E310: The DPI Problem Plaguing Venture Capital & PE

15:22Alex Ambroz:And then it feeds upon itself. The private companies want to partner with the largest firms because that gives them in turn access to a great network and great capabilities to grow as a private company.

15:33David Weisburd:the very top gps in the world what are they looking for from allocators the first thing

15:39Alex Ambroz:is an understanding of the firm's mission the private asset firm's mission you know the goal that they have as an investor and is there an alignment of that understanding because the key as well from the allocator's perspective and what the firm wants is not just an investment in this fund, but an investment in the next one and the next one after that. And almost always a growing investment in fund three and then a larger investment in fund four. The other aspect of it as well is that the private asset fund managers, the firms that are going to allocate is the GPs. They're looking for great partners with which they can have great conversations, great support and looking for help of, you know, hey, we're raising this next fund.

16:22Alex Ambroz:Would you serve as a character witness for the quality of us as an investment firm and for us as a team. So each side are looking for great partners.

16:32David Weisburd:When it comes to these CV opportunities, what are the best practices that allocators should use in order to decide whether they should invest?

16:38Alex Ambroz:The key thing is, does this align with the allocator's goals for the portfolio? Do they have the ability to continue to withstand the illiquid nature of this continuation vehicle? And so if you had mapped out in your cash flow pacing model that you were expecting, for example, 10 years of, you know, about three to five years of the investment period, and then between five to 10 years of the harvest period, and we're late into that harvest period. And now the underlying firm is telling you that instead of harvesting an asset or some of these assets, we're instead going to put them in the continuation vehicle.

17:17Alex Ambroz:And maybe that is exactly what the firm thinks is the best thing to do for these underlying companies because there's unrealized value. But from an allocator's perspective, not just trusting what the fund is saying and trusting what the team is doing, but also their ability to continue to withstand that illiquidity.

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19:25David Weisburd:Why do you think that hasn't made its way into the endowment foundation pension fund market where these are some of the best counterparties that you can have from a credit risk? Why aren't more allocators borrowing against their private book?

19:39Alex Ambroz:That is a spicy question. That's a great question. I'll give you a simple answer to it, which accounts for a huge swath of them. Number one, they're not allowed. It might be written into their legal documentation, usually their investment policy statement, that any type of borrowing at the institutional level. So they recognize that there's a lot of leverage in a lot of the underlying investment strategies with which they're working. But borrowing for any purpose at the institution level is almost not allowed. This is usually also reflective of the fact that a lot of institutions, so think of health foundations or university endowments, they may already be in the debt markets themselves.

20:16Alex Ambroz:And that debt market borrowing, they're usually, so for example, a healthcare foundation may put out a municipal bond and they're getting a decent credit rating because they, as a sophisticated business, have very good credit quality. And so therefore they're able to borrow great rates, but that's for the institution themselves. The endowment or the foundation pool for our healthcare system may be a large part of the balance sheet, but the institution may be precluded legally from borrowing on that part of the balance sheet. The other side of it, in all honesty, is, you know, a lack of exposure in borrowing from that part of the portfolio or thinking about borrowing from that perspective of the portfolio because of an understanding that historically crises when they happen, you know, bubbles when they pop, almost always don't pop because of valuations.

21:06Alex Ambroz:Bubbles almost always pop because of leverage. And if your underlying investment portfolio already has some baked in leverage, adding more, maybe detrimental, maybe adding a little bit more risk for quasi incremental return.

21:18David Weisburd:Is the lack of liquidity in private markets and allocators, portfolios a moment in time, or is this a new normal?

21:26Alex Ambroz:It feels like we've moved to this new normal of large private companies with billions and billions of dollars in revenue, established companies with hundreds, if not thousands of employees. Think of a company like Stripe, two Irish brothers moved to America, built one of the largest and most successful payment processing firms. They've been around forever, over 10 years. Normally back in the 80s and the 90s, early 2000s, they would have already had an IPO. But there's a lot of commitments when you have an IPO, a lot of new governance structures you have to put in place, a lot of new governance requirements.

