E298: How Family Offices Think About Illiquidity, Taxes, and Compounding

19:35David Weisburd:And so the outcome becomes really attractive pricing on these opportunities. The nuance in terms of what we're spending a lot of our time doing is because these secondary transactions come at a discount, some of that is capital gains. And what's really nice about how these discounts work is typically the reference date is several quarters. They happen with a several quarter lag. And so we're looking at some transactions right now that will close at the end of the year where the reference price is June 30th. And so we've been able to see how these companies have performed over almost a six-month period.

20:11David Weisburd:We've seen the interest collection over that period of time. And we've just seen a really good opportunity to buy quality loans at a discount. and then based on how gap accounting rules work. And because we're investing in private credit transactions, secondary transactions where there's a GP sponsor behind it, we then mark up the holding of that investment to the reported NAV from the underlying general.

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21:53Jeffrey Fulk:Get more with Northwest Registered Agent at northwestregisteredagent.com slash investfree. In that same vein, fixed income ETFs have been generating a lot of buzz. Why would someone go about investing into a fixed income ETF?

22:10David Weisburd:So maybe I'll break this down into two things. One, investing in ETFs. And two, why we think the ETFization of the fixed income market has created a really compelling portfolio construction argument for private credit from an asset allocation perspective. And so on the ETF side itself, the market in general loves ETF structures. They're really easy to understand. Clients can easily access it through brokerage accounts. If you were to invest in individual loans, they're oftentimes done by appointment, or then you'd have to go into a mutual fund and the mutual funds have their own issues, especially around passing through of taxes.

22:54David Weisburd:And so the ETF has become a very clean and easy way to gain access to high yield in the leveraged loan market. And I would expect that market to continue to grow. And why that is so important from our perspective is as there's been this ETFization of credit markets more broadly, there's this inherent risk that because the ETFs can be traded and traded in the same way that an equity security or an equity ETF would trade, the potential for those asset classes to collapse in correlation, especially when there's a risk-off environment where people are selling investments more broadly, the ability to kind of sell those ETFs means that investors may distinguish less between are they selling a fixed income ETF or an equity ETF.

23:48David Weisburd:And so you have this potential for volatility and the movement away from intrinsic value on the credit side to be more apparent, just given where we've gone on the ETF side. of. And I think that's super interesting within the context of how credit markets have evolved over time. So if you went back to the 80s, the correlation of a credit security to equities was typically zero to 0.2. In the 90s and 2000s, when you had kind of WorldCom and some of those credit related issues, it got as high as 0.6. Right now, we're probably running in the 0.4 to 0.5 range from a beta perspective. And so the worry there is if you get a sell-off and that beta goes to 0.8, you're not really getting diversification from your credit investment that you were hoping.

24:41David Weisburd:And so this concept of a 60-40 potentially has this correlation risk involved in it. Whereas on the private credit side, there's no risk that it can trade in that manner, the pricing is really tied to the intrinsic value and the underlying ability of that company to make its interest payments. And so even in a more difficult environment, the correlation of the private credit portfolio to an equity portfolio should be very different. And that's part of the value that we see of using private credit in a portfolio construction context. And we talk about layering private credit in as a portion of the fixed income side of an investment within a client portfolio.

25:28Jeffrey Fulk:There's so many trends to unpack in privates. One of the maybe least talked about trend in terms of the influence I believe it'll have is 401ks going into privates. What are the second order effects of 401ks, which will soon be able to invest into private assets?

25:49David Weisburd:It's a great question. We're monitoring this closely because it's moving a lot in real time. The administration just passed this democratization of private investments into 401ks. And so some of the rules haven't even been written yet. We've been talking to some of the big players in the 401k space. And it looks like, you know, there's two avenues that this is going to go down initially. And both of them are within the target date space. And so the ability to incorporate privates into target date funds is something that all of these groups are pursuing. The first way that they're looking at this, and this is something that will probably happen sooner rather than later, and we'll see groups pushing the envelope here in terms of what opportunities they can capitalize on.

