E221: From Citadel to Family Office CIO: Sid Malhotra’s Investment Lessons

0:00So you work at a single family office. Tell me a little bit about Cactus Capital. We are a single family office, which means that we manage capital for one family. We have no external clients. And I'd say in terms of my responsibility as a chief investment officer, my team and I are solely focused on investing day in, day out. There's no marketing, raising of assets. Our interests are fully aligned with the family. We're trying to be stewards of capital for one single family. One of the things I think Cactus got really well is incentivizing everybody within the family office to think long term.

0:41Tell me about how they accomplished this. So when we set up the structure, I actually believe myself that it's critical to have alignment between the investment team and the family. So there's a few ways we do that. The easiest one is maybe investment philosophy and mandate. But beyond that, we want to avoid principal agency issues, which come up a lot in finance and investing. And so one way we do that is, you know, a portion of the investment team's compensation every year is tied to performance of the portfolio, both over recent periods and longer periods. So that really helps incentivize us as an investment team to think long term.

1:24But secondly, the investment team has capital invested alongside the family in the entire portfolio. So that really gives us additional skin in the game where if things go well, the investment team benefits through good compensation, but then also a return on their investment. If things don't go well, compensation isn't as good as you'd want it to be and your investment goes south. And so there's a really good alignment there in terms of aligning the interest of the investment team with the family. And that really makes us think long term and not think short term and avoid noise and really invest for the long term.

2:08It's something that's so obvious and common in nearly every asset class on the planet, whether public or private. And yet in family offices, oftentimes this is an exception. Why do you believe that's the case? I think particularly at single family offices where I work currently in my prior firm because it's, again, one family that you're serving. And so there's no other parties you're sort of trying to appease or make happy. And again, you're not marketing what you do or your performance to other folks. That's basically irrelevant at a single family office. It does not apply. And then the flip side is you're at the whim of one family in that if you're not doing what they want, you're probably not going to survive in that seat for long term.

2:54And so that is a very good governor and governance mechanism. Whereas if you have multiple investors, you don't have to always make them all happy. You probably just have to make the majority of them happy. You probably want to make them all happy, but you don't need to necessarily. especially if you're fundraising because if certain investors don't like believe you, you can try to find other investors. That concept doesn't apply to a single family office. You're all in with the family and you got to make it work.

3:25And tell me about the trade-offs of having your own capital and investing on behalf of the principal versus some other multifamily offices where they have maybe some of the patriarch's capital to start, but they also raise capital from other family offices? There's definitely trade-offs. And I think both approaches are very valid and serve different purposes. I think once a family gets to a certain critical mass of investable assets, a single family office makes a lot more sense because that way the family has control over effectively all the investments. There's no other incentives at play, whether it's other families that want something else and there's one firm trying to cater to everyone and maybe meeting their needs or maybe not really meeting all their needs, but sort of meeting their needs.

4:16The second thing is as a single family office, we don't have a business, right? And so we don't have business goals or objectives versus a third party firm that has their own objectives and goals aside from what their client's objectives and goals are, right? And sometimes those can be in harmony, but many times they can be conflicting or not be fully aligned. And so by being at a single family office, you sort of put all that stuff to the side because it doesn't apply. And it's just a lot easier, I think, to have better alignment with the single family. They have control over everything that's going on.

4:53You're sort of serving them, if you will, versus a variety of different clients. And then the other thing is it's easier to sort of meet the demands or unique requirements of a family under a single family office umbrella than a multifamily office umbrella. Because again, your singular focus is just on that one family and doing what they want and what's right for them, not catering to a variety of different people. So it's just a different construct. They're both very, very valid and have different pros and cons. A lot of people talk about the quote unquote strategic nature of taking capital from family offices.

5:31is double-click on how family offices can be strategic versus endowments, pension funds, and foundations. I think there's a few ways family offices can be strategic. One is if the family has a background or expertise in a certain sector or type of company, that can be very much a value-add relative to some of those other institutions you mentioned, where they have talented investment teams, but there's maybe no in-house expertise in running. a manufacturing business, if you're looking at a manufacturing deal, for example, right? Or if you're looking at sort of a tech platform and it's a tech entrepreneur who has expertise in that end market, they get out a lot more value than just a typical investor that's just sort of, you know, doing due diligence and writing a check.

6:19So you can definitely be strategic in that way. The other way is connections and just introductions. If you know people in the industry or that can tangentially help the company or an investment or a firm, that also, I think, is a way that family offices can be a little bit more strategic than many other types of investors, where again, they have the investment team, but they don't have the Rolodex of a very successful family that has lots of experience doing something very well. And then the last thing I would say is, I do believe that many family offices have a longer time horizon than and some endowments and foundations, because some of them are really trying to be multi-generational in nature.