22:00Alex Ambroz:And so this whole conundrum of private is the new public seems to have taken hold. And there don't seem to be any material forces pushing back against that.

22:10David Weisburd:Do you know the origin of the four-year vesting schedule for startup employees?

22:15Alex Ambroz:The numbers are easy, 25 % a year over four years.

22:18David Weisburd:Four years used to be the expected timeline to go from private to going public. I wish that we could see more of that today. To give you a sense for how much we've drifted from the original assumptions really going back to the 90s. We went from four years to now really 14 years. This kind of feels like a new normal. I remember in 2012 when Facebook went

22:39Alex Ambroz:public and I was working at JP Morgan. We were part of the desk that was distributing shares to ultra high net worth and high net worth individuals, institutions that were looking for shares of this IPO. And it was a big deal. That had taken a while for them. They'd done so well. And we were so grateful to be part of the team that was leading that IPO. But yeah, I don't know what changes because the benefits are so diffuse in terms of the allocators asking for it that it's hard to get them together as a group and advocate for it. Whereas the benefits to the private firms and the private funds that are managing this are so tight that it may continue like this for a long time.

23:14David Weisburd:Assuming this is the new normal, what decisions upstream should allocators be making in order to prepare for this new normal in their portfolio?

23:22Alex Ambroz:All allocators need to adjust models to acknowledge the fact that the expected distributions, the models that we had for years handed to us from David Swenson's team at Yale over 25 years ago, that these models of the expected timeline of distributions from all private assets need to be stretched out further. The only asset class in a private perspective where we're seeing distributions stay approximately in line with expectations is private credit. So private credit has historically been the one private asset class with a very short call down schedule and a very short distribution schedule. And that seems to be sticking to history.

23:58Alex Ambroz:So for the last 25 years or so, it's had approximately a decent 24 % distribution yield. And for the last couple of years, it's still around 22, 24%. This is in stark contrast to private equity, buyouts, and to venture capital, where the distribution yield has dropped to low double digits, if not high single digits. So number one, for all allocators, adjust the models to acknowledge the fact that the illiquid part of your portfolio is going to remain illiquid for longer than you thought.

24:26David Weisburd:A lot of people are looking towards 2026 liquidity via IPOs almost as the savior in their portfolio. And although it might help minimize some of the issues in the short term, I think you have to take a step back and look at what are the incentives that are driving private marks and private assets to stay private longer. I think the incentives are obviously on the asset level. These assets want to stay private longer. It's only become more and more difficult to become a public company. You have to deal with a quarter by quarter scrutiny, which, in my opinion, is value destructive. And two is you have to look at these other factors like CVs.

25:06David Weisburd:I think CVs have now reached$100 billion. I think CVs are here to stay for many of the reasons that we talked about. and a great IPO run may even solve issues for one to two years. But if you're starting to deploy in the next vintage for the next 10 to 15 years, you should not rely on a hot bull IPO market. I think you really have to look at the decisions of this new normal and of all these players and how their incentives are aligning because in many ways, allocators are at the mercy of the incentives of GPs and GPs are at the mercy on the incentives of the portfolio companies. Obviously, everybody has leverage and everybody has some power in the market, but ultimately the decision lies with the underlying asset.

25:48Alex Ambroz:100%. And I would just summarize that to something you hinted at, which is why. Why go public? In the past, private firms would go public to raise capital, to help with their expansion needs, to help recognize the entrepreneurs that started the company financially. But if you can get that in a secondaries market, because you're doing another series round for your private investment firm or your private company, and you can raise the capital on all the capital that you need on the private markets, then why deal with the hassle publicly?

26:18David Weisburd:There is a silver lining here, if we assume that this is a new normal. And that is that there may be the comeback of the liquidity premium. As more capital has come in and as liquidity has become more and more of a thing, some argue that the illiquidity premium has gone down. If the opposite happens and now the new normal is that it's 10 to 14 years, the institutions, which primarily are these endowments and foundations and to degree pension funds are able to hold for that long. They should be the natural beneficiary of this lack of liquidity.

