E246: Private Equity in 2025: Fees, Rates, and the Law of Large Numbers

27:38And then look for these rolling droughts, as I'm calling where liquidity dries up in an asset class or a sector where you can take advantage of it. Yeah, there's this reflexivity to markets. It's almost so basic that people don't talk about it. We had a good example, small cap value. For 30 years, everybody knew that small cap value outperformed. And now there's this counter meme in the last 10 years that everybody knows that small cap value underperforms. And there's these kind of memes that start to spread. And over time, they just become, people buy into them so much that they don't even look at the underlying investments.

28:17And that's where the alpha opportunity is. There's a narrative violation. there's an opportunity to capture an asset that's intrinsically valuable that maybe you never have to sell. Who cares what people think if you never sell and it's cash flowing, it's a, it's a good business. Absolutely right. So I think when you're trying to capture those things, ensuring that the fundamental characteristics are still sound and having change, some things get cheap for a reason. As long as those, those fundamental characteristics are still in place and it's more of the reflexivity and the, and the meme and becomes a known, even though the facts don't, don't bear it out.

28:50So I think that's where opportunity lies. And it can go on longer than you think is the other thing that I've found out the hard way many times is you don't want to pile in. You know, this is the bottom, but lean in a little. And if you're if you're too early, make sure you have a second, third bite at the apple, because it's hard to know when those means can change very quickly. But it's really hard to predict the exact point. I want to get to kind of timeless principles and portfolio construction. Somebody comes to you, they just exited their company for a billion dollars post-tax. They have to invest their money.

29:29They're not looking to buy a super yacht or a super mansion or a jet. So this is essentially an evergreen pool of capital. What are some first principles on how somebody should go about investing that capital? Yep. first principles for us are start with risk, not return. And you can boil it down to four key risks that you want to identify in the front end. And by the way, risk is good. It's just how much and where do you want to take those risks? So those risks are first, what are you trying to achieve? If it's the enterprise, is it more capital? Your example is a more capital preservation is that I want to get double digit returns, whatever it is.

30:10There's no generically good portfolio construction. you must actually have a purpose for the capital. What are you trying to achieve? And be very clear on what are you trying to achieve. So what's the goal of the enterprise or the pool of capital? Be clear on that in the front end. And then once you've determined that, how much market risk are you willing to bear volatility? If, again, if 08 repeats and that portfolio is down 20, can you stick with the strategy? The best strategy is one you can stick with over the long run Is it a 10 % drawdown, 20, 30? And again, we're not going to get it right down to the basis point, but understand we're going to build a portfolio to achieve your goals that when bad things happen, it can be down in the range of X or Y.

30:54The next risk is illiquidity. How much of the portfolio can we accept illiquidity with? Is that 10 %? Is it 30 %? What's that number? What's our illiquidity budget? And then the last one is less scientific, but I think incredibly important. I call it maverick risk. How willing to be different are you, be it to market benchmarks or other peers or pools of capital that you may compare yourselves to? And the classic example I give there is we work with a lot of university endowments. Managing risk for your business may be complicated, but your relationship with your insurance broker doesn't have to be.

31:31NFP and Aon Company can help you navigate insurance markets and negotiate with carriers to build the right coverage for your business. helping you turn your risks into leverage. NFPs advisors are total business partners who help you protect your business and connect you with solutions to your toughest financial and workforce challenges. Whether your goal is to manage risk more effectively, attract top talent, empower your workforce, or grow your legacy, NFP is ready to help you succeed. Visit nfp.com slash how I invest today to unlock your full potential. And a lot of them compare themselves to the schools they play football against on Saturday afternoon.

32:05And if they look too different, They want to beat them just like they want to beat them in football. So is there some concept of maverick risk and how different are you willing to be? Some people have a high tolerance for that. Some have a lower tolerance. And if you can't stick with it, it's not going to work. So what are you trying to achieve? Market risk, illiquidity risk, maverick risk. Get those right. And you're setting yourself up for success over the long term. Your tolerance for variability and your tolerance for having different and being outside of the herd. I think most investors start out with a lack of self-awareness, including myself.