26:35David Weisburd:But the mutual funds that are part of the target date funds now have more freedom to invest in private investments out of the mutual funds. And so historically, growth mutual funds would dabble a little bit in late stage private venture markets. And so you'd get a little bit of that exposure.

26:54Jeffrey Fulk:Wellington, Fidelity, that's the genesis of their entry.

26:59David Weisburd:Exactly. And now there's kind of a green light for that to expand. And so I think you're going to see more of that. I think you're going to see more of it as this concept of private companies that look more like public companies, whether it's OpenAI or Anthropic or these companies that historically would have been public, but for variety reasons aren't public now. And so I think that's kind of the first way. And then the second version of this is I think the industry is moving towards this concept of You're going to have your 2060 target date fund and you're going to have your 2060 target date fund star P or something like that.

27:38David Weisburd:That's going to be make portions of the target date investments into your traditional institutional style private managers. And so some of it will be on the private credit side. Some of it will be on the private equity side. And then basically the 401k participants are going to have this option to be able to look at which ones they prefer. And I think if it's done well, these private, the star private ones, you know, will attract dollars that way and be a really interesting addition to the 401k platforms. If you have a 2060 target date fund, so that's 35 years away, it's absurd for it to all be liquid because that's almost the number one place where you should have liquidities in your retirement account.

28:29Jeffrey Fulk:I'm actually advocating and trying to get this idea that when these funds go out to the retail market, which today is defined as$5 million plus qualified purchasers, but still a much less sophisticated audience than, say, the endowments and the pension funds. I think they should actually have the target date of when the fund ends in the actual name. So you should have ABC private equity 2035 fund. And I think there needs to be a collective effort to educate investors on just what it means to be illiquid. Because I think it's one of those things that some people don't even understand. But even when they do understand, they don't viscerally understand.

29:14Jeffrey Fulk:And they may not internalize what it means to be illiquid for 10 years. I think as much as GPs and funds can just make it as explicit as humanly possible, I think that's going to be great for the entire industry.

29:27David Weisburd:I think that makes a lot of sense. We're also seeing a lot of innovation in the evergreen structures that potentially put additional pressure on these managers to create that liquidity in very specific timelines. and the managers having to be more thoughtful around how they're constructing portfolios to be able to provide that liquidity, which I think is helpful in the 401k context, but I think it's really helpful for wealth clients to be able to access this market with the ability to tap into periodic liquidity as they need it, instead of being held captive to the private equity managers determining when they provide that liquidity.

30:04Jeffrey Fulk:What's the best use cases for evergreen funds today? What asset classes?

30:09David Weisburd:We love it in private credit because there's a fixed date when the principal gets paid back and you're getting interest payments along the way. And the interest payments along the way can be used to provide the periodic liquidity that the managers can provide to do the share repurchases on a quarterly basis. So we think that's a really good fit. We like it in private equity, but it's harder to get the visibility into the liquidity. But what's really great about the private equity side is the biggest hurdle some of our clients have with going into private equity is managing the capital calls, ramping up the exposure to the market, getting the timing right on when they're making these allocations, things of that nature.

30:54and the evergreen structure solves all of that.

30:59David Weisburd:So there's no J curve, they're participating in the market. And you take this concept of, let's just call it an 18 % IRR and you convert that purely into a multiple of money. Whereas an IRR in multiple of money can diverge quite significantly in a closed end fund depending on the timing of the cash flows. And so we like the purity of the multiple of money you're getting on your investment much more reflects your IRR.

31:27Jeffrey Fulk:It's funny because a lot of people in the institutional world will kind of look down at, well, how can you not manage your capital calls? But they forget a couple of things. One is they themselves don't have to really manage them. Usually there's back office. Some people's entire job is to actually manage capital calls. And two is to that same point, I might be investing in venture or private equity. and I might want to put in$250 ,000 into private credit. Do I want to spend 100 hours a year managing capital calls or would I rather put that in an evergreen structure? Maybe I lose 100 to 200 basis points in alpha, you could argue, which there's arguments to the contrary as well, based on fees.

