E191: Randal Quarles: From Fed Vice Chair to Private Equity Trailblazer

0:00Randall, I've been very excited to chat. Welcome to the How to Invest podcast. Thanks for having me. Glad to be here. Tell me about why private equity funds are a better fit for pension funds or endowments versus family offices. If you're even a pretty large family office, you don't own everything that Carlisle and Blackstone and KKR and Apollo own. And so when something is sold after a few years, you know, you do pay taxes. You have to think about how to redeploy that return because it hasn't been automatically moved into another pocket. It's disruptive for the business as well. That's not so much a family office issue, but it is has become from the point of view of the portfolio company, you know, something of a negative of private equity investment that if you are still expecting a lot of growth in your company, it becomes disruptive to have accepted private equity capital that's going to roll out in a few years to another private equity holder that's going to roll out in a few years.

1:01So from a family office standpoint where you have or you're willing to take a longer perspective with respect to hold periods, you have an incentive to do so because of tax effect. You have an incentive to do so because it's more complicated for you to redeploy returned invested capital. All of those argue not so much that private equity is wrong for family offices, really. In fact, I think the opposite. The private equity asset is important, but that there needs to be a different delivery mechanism. On taxes, I think people over-index on the tax paid and under-index on when you pay it or how often you pay it.

1:39if I put in$10 million and now I have to recycle it in two years, I'm essentially redeploying if I'm in a high tax state, even at long term capital gains, I'm redeploying 67 cents on the dollar. So now I have I'm redeploying 67 cents versus if it continues compound, I'm essentially redeploying 10 million. I'm just holding it in a essentially tax deferred. I know that's not the way that most people use it. But if you think about compounding, you're essentially deferring the tax until liquidity, then that could really add up. No, it absolutely does. And the private equity industry as a whole, and particularly the larger firms, because they have the capacity and the scale to have different funds that are doing different things, they've tried to address that.

2:25But still, as a whole, the template for the industry as it has evolved, it really evolved in response to the incentives that were created from what had been the principal source of investment, which were pension funds, sovereign wealth funds, large institutional investors that had a different set of incentives from family offices. Said another way, there was product market fit. It just wasn't with family offices, it was with a different type of customer set. And now you have these family offices that have continued to grow. Some of them are larger even than some pension funds and some endowments.

2:58If I was a single family office, I had a billion, $5,$10 billion, if I can get similar to private equity style investment, you know, 10, 20 years ago. At a$5 or$10 billion family office, you have the, you know, you have the ability to invest in any of the large pension fund, I mean, any of the large private equity funds and get that exposure. Increasingly, there are generally smaller funds from smaller firms, or some specialty funds that are being offered by the larger firms, promise longer hold periods, and, you know, intend to deliver on them that are more sensitive to tax structuring. One of the things we've tried to do in our own investing, for example, we have focused on, at Signashore, we focused on investing in cash-flowing businesses, which gives us an opportunity to allow the investment to continue to compound.

3:50If it's going to compound at our desired rates of return, we can allow it to compound for a long time. But if it's cash-flowing, it also gives us, because it's a challenge for the private equity provider to say, if I'm going to, you know, I have to pay my people. And if I'm going to provide them competitive compensation, and you have the other model where things are turning over and carry is crystallizing faster in order to pay the professionals, it's like, well, what do I say to my professionals if we're going to try, you know, if we're going to try to structure these investments to hold them longer.

4:23And obviously, that's easier if you have a cash flowing investment, because you can have a structure that allows you to take a portion of your carry out of current cash flow, but allow the value of the investment to be continuing to compound over a longer period of time. And that's usually in everybody's interest. One of the things that I've learned over the last month or so is that some pension funds are starting to invest in private equity through evergreen structures, which kind of really blew my mind because I saw evergreen structures as this product for family offices that wanted to kind of delay their taxable income or their taxable gains and also wanted to have access to more liquidity.