32:39I'm putting myself into this. Everybody thinks they're able to take as much risk as possible to maximize their return. And everybody thinks that they're willing to go as outside of the pack as possible in order to maximize their return. And yet, when they run the simulation, when they go through a market cycle, behavior says otherwise. Absolutely. It's the Mike Tyson line. Everyone has a plan until they get punched in the face. So this now billionaire comes to you, they say, okay, I want to maximize growth. I'm willing to take as much volatility. I'm willing to be different. I'm willing to be illiquid.

33:17And now they get punched in the face. Is there like a second, okay, basically you sit down with them and you say, look, let's talk about what your tolerances are at this level and kind of recalibrate the portfolio or how do you deal with that? Yeah. So the, it comes back to that first blank. Are we still on the same, has anything fundamentally changed on what we're trying to achieve? Usually it's no. That's upstream of everything. That, that, that's the most important consideration. That's the most important. And then if so, come in and say, this is when fortunes are made. You've got punched in the face.

33:54People are panicking. Like we should go on the offensive. We all agree this is a portfolio that when this bad thing happened, we knew we were going to be down. We want to actually lean in and be like a kid in a candy store and go finding opportunities, not panicking. So that's where that preparation on the front end of this is this is our risk tolerance. And then remind them, this just happened. The risk came to bear and we knew this was going to happen. We're not going to panic. We're not going to go to cash. We're going to say we still have the same risk budget. And now asset prices just went on sale by 30%.

34:32Where can we deploy capital? And on the back end of this, we should be in a good place. Not everyone says, yes, that's a great idea. But at least you've set yourself up to try to minimize the behavioral risk of panic when you get punched in the face. Don't you have to set those expectations before the market draw down and basically do these mental exercises before? given that this is behavioral finance. An AI would not have to deal with these existential issues. Absolutely right. You got to do it beforehand and you got to remind folks, this is not a one-time exercise. And I think that's one of the things that I've learned over my career is that the behavioral economics is just as, if not more important than the true fundamentals and DCFs and all of that, because we're all human beings and subject to our own biases and emotions.

35:22and you can whipsaw yourself and you take the pain and then you lock it in and then you miss the upside. So setting those expectations on the front end, reminding folks in good times, right now is a great time. S &P keeps hitting new all-time highs to remind folks bad things do happen. This is our risk tolerance. When it happens, we're not going to panic. We're actually going to say, we knew this was going to happen. How can we go on the offensive now when animal spirits aren't in the same place that they were a couple of years ago. It's the coaching mindset. When you're winning, beat everybody down.

35:56When you're losing, pick them up. So make sure that they're always kind of at the rational headspace to maximize performance. I had the former CIO of Northern Trust, Thomas Sweeney. And one of the things that he talked about, which was, I thought, really interesting, is he really focuses on the fixed income market. That's what he spent his entire career on. So he had a really interesting first principles approach to it. So why do you have bonds in your portfolio? You have bonds to be negatively correlated to stocks. So first of all, you want to make sure that your bonds are negatively correlated to stocks.

36:28Unfortunately, things like junk bonds are not negatively correlated to stocks or have not been. So a lot of people make the fundamental first error, which is you should never even have bonds in your portfolio if they're positively correlated, because then you rather just have more stocks because they have a higher expected return. Secondly, he had an interesting point in that he wanted to make sure that not only are they negatively correlated, the bond portfolio, but also that they're liquid. Because that way, if you have it in these interval funds that we talked about earlier or some illiquid structure, when the market's down 30%, which usually doesn't last long if you look historically, there's been a lot of, especially recently, a lot of these V-shaped recoveries versus these kind of slow recoveries.