32:13Jeffrey Fulk:But let's just say even I'm losing a percentage per year, I rather actually eat that percentage, pay$2 ,500 and not spend 100 hours. So I think there's something very pragmatic about not managing all this headache in assets that it's not your full-time job to manage.

32:33David Weisburd:Yeah, and then what really warps your mind is if you do lose that 200 basis points, do you actually still get a better multiple of your money because you're fully invested that whole time and get a better outcome on a dollar perspective by being in the evergreen structure?

32:51Jeffrey Fulk:several family offices have told me that they're actually having some of their clients redeem from the flagship funds or from the non-evergreen funds and invest into the same exact side by side evergreen fund as the core fund because it's just the same structure with more liquidity and lower fees what do you think about that we're hearing that trend

33:17David Weisburd:a lot as well. I think where we stand... Can you double click on that? Yes. For some of the reasons that we've already touched on in terms of the efficiency, the potential better return outcomes, the lack of operational stress, this idea that instead of re-upping in a private equity buyout fund every three years, because these managers will come to market every three years, you have to fill out your commitment documents, you have to manage the capital calls, you have to basically start with small amounts of capital called to build up your position and then take distributions and figure out what your recycling of that capital will look like over time.

33:58David Weisburd:In the evergreen structure, that's all handled for you on the back end. And if you have a really good institutional partner, they will optimize that to improve your outcome in terms of the capital efficiency of your money. And it's very hard to kind of align your distribution since you have no idea when they're coming to capital commitments. If you had a target allocation to private equity of 10%, it's very hard to manage that through a private closed-end fund. And so we're seeing groups wanting to use these evergreen structures to ensure that they're maintaining the exposure that they want to private equity or private equity buyout in this case.

34:38Jeffrey Fulk:How strong are these regulatory protections that you know that the side-by-side funds are getting similar exposure to if you were to go direct into the capital called form of the fund?

34:52David Weisburd:As an investor, I would not rely on kind of regulatory protections on this. I think I would rely on the trust that you have in the underlying general partner that you're investing with and alongside. side. We've seen this over and over again throughout various cycles that unless you choose the best practitioners and the most honorable investors, there's always the ability to kind of move things around. There's going to be reasons why that they move. You know, there's one deal that they couldn't fit in to the Evergreen Fund or things of that nature. if it's like a really good deal and, you know, there's some questionable practices happening.

35:35David Weisburd:So in the end, and especially since you're in an evergreen and you're probably going to be there for five to 10 years, you know, you need to find groups that you really trust and that are making decisions on your behalf. And you want to make sure the incentive alignment is there, that they have the incentive to make the right decisions in a lot of cases.

35:54Jeffrey Fulk:What are you seeing in the private equity market today, whether large buyouts, lower middle market, middle market? What's your read on the market today? And what do you see evolving there over the next 35 years?

36:09David Weisburd:Yeah, it's a great question. I get this all the time, because there's just been a lot of negativity around private equity. And that's especially in the buyout space. You had a lot of negativity around venture, and that seemingly has come back with some of these big deals that have been done recently. But I think what the general investing population has been thinking about buyout is you had this great run in buyout because interest rates were coming down from, call it the 90s, all the way through to 2020. You also had lower entry prices and now entry prices are higher and interest rates are higher as well.

36:50David Weisburd:but from our perspective we see these really interesting pockets of opportunity and so the first one is on the buyout side within continuation vehicles and so this idea that you can acquire trophy assets through a continuation vehicle investment these are investments that have probably been held for five for four to five years and you have the potential to make an investment in here and maybe there's a monetization event in an additional four to five years. And so we like that aspect of it. We also think that there's kind of just a scarcity value to trophy assets. And so if you're doing continuation vehicles well and acquiring these high quality assets, they inherently have some value.

