that's being onboarded. They have no idea if this fund is any good or not.

24:54And while they may be invested in our private debt product, they may call us and say, hey, Steve, is this fund any good? And we can give a quick answer. That value add or that advice beyond just a single product, I think, is really for us the difference between success and net. 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.

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26:29I had an East Coast person, a West Coast person, and we raised, I think it was like 120 million out of the box, that got us going. I will say launching a 40 -act fund is a tremendous vehicle, but getting one launched is extremely difficult. You've got to go through the entire regulatory process, which is a bear. You need to raise capital to launch all at once. And with the interval fund, there's not drawdown capital, that kind of stuff. But there are huge advantages, but getting it launched is a challenge. And you just have to be committed. And we were committed. What are some of the advantages of the Interval Fund product?