37:14You want to make sure that you're liquid or else why are you, again, there's no value in having liquidity during difficult times if you can't use it. If you think about those principles, those are good ones. I think that's a helpful reminder to all of us. And in 2022 when rates are at zero, we saw the correlation isn't always negative. So there's times where you're getting more of that correlation benefit than others. And then that liquidity piece is critical because if you can't sell it to redeploy, you're minimizing your ability to be counter cyclical and contrarian. So if you think about hedge fund portfolios as an example of another diversifier that folks use and we use to diversify away from equity risk, which is the dominant risk in almost every long term portfolio.

38:06There are great hedge fund strategies that aren't correlated to equities, but you can't rebalance whenever you want. you don't have that liquidity feature. So you need a higher return out of that portfolio to make up for that lack of liquidity and the ability to redeploy capital in times of stress. So it doesn't mean hedge funds are inherently bad, but if you think bonds are going to do 5 % over the next decade, if you're investing, and there's different flavors of hedge funds, it's like Baskin-Robbins. If you're using them as a bond proxy and stay rich money, you should command some sort of premium over bonds.

38:46Pick your number, 3%, 5%. If you're not getting that out of hedge funds, if you're just getting a percent over bonds, it's probably not worth it because you don't have that ability because you're going to have a 60-day lockup with a 90-day notice. So in nine months, I can... And rest assured, there would be no gate during a market correction. That is the one time you're guaranteed not to get your money back. Exactly right. Exactly right. His model strategy was, let's say you're 60-40, is when there's a market correction, you overweight equity. So you might sell off some of those bonds, and now you're 75-25.

39:25So you're not at your long-term portfolio diversification on purpose because you believe that there's basically a panic discount to stocks that you're able to capture. How do you buy into a downturn? So usually downturns are not a day, although the liberation day was a very quick turnaround. I think it was less than 30 days from trough to, to where they were before. How do you play a crisis? So take me step by step because it's certainly better to talk about this today than, than when the crisis hits. So while I have a rational mind, how do you, how do you play that a crisis? What's the best practices?

40:04Yeah. So you want to have a game plan in advance. I think a couple of things that are helpful in that prepared mind is build a discipline process and it can be different for different organizations, different groups, and also some semblance of humility that you're not going to time it right. So I love the Cliff Asnes line, the founder of AQR, that market timing is a sin and you should sin a little. Don't think you're going to get it right. So calibrate your bets accordingly and you can move incrementally so that if you're wrong, you can lean in and have another bite at the apple. And we've created a process that we call it VFS stands for valuations, fundamentals and sentiment.

40:46And we track every major asset class on those three characteristics. And it's not a black box. This isn't Renaissance or D shot or some quant shot, but it just gives us an opportunity, a way to calibrate based upon valuation levels, various fundamental characteristics, earnings growth, profit margin, debt on the balance sheet, and the like. And then sentiment's a real thing. So is there momentum? Trying to avoid catching the falling knife or coming in too early, or conversely, taking chips off the table too quickly when things are running. Having that discipline process you can fall back to of this is who we are, this is how we invest, and this is our framework and our mental model so that you're not just sticking your thumb in the wind to try to determine what you're going to do.

41:31So building that game plan up front and saying, stick to the process. Played baseball in college. My baseball coach used to say, don't be fast, be good. So be good. Know your process. Execute it. Don't try to rush anything and stick to it in good times and bad. I think having that process, whatever it is for different investors and sticking with it, increases the odds of success and not panicking in those times of stress. Every crisis is a different flavor. history doesn't repeat, but it rhymes. The way that I would approach this very rough, and I want you to improve my model, is you want to look at how long the average crisis lasts in terms of how long it takes for stocks to go down before they start going down, like from beginning to trough.

42:17And then essentially dollar cost average over that period of time with some kind of standard deviation so that you're on average buying all the way down. And then that's kind of where you're at. So what am I missing and how would you improve that model? That's the right model in our view, high level. And then I think you can approve it by looking at not just price, but price relative to free cash flow or earnings to determine the relative attractiveness or riskiness of any asset. So price action is helpful. But if it's the equity market, you're trading at 50 times earnings and you go to 40 times, you may not want to be as aggressive if it went from trading at 20 times earnings down to 10.