6:59And they're not as concerned about what performance might look like on investment in the short term, because the family really understands this is truly meant to be long-term, whereas those incentives may be a little bit different at some of these other types of investment firms we're talking about. Yeah, I see a lot of the value for our family offices are these zero to one decisions that institutional investors can't make or choose not to make. For example, they could invest into crypto before it was fully regulatory approved. They could warehouse opportunities. They could backstop opportunities for people that don't have funds.

7:37They could seed new opportunities with managers that are going into these new asset classes or new variations on their asset class. I think that could be extremely strategic. And also that it's one of those areas where the family office could get outsized returns, maybe they get co-invest, but also it's extremely valuable beyond just the check for the managers. It allows them to expand their business dramatically. I would agree with all that. It's interesting that we're talking about strategic family offices. The two most strategic family offices that typically come to mind, at least the slightly less secretive ones, are MSD Capital and Pritzker Group.

8:15You were at Pritzker Group previously. What was your main learnings and takeaways from the Pritzker Group? It was a great experience. I was there for a bit over six years. I think the biggest takeaway for me was that family had the DNA of owning a lot of businesses in the past, and a lot of them had a manufacturing bent to them, as well as some real estate assets. So it really gave me an appreciation of just the legacy of family and the wealth that's been created through it and keeping a business throughout time and shepherding it. And related to that, to the prior topic we were talking about, just all the expertise you might have in those sectors, contacts you may have in relationships.

9:01And those can be very, very value add when folks like myself on the investment team or trying to make investments or add value to partners that were looking to invest alongside. So I think that was very, very interesting and eye-opening since that was the first time I worked at a family office. And my prior firms were also amazing experiences, but we really didn't have that strategic angle or that legacy of owning businesses over time and just the collective wisdom that sort of comes with it. Today at Cactus, you're really focused on absolute returns versus relative returns. What do you mean when you say that you focus on absolute returns?

9:42The way I define it is trying to generate a positive return regardless of market conditions or market performance or outcome. It sounds great, but it's hard to actually achieve. What that means is we're trying to generate a positive return every year, even if markets are flat, down or up a lot. We're trying to just compound the family's capital over a long period of time by having an absolute return mindset versus just thinking about trying to outperform a benchmark by a little bit. It's great to outperform a benchmark when it's down, but we would prefer not to lose money and hopefully make money in those scenarios when the market's down.

10:23So it's a little bit of a different mindset where we're trying to, again, compound capital over time. And I think the best way to do that is, one, don't lose money. use your seven time. And then as Warren Buffett would say, rule two is don't forget rule number one. And then rule three, I would add is take prudent risk. So you got to take risks in this business. That's what it's all about. And there will be losses at time, but we're really trying to minimize losses and have a high batting average of singles and doubles versus trying to have a high slugging percentage because a lot of those at-bats are not going to be successful.

10:56So double click on your criteria for how you decide whether you want to make an investment and a manager? For us, the way we think about investing is really two ways. It's bottomed up, right? The manager is just compelling in terms of what they're looking to do. They're best in class. And so there's obviously demonstrated investment capability there, and we believe it's best in class. However, we also need to be pretty positive on the opportunity side. You can be the best investor, but if the opportunity set's not that great, it's probably not going to be the best For us, we need to have conviction in the opportunity set or at least not have a neutral to negative view on the opportunity set.

11:37So that's also really important to us. A few other things I think, though, without saying, are this alignment of interest with the manager, if it's a third-party manager we're partnering with. We want them to have skin in the game. We want them to be a true partner and think of us as partners. And again, try to avoid those principal agency issues that can come up as an OP investing alongside the GP. Rahul Mugdal, previous guest, talks about these two different ways to go about asset allocation, the jigsaw puzzle, which is putting together a portfolio that works great together. And the second one is a treasure hunt, finding the best possible investments.

12:14And maybe they're not fully diversified at every step of the way, but you're basically getting the best returns. How would you categorize your investment style and why invest in that manner? I'm a big fan of Rahul. He's Ray. I'd say our approach is a little bit of a combination of both. What we've really been doing for the last decade or so is analogous to the total portfolio approach. We were sort of doing it without even knowing this was the turn forward. And so what that really means is whenever we're looking at an investment, we're always cognizant of the macro environment. The macro environment, from our perspective, needs to be at least neutral to benign for the strategy.

12:53If it's not interesting, we're not going to just push or fill an allocation like some other groups might do that employ what's called strategic asset allocation, which kind of says, you know, fill these asset class buckets and, you know, don't necessarily worry about the macro environment or what's going on because this is your policy portfolio. We don't really take that mindset. You know, everything we do, we need to be positive just from a top-down perspective or at least not negative. So I think that's one thing. And so there's definitely certain risk exposures we want to have in the portfolio at all periods of time.