5:01But the reason that pension funds are doing it is because in their traditional private equity investments, they're only deploying on average 67 % of that capital is called at any given time, meaning that 33 % drag that is sitting in treasuries. So that obviously dramatically hurts their return. So they're actually investing into these evergreen structures. As an entity that has mostly taxable investors, how do you look at structures like evergreen funds? We pay a lot of attention to structure of our investments for tax efficiency. We don't have any evergreen, well, actually we do have an evergreen private credit fund, but evergreen funds have not been a theme of ours, although we are certainly open to them.

5:41We have tended to address that though through the structure of individual investments to ensure that we're maximizing tax efficiency for our investors. Tell me about Sinister Group and what is Sinister Group? We're a diversified boutique investment firm. We're anchored by a family, the Eccles family. We're not a family office per se. We like to think of ourselves as kind of the early years of a Lazard or Rothschilds or Lehman Brothers, an investment firm with many clients and many different investing strategies, but that has been anchored and we intend to continue to be anchored by the Eccles family.

6:21The genesis really was, you know, the Eccles family built its position over the 19th and 20th centuries with a number of investments in private companies in the Intermountain West, some of which grew to be quite large. By the end of the 20th century, all of those investments in private companies had been sold to large public companies. And that That created a set of investment challenges for the family. We now had a lot of liquid securities. They'd all been private companies before. We had a number of foundations, private foundations from the previous generation of the family that were now funded with assets that would benefit from active management.

7:05We had a lot of family members with taxable family members, individuals that had individual wealth advisory needs. We wanted our liquid positions to be managed, you know, a little bit more, more sophisticated fashion, you know, than typical passive investment. And I was a partner at the Carlyle Group at the time, had been for a while. And we were at the same time investing in a lot of investment advisory asset management firms. We formed that thesis before it became the flavor of the month. There are a lot of private equity firms that invest in investment management now. there weren't a lot 15, 20 years ago.

7:42And I thought that I'd kill two birds with one stone. I'd find some great investments for Carlisle and I'd find some great firms that would help us solve these new problems that we had. I found some very good investments for Carlisle in that thesis, which really had been formed by a young colleague who was working for me at Carlisle named Keith Taylor, who I brought with me to Sinashore. It's proved to be a great investment thesis. It was good for us at Carlisle. It's been great for us at Sinashore. But I didn't find any firms that actually I was happy being a client of for our particular needs.

8:14And so we concluded that if we wanted those problems solved, we would have to build it ourselves. We'd have to build a private investing capacity that addressed some of these issues that we had talked about, about the structure of the private equity industry. For families, a lot of foundation and endowment, comprehensive portfolio management is pretty kind of plain vanilla and CYA not really aimed at maximizing the impact of a foundation over time by growing and by really growing its assets. You know, a lot of individual wealth advice, again, is expensive and poor, you know, and hedge funds are all over the map.

8:54And we thought that if we could build something that solved our issues in each of those areas, it would solve a lot of other people's issues as well. And that would be a commercializable business as opposed to just a family office. And that would have a couple of benefits of which the principal one is that you'd be creating equity value that would allow you, it would be part of what you could use to recruit really the very top investment professionals into helping you grow this business. We looked at it a little bit like the FIPS Family starting Bessemer Trust, except that we were, you know, we had kind of a different set of specific investment challenges that we were trying to solve.

9:34But just as they grew what had been their family office into, you know, a diversified business with, you know, most of the clients outside the family, that was our objective and what we've been growing over the course of the last 12 years. So that's why sometimes people think of us, you know, put us in the bucket of, are you a family office? And the answer is no, we're an investment firm that's anchored by a family. The bulk of the capital that we manage now is not the families. We have clients from Alaska to Australia, all around the world. But the genesis of the business is solving these specific issues for other families.

10:13And the thesis that we started out with appears to have been worn out. There are a lot of other people who say, yes, that's what we've been looking for. When you look at what drives returns for either taxable or non-taxable investors, all the research points to one thing, which is portfolio construction, not even manager selection, but which assets are you in? But implicit in that is somebody is making that portfolio construction decision. And in order to recruit those type of high caliber people making those decisions, you had to give them more than just a typical single family office construct.