43:04So there's also a historical context. There's a relative context. That's right. So I think the overlay of the fundamental component, I think, is the way to improve on that model is just pure price action. You've been at FEG for 21 years. You've seen a lot of market cycles. I've been more on the private side, so I don't check the stock market as often as probably you do. Do stock prices, when they go down, they're essentially always rebounding regardless of these qualitative metrics?

43:40At the market level, not individual companies necessarily. and some markets have been down for long periods of time. So there are value traps are real. There was a point a year or two ago where the 30-year return for the Chinese equity market was flat. 30 years is a long time to wait. So diversification is your friend. So if you can look at those markets in different pockets by region, sector, you name it, and then take that same approach at the macro level of, am I more risk on risk off of just how much is in equities and then slice and dice and use that risk budget under the hood at that next level, it will smooth out the ride.

44:31And if when you're too early or wrong in an area, you have something else that's going to be working in your portfolio. it. My personal view slash bias is that public market investors understudy politics, they kind of see it almost as exogenous, not as playing an active role in the stock market. And one of the views out there is that the government, because there's so many stockholders with S &P 500, the government and Congress, the president will never allow the stock market to go down for a long period of time. They rather cause inflation in the market. Is there any truth to this? And what are your thoughts on kind of the public policy aspect of the government having one of these levers?

45:14So the Fed doesn't control all the levers, the government does. And if there's this bipartisan incumbent view that you can't let the stock market go down, they're going to pull one of those levers. What do you think about this theory? There are certainly elements of truth to that. If you study public market returns and cycles based upon presidential cycles, as an example, and they're coming into a re-election, there's an incentive if you want to get re-elected, and most politicians do, to have more pro-growth, pro-market policies. So if you're going to do something you know the market's not going to like, do it early, right after you got elected, and they do more pro-growth in the stock market.

45:57Not always, but kind of rhymes with that approach. I think you need to be aware of it. I think it's also tough to make huge bets and be successful predicting what policy will be. But I think policy and interest rates have a massive, in the Fed, have a massive impact on the markets. So you have to, at a minimum, be aware and recognize people have incentives and what are those incentives? And if they have more influence, be it through policy or level of interest rates, that's going to have an impact. I got some numbers, by the way, to back up this theory. In 2022, the rate of incumbents running for reelection was 94 percent, 2024, 95 percent.

46:43And for Congress, House and Senate, one of the estimates is that 2024 incumbents win rate was 97 percent. And if you want to think about the most rational and calculated people on the planet, it might be quant traders and politicians. Exactly right. Exactly right. Going back to 2004 when you started at FEG, what one piece of timeless advice would you give younger Nolan there that would have either accelerated your success or helped you avoid key mistakes? Yeah. I'm going to give you two. One is from a macro investing perspective, don't fight the Fed. It's the classic Warren Buffett that interest rates are to asset prices what gravity is to the apple and don't get in the way of the Fed.

47:46the other is I was more relationships matter. I did not appreciate that as much. I was more of a introvert math geek as a kid and relationships are essential in this business to investing, finding the right partners to invest with, finding the right folks to work with. And I got there eventually, but if I would have known that and appreciated the impact of that earlier, I think it would have helped accelerate my career quicker. Don't fight the Fed. It sounds obvious, but I would argue, isn't the Fed, interest rates, and the policy priced into the assets? So what does it mean to fight the Fed and what do you want to avoid exactly?