13:28But at any other period of time for day to day, we're just looking for the best opportunities out there on an absolute return basis, risk adjusted reward basis. Or thirdly, there might be a theme or particular exposure we want to add to the portfolio at that point in time. So that approach is more sort of like a top down thematic approach. And then the prior is more bottoms up. we come across an interesting investment or an interesting manager, and we think it's worth spending time on. So I'd say our approach is a little bit of a blend of both, but it's probably best summarized these days as the total portfolio approach.

14:02Last time we chatted, we had this interesting conversation about what you do in a market sell-off. The most extreme in the last couple of decades was the global financial crisis. How do you prepare for the next market correction and what do you ideally want to do when that happens? First of all, it'd be nice to know when the next correction is going to be. It seems like they get shorter and shorter more recently over time. The way we sort of prepare is we always like to have some dry powder. And so what that means is you may have cash on the sidelines or some investments that are fairly safe that you liquidate at hopefully market value and then redeploy into assets that are much cheaper or dislocated or on sale, however you want to put it.

14:53So there's sort of that. We always have dry powder in case something happens that's unexpected. When there is a market sell-off, particularly if it's something dramatic or something where we think it's ominous and something worse is on the horizon, I sort of have a three-pronged Metro checklist. The first is, you know, think about defending the portfolio. So what does that mean? Looking at all our exposures at a high level and then every single investment and thinking, is there anything here we should be selling just given what's going on in the market, especially if there's an economic or macroeconomic regime shift that we think may be happening?

15:29The second is if we can't sell something we don't want to, can we hedge out some exposure that we think is on the horizon in the near term, which allows us to keep that investment, but we effectively hedge out any negative implications that could come to that investment due to the concerns that the market is perceiving or that we're perceiving or perceiving to get worse over time. And then the third thing is really playing offense. Let's see if there's anything interesting to buy. Again, not because we're short-term traders, but because we're actually long-term and we believe in mean reversion for a lot of asset classes and things technically get oversold in the short term.

16:09And so we'll look and see if there's interesting things to buy where we believe the downside is fairly protected. And there is upside. And it's just a matter of how long it takes for these assets or investments to recover. You mentioned that you like to keep money in dry powder. Is that in treasuries or are there ways to earn a higher return in your dry powder capital? There probably are higher ways to return on your dry capital, but I would say we are fairly conservative. And so we will invest, at least at the moment, in three to six to nine month T-bills, just depending on what yields are and our view on what the Fed might be doing.

16:47From our perspective, we want cash to maintain its value and we want to be able to liquidate cash at the value it's held at in order to buy dislocated assets. We don't want to take a loss on cash or potentially have, if it's a mutual fund or something along those lines, like a gate or some sort of issue like that, come as a surprise because that really would be a tragedy from my perspective because why are we holding the dry powder then if we can't access it? And so we really employ a very conservative practice these days of investing in T-bills that may change in the future as the fact continues to cut rates.

17:22But the nice thing about holding T-bills is, you know, today you're making 4.3%, which, you know, isn't anything heroic. It is above core CPI, so there is a nice real return to it. If something bad were to happen in markets, particularly equity markets, what typically happens is the yield on those T-bills compresses because the market believes the Fed's going to cut rates in advance of them doing so. And so it's kind of nice because you're able to exit these T-bills at what you're carrying them at on your balance sheet and sometimes even at a profit because as the yield compresses, the market value goes up.

17:57And so you actually pull forward that return you were holding for. And so we've had several successful experiences doing that in the past. And that's kind of a little bit of a bonus to holding T-bills. That's not why we do it, but it's kind of nice knowing you're going to get the value of it. And sometimes you get more than what you're holding it for or things that would do really bad. And you can buy cheaper assets with certainty. Summer's here, which for me means occasionally trying to escape New York City on the weekend. When I get time off, the last thing I want to do is worry about keeping my personal finances organized and my budget in balance.

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18:58I also like Monarch's AI Assistant. You can ask questions like, how much did I spend on travel last summer? Or how many subscriptions am I paying for? And get answers instantly. Use code invest at monarch.com to get your first year off Monarch Core half off at just$50. That's 50 % off your first year at monarch.com with code invest. One of the issues that investors find in basically waiting for market correction, one is there could be a compounding negative effect of keeping money in cash. So over 10 years, that might be a delta of 300, 400 basis points on a, you know, equivalent diversified portfolio.

19:34So at that point, two things happen. One is you need to now have a 50, 70 percent discount just to break even on these undervalued assets. And then also that doesn't price in the behavioral finance aspect of taking right action when there's blood on the streets, which is extremely difficult. How do you reconcile that with kind of the those two factors? To address the first issue, so for us, today from our perspective, most assets are fairly valued to fully valued. And so to elaborate, we'll hold maybe more cash to an environment like today where assets are fairly valued to fully valued from our perspective.