10:47One of the things that a lot of people don't say in the industry is that family offices don't always have the highest caliber of talent because they're typically picked off by higher paying opportunities like endowments. But you solved around that by expanding the platform and being able to give people equity that joined Sinusure. sign of share. That was the thought. I don't want to diss the family office folks at all, because we work with some large single family offices that have fabulous people. But a lot of that comes with scale. And you can have what is a pretty large family office and still have trouble with the scale that's required to compete in the investment industry with what you have to here.

11:33We do think that thesis has been borne out of creating a business that has equity value, that does business well beyond the family, even though we continue to anchor it and run it. We're very, very proud of our team, and that's been a big part of it. I will say, by the way, it has nothing to do with the structure. It has to do with the practices. In other words, there's nothing that keeps a single family office. You mentioned scale, maybe a smaller family office, but a larger family office. There's nothing that keeps them from compensating their talent in the same way that a Blackstone or a Carlyle might do.

12:07It's just an industry practice. And we have seen people bug that trend, obviously, with Gates, with the Gates family office, with Michael Dell, with MSD Capital. So you do see some very sophisticated Patriots, Pritzkers as well. It's not to scold all family offices more. to be, it's more about there, it just happens to be kind of this bug in the industry. So you alluded to the Sinusure structure. So tell me about how Sinusure is structured exactly. So we're structured with a holding company that has, you know, at the moment, six, two are relatively new, but six kind of operating business lines that we run the economics through a set of six subsidiaries.

12:51One is private assets, private equity, private credit. Our private equity, I think we would call again to address some of the issues that we were talking about at the very outset of the podcast. I call it more growth equity for unloved businesses. So one of the things we wanted to do as a family in organizing our own private investing, now that we had all of these liquid securities kind of concentrated in a handful of public companies needed to redeploy and wanted to reploy it in private assets, kind of using 21st century financial technology as was being built up in the private equity industry.

13:25But along the principles that we'd operated on in the 19th and 20th centuries was, you know, the Eccles family had invested often as minority investors in a range of companies that in our part of the world here in the Intermountain West were thought of as Eccles companies in sugarbeets and lumber and banking and construction and mining, railroads, hotels. But very frequently, we were not majority investors. We were very active investors, but we would back management teams, provide them with the expertise that was gained from from our involvement in a range of these industries and hold those investments for a long period of time.

14:16We're willing to hold them for a long period of time. Similar to growth capital practices now, but most growth capital in the country, as you know, as your listeners know, is focused on tech, health care. if you have a tech company that's growing rapidly, there's a lot of growth capital that will be available for you. If you have an industrial company that's small, growing rapidly, there are 100 middle market LBO companies, private equity companies that will buy your company. But there are just relatively few that will make a growth investment in your company. Say, look, We're willing to provide you growth capital.

14:59We're even willing to take a minority position, if that's what makes sense here. You know, you'll grow it over the next several years. We're backing you as the manager. We don't we're not coming in intending to replace you. We're not we want you to roll as much as possible of your position into the company. And to do that for, you know, among the things we've invested in are HVAC distributors and porta potty companies, which have been fabulous investments, but but for which there's just not a lot of growth capital. I don't fully understand why that is. It is much harder to do that, to come in as a, you know, to be willing to come in as a minority investor.

15:44We spend a lot of time with potential portfolio companies because it's like a, you know, it's a partnership. It's not like a partnership. It is a partnership together. We all have to be comfortable with each other. We protect ourselves, obviously, with minority investor protections when we do take a minority position, which isn't always but frequent. But we've never really had to deploy them. We've never had to deploy them because we spend a lot of time up front. So that's how we've organized our private equity investing. We have a subsidiary that does essentially an outsourced chief investment officer for foundations and endowments.