48:29Yeah. So when interest rates went to zero after the GFC, cost of capital, incredibly low for businesses. If you took the approach, this is inherently risky. The Fed's balance sheet's ballooning. The world's coming to an end. We don't want to own risk assets. You missed out on an amazing bull run in public markets. There was a lot of risk appetite in private markets to create new businesses because it didn't take a lot of capital to start a company. So when interest rates are low, it's typically good for asset prices writ large. And conversely, when asset prices when interest rates are high that's that's tough uh for for most asset prices when look at 2022 rates go up stocks and bonds are both down double digits so i think everyone knows it but there's always a reason and a narrative and a story of like why this could be the inverse and and don't overthink or underappreciate the impact of the level of interest rates and the cost of capital i think it's something that is it's easy to forget because there's always a reason to think this time may be different.

49:41And I don't know if you'll admit it, but it seems like the strategy under something like that, where you believe that you're right about interest rates being too low and the Fed still keeping them at that point. It's basically to ride the wave, knowing that you're going to get more on the upside than you're going to lose on the downside. So you might be up 3x and then you go down 20%. And there's no way to really time that. Is that the correct predisposition or could you somehow hedge yourself in a cost-effective way? And how do you play that kind of, I would call it a cognitive dissonance in that you believe one thing, but the market believes another thing.

50:14And you've now learned not to fight the Fed, not to fight the market. Yeah, you have this kind of dual conflict in your brain. On the one hand, when that's happening, valuations probably aren't cheap. So it isn't this contrarian. It's heady balance, not overpaying for assets in this contrarian instinct with appreciating markets do cycle and there are these trends. And if you, if you jump off the bus too early, you just give up a lot of that upside. So I think I started in 04 coming out of the tech bubble and it was like, yeah, you just, you know, that was obviously a bubble. Like I didn't live through it.

50:51I didn't have to have the pain of being wrong early. It just seemed obvious that you just be contrarian and yeah, contrarian instincts are good, but you can take any good idea too far. Markets also trend, whether it's stock prices or the fundamentals of a business. If a company has 60 % margins and is growing 20 or 30 % a year, they typically don't just crater in a quarter or six months. They tend to look at NVIDIA's growth over the last handful of years. There are reasons why things trend and cycle and trying to balance a contrarian instinct, but also have an appreciation for that component of cyclicality and trends is the tension that you have to try to balance in investing.

51:30And you never get it perfect, but appreciating both exist and are real and don't lean too far one way or the other, I think, helps you avoid massive mistakes, which I think is half the battle in investing. Being in the market is very positive in those cases because you get the run-up, you get all the benefit. And then I do believe in this, not Fed put, but essentially politicians put, in that politicians will not allow the market to go down more than 20%, more than two years election cycle. That's my own personal belief. Would love to hear if you agree or not. But so you get all the upside on the on the up and then you have a temporary pain, but probably it's not going to be long lived because politicians want to win back and presidents want to win elections and politicians want to win back their seats.

52:22Why is that wrong? I think it's more right than wrong. During the initial tariff tantrum at the beginning of April, it was a little nerve-wracking. And my standard line that many of our clients heard from me is a wonderful quote from Winston Churchill that, But you can always count on Americans to do the right thing after they try everything else first. So when there's a bad policy and markets puke, they tend to find the right path. So you do have these little setbacks. And then we'll do the right thing after we've tried everything else first because no one wants to mark it down for an extended period of time, least of which politicians that need to then run again.

53:12The general reaction function of thinking that way, I think, is healthy. And then you just have to worry about the downward spiral of negative. Like tariffs could have gone horribly wrong if we stuck with it and then people react because they view tariffs are going to be negative and you can have this horrible downward spiral. So once every couple of cycles, you get these extreme pullbacks. So you don't want to just be Pollyannish and assume it can never happen. But on average, you tend to have pullbacks and then go back off to the races versus these horrible downward spirals. And the world can only end once.

53:47So betting on the end of the world. I made a big bet on Robinhood during COVID and the Sequoia round. That was exactly my thesis was, if we end up, if everyone dies, it doesn't matter. And if we don't, it's going to be a good investment. And I don't control either outcome, but this is the highly rational thing to do. And I talked to so many family offices for many years. They're like, well, obviously if Sequoia is investing, I want exposure to this. We had more allocation than we could fill. And they said, well, yeah, but now it's COVID. Or yeah, now it's tariffs. Not understanding that that event in the market is the reason this is a once in a generation opportunity.