20:16We're fully aware that the path of least resistance is up and to the right for all assets. Assets have positive expected values, so they should go up and to the right. However, I'd say we aren't really incentivized to chase markets in the short term, just going back to our long-term investment approach and trying not to lose money over time and make money. The second thing is the behavioral financing is definitely a very real phenomenon in this business. Everyone says they're going to be greedy when people are fearful. And it doesn't really turn out to be the case because, one, people don't have capital to invest.

20:52And then two, they get really, really scared or they think there's going to be a better buying opportunity, right? So, you know, I think from our perspective and then the family's background, you know, we're very comfortable buying into sell-offs. The biggest issue is no one rings the bell at the bottom, right? And then no one puts it on the top. And so the biggest issue has actually been these sell-offs have not been as prolonged as you would hope. Sometimes you'll build your full position. But we do like sell-offs. because we do believe over time things do revert back to normal, whether it's through government intervention or Federal Reserve intervention.

21:30And so long-winded way of saying, you know, we are prepared to invest when things get ugly. Let's say there's a sell-off going on. Are you dollar cost averaging on the way down? Is that how you operationalize your strategy? That's the ideal setup. So it's, again, you know, I think that's the prudent way to do it because you just never know where the bottom is going to be. And so the framework I have is sort of if you want to invest, let's just say a million dollars, just think of it as like maybe three tranches or maybe you can do two, four or five, just depending on the situation. And so you kind of want to dollar average down and say, you know, look, I've got three times to buy this thing.

22:14If there's a very sharp sell-off, like the market's on like 25%, we're like, all right, maybe I'm going to put four-fifths of it in right now or 100 % because that's a pretty big sell-off. But if it's like a 5 % sell-off, maybe you only put in a much smaller amount, right? So we kind of keep in mind how significant the sell-off is and how much worse we get. And then again, where are assets trading at that new sell-off level? Are things still kind of frothy or are they actually fair value or cheap? We're trying to keep a multifactorial model in our head as we think about this. I'm not as heroic as you guys.

22:49So my version of this that I picked up from institutional investors is when there's a sell-off like the global financial crisis, typically what happens is obviously equities sell off. Let's call it 15, 20, 25%. But the real opportunity is actually on the relative opportunity in the illiquids in the private. So those might sell off 35, 40, 50%. So my plan for the next crisis is underweight or sell off some of my public securities and put those into illiquid. So go illiquid at the time that everybody else does not want to be illiquid because essentially the drop has already happened. That's my less heroic version of that.

23:30That's a totally valid approach. But again, I think to do that on the public side, you have to have securities that hopefully don't go down a lot of value because this concept of loss aversion kicks in where people don't want to sell their losers even if they can buy other things that are cheaper because they're like, oh, I just lost 20 % on my S &P portfolio, for example. I guess I could buy something at like a 25 % discount. It's not that big. This 20 % should come back. So I totally agree with what you're saying, but I think for a lot of folks, there's this concept of cognitive dissonance where your brain is kind of thinking two different things and they're competing, and sometimes it just leads to no action, unfortunately.

24:09I love this idea of pretending your private holdings don't change every day and just pretending it only changes once a quarter is actually very appealing to the brain, but that's essentially what people do is they'll look at venture capital positions and they'll look at their public positions. They'll say, well, my publics are down 20%. And then this is cognitive distance. Obviously, you know that the venture is probably down 35, 40%, but a lot of people don't internalize it or choose not to internalize it. I think you're 100 % accurate on that point. Cliff Asmus, who I know you've had on here before, great investor, very well spoken on this topic of volatility laundering in private markets.

24:49And basically what he's trying to say is, to your point, there's typically only four performance measurement dates for privates, right? So that makes it a lot less volatile than the S &P that maybe trades 250 days a year. and then privates, you buy things at cost and they typically get marked up. So there's really just like a lot of upside volatility, not much downside volatility. So I think what you're saying is totally true. But it is interesting because one has to ask in today's environment, what are a lot of these private assets worth? Just given that there haven't been many markdowns and a lot of things were bought at much higher valuations in the private market.

25:26And even though public markets are at a new high, it seems like private markets multiples are not at new high for most assets. I reframe all these difficult things as different sources of alpha. It might be difficult to do a lot of work on asset class. That's time alpha. It might be difficult to structure the right deal. That's structural alpha. It might be difficult to do the right action. That's essentially patience or patience alpha or behavioral alpha. So you can reframe all these very difficult things. And I I think one of the most interesting approaches to this was I had the CIO of CalSTRS, Scott Chan.