16:18We started off with the family foundations, but we now have, you know, university endowments, other family foundations. Their ranking in the NASDAQ sort of return, comprehensive return rankings is at the, you know, is at the very, very tippy top, you know, much more than the 10th percentile. Net about 15%, not quite 15 % over the course of the last five years, whereas Stanford and Harvard, to take examples of extremely well-managed endowments, are at eight or nine. So we've been very pleased with how that has done. We have a subsidiary that does ultra-high net worth, a wealth advice, and RIA. It's a team we brought on from Silicon Valley Bank, a lot of tech entrepreneurs, as well as the family anchor.

17:03And then we're seeding a quantitative long short hedge fund for the sort of more sophisticated management of our liquid positions that I also talked about earlier. We have just partnered with David Chekits, who's a storied person in the sports world, to have a sports investing private equity capacity that's off to a great start. And we're partnering with a real estate group to develop a real estate investing capacity as well. If I made you guess as to why there's a dearth of growth equity versus private equity buyout for$5 to$150 million companies, why would you say that is? It's mostly what I said before.

17:48It is harder to do. To provide growth equity, not every one of our investments. We do have majority positions in some of our private equity companies. that are growing very rapidly. But on average, we take a minority position and we're generally very happy with that because it means that the founder and the management of the company are keeping a big stake. They believe in the runway that's left for their company enough that they're leaving a lot on the table. Most frequently, the founders aren't taking any money off the table when we invest in them. So occasionally we'll buy out a kind of a senior founder who's aged out, but then often the younger management will invest even more in the company at the time that we come in.

18:33But if you're investing in that way, and particularly if you're a minority investor, that's harder. If there are steps that the company needs to take, we need to make a case. We can protect ourselves against catastrophe. We can require certain events to happen under the minority protections that we negotiate, but we don't control the company. We can't decide, look, we didn't anticipate this. Things have just taken an entirely different turn. And so we're going to take an entirely different turn and we can because we control it. That is an uncomfortable position for a lot of private equity firms.

19:07It was something that, when I was at Carlisle, we made an effort to do this kind of investing in a new fund that was being created. It was very hard to do in financial services, the financial services fund that I helped run at Carlyle was, you know, a lot of financial services investing for regulatory reasons. You'd take a minority position. It's just very uncomfortable. It's very uncomfortable for private equity investors. For smaller private equity firms, it's just hard. Why do the hard thing when there are plenty of opportunities to do the easy thing? Our answer is because over what's now a longish period of time closing in on 15 years, Our returns have been at the top end of the scale, but that comes as a result of a lot of work.

19:53I interviewed the CIO of CalSTRS, Scott Chan, and one of the things, they have this kind of$350 billion pool of capital that they have to deploy, which I don't envy them. It sounds very sexy, but it's a very difficult job. But they have to look within each asset class supply and demand dynamics because they are literally moving the market. I would actually argue that everybody, whether they're aware of or not, is subject to these supply and demand dynamics and should be looking at it from that perspective. Because if something's definitely a good idea and everybody sees the same things and everyone sees it has the same set of skills, it will be commoditized away.

20:29Whether you're the one commoditizing it or not, the industry has a steady state. And I think people fail to see that they're an actor within an ecosystem with supply and demand dynamics across every asset class. I completely agree with that. I think, you know, I think some of the structural obstacles there are to more competition in what it is that we do is that it is, you know, it's more of a challenge for running your business. That's not the investing side of the business, but the management of the investing business. We talked a little bit about the challenge of paying people if you've got longer hold periods.

21:05And so how do you crystallize carry? How do you create compensation structures that allow for that while allowing you to achieve your investing objective? You know, there is an increasing demand as, you know, growth companies outside of these hot areas like tech and and health care become aware that it's a possibility to get growth equity. There's increasing demand for it. But as one scales a firm that's based on this thesis, you can't start increasing the profitability of your firm by increasing AUM per investment professional beyond a certain point, because now that's a different business. Now you're at companies that are at such a scale.