37:34David Weisburd:And then the continuation vehicle has a lot of the dynamic that secondaries have in the sense that they're typically coming at a discount to the price because that's what's needed to transact on those investments. And we like it better than the secondary market because in the secondary market, you have to buy a pool of assets. And it's really hard to underwrite the entire pool of assets, whereas the continuation vehicle, in most cases are the deals that we like. You're buying a single asset and so you can really get confidence around this single asset. The second area of buyout that we like really ties back to the platform shift that we're seeing in AI.

38:10David Weisburd:And so where we see buyout really working is in the ability to add value to portfolio companies. And so there's a select group of buyout managers that are helping deliver AI solutions into their portfolio companies. And we see the ability to do what happened in the 2010 to 2020 area, which was really around cloud migration and digitalization. And so the best buyout managers during that period were groups that were really at the forefront of moving their companies into cloud and getting an edge and building moats around businesses from cloud implementation. And so the value add on the AI side is another area.

38:51David Weisburd:And then we touched briefly on this, but on the growth equity side, we like what we're calling the private magnificent 15. And so there's these really high quality companies in private markets. They probably shouldn't be private, but if we can get our clients exposure to that where they can't get it through an ETF. It's a really value-add proposition to our clients. And then on the venture side...

39:14Jeffrey Fulk:How do you access those? Those on an individual basis?

39:17David Weisburd:We do it through a combination of fund managers and co-investments are the primary ways. There's also some... We're seeing more co-investment growth equity funds where it's just four to five of these really high quality companies that their managers are creating a portfolio around. And it's actually a really unique dynamic. And it's only because of how the market's evolving. And so what you've seen is these venture deals have gotten so big that they're bigger than what a growth equity manager can invest in out of their fund. And so to be a lead investor in a large language model, you need to bring 1.5 billion to the table to lead that round.

40:02David Weisburd:And these funds were not built to be that big or to play that much capital. And so now there's a whole new kind of industry being built around how did you raise additional money to be a lead investor on some of these deals. And oftentimes it's being done as a multi-company portfolio where you can get some visibility into what the portfolio could look like. So those are the primary ways that we're accessing it.

40:27Jeffrey Fulk:I think Menlo invested$500 million via SPV alongside their fund investment, but as a co-invest$500 million to Anthropic. And I'm sure there's many others as well. If you could go back in time and give younger Jeff in 2001, as you were graduating college, one piece of advice that would have changed the trajectory of your career, what would that piece of advice be?

40:52David Weisburd:It's really pushing in harder on these pockets of opportunity that arise over the course of a career. And so, you know, the first example was in 2008, there was this whole disruption of, there was the whole credit crisis and new industries came out of that credit crisis. And, you know, when I looked at that opportunity at the time, I was kind of like, okay, there were some really good managers that navigated 2008 really well. But were they really the managers that were set up to do the best job possible going forward? Because we had just gone through this regime shift. And I had a good friend at the time that got this job offer to go into a credit fund, they were going to be doing private credit.

41:39David Weisburd:And I was just having gone through 2008, it felt to me a bit scary to kind of go into that market. and you know i was like well maybe i can introduce you into some of these other relative value funds that seem to be able to survive these markets and uh she ended up taking the job and it was fantastic right she pushed into that area of opportunity a lot of lessons and life lessons

42:02Jeffrey Fulk:people frame as almost these are the mistakes i made and this is how i would have avoided those mistakes but sometimes you can actually over learn and you become too conservative and you almost lose that beginner's mind or that kind of like overly optimistic mind that could sometimes actually be a better way of looking at opportunities than purely with a cynical mindset, which you just naturally get as you get older.

42:29David Weisburd:I think that's exactly right. And also into these new markets, everyone's learning in real time. And so, you know, as somebody that's up and coming you know, there's more room for you to grow into those markets because everyone's learning at the same time and it just becomes who has the most curiosity.

42:48Jeffrey Fulk:Well, Jeff, I've been looking forward to this. Did not disappoint. Looking forward to doing this again. And thanks so much for taking time.

42:55David Weisburd:Thank you, David. This is wonderful. I really appreciate the opportunity.

42:58Jeffrey Fulk: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. Thank you for your continued support.