54:27People kind of miss this, the cause and effect. For sure. Second thing that you said, relationships matter. What does that mean exactly? And what is a source of relationship alpha as a CIO managing tons of billions of dollars? You can't know everything. So you can speed up your learning curve, your ability to understand what's going on in markets, your ability to access great managers by recognizing that fact and building relationships with other folks that if you need help in an area, you have someone that you can call on and you just expedited that growth curve 10X, 100X. And you can't do it just by asking for favors all the time.

55:21You actually have to do it by being genuine and helping other people out and asking for nothing in return. So how do you build relationships? Try to be a good partner, a good actor in the community. It's a small world at the end of the day in the investing community. So get to know folks that you like, trust, respect, admire, try to understand what they're grappling with. If you can help them out, do it, ask for nothing in return. And when you're struggling with something, whatever it is, what's going on in markets, I'm trying to get, I need more lower middle market managers or early stage venture managers.

55:55Who's a smart person in that community that you can call to try to get up to speed? Can they provide an intro to someone? That connectivity is hugely powerful. And I didn't fully appreciate that when I was younger. There's a great book called The Storyteller's Secret that interviews different entrepreneurs and business owners. And one of them made the point that I love that a lot of people in business and in sales in particular to talk about ABC, always be closing. He's like, I hate that. No one likes to be closed. I don't want to close people. His mantra was ABCD, always be connecting the dots.

56:35Figure out what's going on, what dots can I connect? Who can I help? If I'm trying to figure something out, who can I call? And if you build that Rolodex, if you will, no one has Rolodexes anymore. You just increase the odds of success if you know someone that can help you out with whatever the challenges that you're facing at that point. The way that I like to think about it is how do you provide so much value that would be unreasonable for other people to help you down the road and to provide value for that? And there's actually evolutionary backing on it. So one of the reasons there's not many truly selfish people and we have this reciprocity bias.

57:10So if somebody has done a lot for you, you feel the need to do that. It actually goes back to evolutionary times where we were in a tribe and the people that just took and didn't give, they were ostracized and either they literally died out. And then, you know, the people that stayed, so our ancestors, the people are still alive. They had this reciprocity gene, more or less most of them. So it's literally hardwired in people to be reciprocal, which is if you go around and help people and are very generous, you can't even control it. People will feel this like, almost like this fight or flight feeling to help you.

57:48They're going to die if they don't help you back. So it's a cool way to live the world, live your life. It's like, how do I provide so much value that it becomes unreasonable for somebody not to help me or just in general for the network not to help me back? It's amazing. It's absolutely a real thing. And I think it's just a better way to go through life. If you're wrong, you help people out and that's not a terrible thing. And I think venture capitalists are some of the masters of this, like the concept of lead with value. I've heard many venture capitalists talk about they are, they're some of the best folks in the universe I've seen at this concept of how do you build those relationships, help people out and have that.

58:27A lot of the firms operationalize. It's the answer to how do you be at a multi-stage firm? You give, give, give and give enough value. And then when the time comes and Sequoia comes in to raise the round, the founder is going to pound their table for one or two investors. You want to be one of those two investors. And you do that through giving, not through positioning, not through marketing, not through saying that, how can I help or how much value can I bring, but actually bringing real live value that improves the value of the company. Makes sense. On that note, Nolan, thanks so much for taking your time.

59:00I'm looking forward. I'm from the Midwest. So I need to make it back to the Midwest sometime soon and sit down and continue this conversation. Would love to. Let's hope the Reds make the playoffs. You can come and watch them. We're tied right now with the Mets. So the little guy. Okay, don't threaten me with a good time. Awesome. Thanks, Nala. That's it for today's episode of How to Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week.

59:38Thank you for your continued support.