21:49But again, unless it's tech or health care, certain types of industries, you're unlikely to be hitting the growth rates that we want for the returns that we've been able to achieve. So what that essentially means is that you need a bigger team to deploy a large amount of capital. There's definitely increasing demand out there for this type of investment. So one can deploy a larger, larger amount of capital, but you can't do that by increasing AUM per investment professional. So that's just more expensive. We think that on balance, in part because we're anchored by our family, we can kind of cover the costs of investing in that structure.

22:27And that as the firm grows, you know, eventually the higher returns that will be generated from that investment strategy will support being able to pay a larger team in a way that is equally profitable to the typical private equity model. But that takes a while to get there. And it takes kind of a source of strength like that while you're building the firm in that direction. And again, it's just a dive of a higher degree of difficulty that is, you know, that is daunting for folks who would think of making that the strategy of their firm. you're chairman of sign assure and you went from carlisle to to helping manage the firm you're part of leadership you've you've built these kind of six subsidiaries during your time there has that come from like leadership sitting in a room and coming up with great ideas has it come from recruiting the best people that went out and had those ideas did it come from customers talking to leadership.

23:26Tell me about the product development. How do you see your role as leadership? Do you see your role as thinking about the strategy of the firm or just being very good at recruiting? The answer is all of the above, actually. So, you know, our private equity strategy, we came to building the firm with that. It was, this is how the family operated for 150 years. The world we're operating in uses slightly different terminology, has slightly different technology, but those principles we think will be the same. We'll implement them. We implement them through a private equity fund strategy. And so that was kind of built from the ground up that was part of what we came with.

24:06Similarly with the OCIO business, but I would say that the OCIO team has developed the asset allocation framework and very particularly the detailed and very mathematical liquidity analysis that is necessary to support a heavily alternative asset focused portfolio construction that has allowed those returns to be very high. As a family said, we want a structure that is, you know, we're comfortable with a large amount of illiquidity in these foundation portfolios, but they have distribution needs and so forth. And the team has been very critical in developing that framework. It was always part of the strategy to have the ultra high net worth wealth advisory team, but that was a little bit opportunistic.

24:57Silicon Valley Bank was falling apart and we had a connection with some folks there and we said, look, this has been something that we believe the firm has, was part of the fundamental reason of being of the firm. So come with us and they brought an existing business. The sports investing was brought to us by David Chekets, our partner in that enterprise. He's somebody that the family had a relationship with for 40 years, going back to the early days of the Utah Jazz here in Salt Lake. But he said, look, I have this capacity. I've got this idea. I want to do it with some folks who really know private equity investing.

25:36But he brought that to us. So it's the sources have varied. All of it, whatever the strategy, all of it depends on execution. And so, you know, the really excellent investing teams that we have across the firm in the private equity investing, private credit investing. Again, my colleague, Keith Taylor, who came with me from Carlisle, is the chief investment officer of that and co-head of that group. He's been critical in the results that we have obtained there in executing on that strategy that we had. And if you were to ask me to get to the end of your question, what's the single most consequential thing that you've done?

26:16I say this to the team and to our investors all the time. I'm proud of the strategy of the firm. I'm proud that it is sort of operating in the way that I had thought that it would operate. And even some of the people who were joining with us in this process, my close partners is Bud Scruggs, co-founder of the firm, who's about my age and was very willing to join with me in starting this, but didn't really believe it would grow to what it is growing to become. So I'm very proud that that strategy has worked as planned, But it's utterly impossible without the really stellar execution of all of the investment professionals.

26:57And so I'd say the single most consequential thing that I've done is recruit those investment professionals. You've recruited the professionals. You basically created almost the skeleton of the house. And then the team has come in and both obviously you can't have a house without a skeleton. Both have been instrumental. The reason I've been thinking philosophically in another domain in tech, the best way that I could define this is two different frames of thinking. One is the kind of the Elon Musk way, which he conceptualized, I want to go to Mars, I want to start SpaceX, I want to start the Tesla.