26:49Alex Ambroz:As long as they demand it. So if your assets are going to be illiquid for longer, then this illiquidity premium historically was based on a given understanding of a capital call and distribution schedule. But if that distribution schedule is going to be pushed out longer and longer, well, then we should get a greater and greater return from it. Otherwise, our IRRs are going to deteriorate over time. Talk to me about private marks. Oh, very controversial. Very controversial. Thankfully, most firms have very serious third-party valuation processes that they use. And a lot of times, something that we see with a lot of allocators is they have a good understanding of the private investment company.

27:30Alex Ambroz:So the underlying companies with which they're invested in a venture capital or private equity fund. Sometimes there's investments from other firms. And so you'll see marks. So Kleiner Perkins has a valuation. A16Z has a valuation. Everyone has a valuation. And so hopefully these guys are all in line with each other. There's sometimes differences. Fidelity, for example, sometimes will have a very stark difference between how they're marking it on their books relative to how Silicon Valley may be marking the exact same company. But most of the companies are keeping their heads above water because ultimately they want to maintain what is their most important asset in the industry, especially with allocators, and that's their reputation.

28:09David Weisburd:Professor Steve Gafflin, previous guest, did a study on this. And he found that the bigger funds, the more traditional and established funds had a more conservative marking than the emerging managers in that the emerging managers wanted to maybe mark a little bit more aggressively, hoping to land into the next fundraising cycle. Whereas the more established firms really focused on the long-term relationship with the LPs more. That's what the numbers showed. So that sounds right.

28:37Alex Ambroz:And that feels right too, because the newer firms have to establish themselves and are just trying to raise fund two or fund three. And so, you know, by their nature, it might be a little bit more aggressive. But the larger, more established firms, they don't need your money. There's a line out the door waiting to invest. So they can be much more conservative in their marks.

28:55David Weisburd:Talk to me about why there's not more pressure from LPs towards GPs to mark down their books.

29:01Alex Ambroz:Partly it's because if the LPs pressure them to mark it down to maybe what the LPs think it should appropriately be in one part. Well, that would mean acknowledging that the LP's performance is also going to drop. And they have to explain that to their investment committee, to their trustees, to some politically exposed persons. If there are political appointees to a pension, that can be a difficult conversation. And in some cases in the past, performance calculation updates have led to people losing their jobs. So not a conversation you want to have sometimes. But the other part about it is much more functional from an LP's perspective of what is their role in managing a portfolio of assets.

29:37Alex Ambroz:And their role is finding, evaluating, investing, trusting GPs, trusting the investment managers and their processes. Their roles as LPs are not securities analysts. They're not valuation analysts. And so they may think it from a big picture perspective, but just historically and professionally, it's not something that they're always comfortable with doing. Even if, And I remember sitting around table joking, seeing in 2018, 2019, I'll never forget, there was a 2006 vintage year fund that was still being marked at 1x on the book, you know, 10, 15 years later with no distributions. And we used to joke about it.

30:13David Weisburd:You know, what are these guys doing? When are they ever going to give up the ghost?

30:15Alex Ambroz:But a large part of the LPGP relationship is trust in the separation of duties.

30:23David Weisburd:And there's also career management aspects to this on the LP side. Tell me about that.

30:26Alex Ambroz:Most senior investors working at an allocator, I saw somewhere that their average tenure working at a given allocator may be between five to seven years. And if you're making investment decisions, you're locking up capital with a private equity or venture capital fund that's expected to be on paper 10 years plus optional two one-year extensions. Great. That's, you know, at least approximately a 10-year life on that investment. And if there are continuation vehicles and it just keeps going, well, we may never see the end of that fund. But it may not matter to you because you're already working at your next role.

31:00Alex Ambroz:And so the outcome of the investment decisions you made at the prior place, you never actually get to see how they fully played out. It is rare to see a senior investor, any allocator who stays in one place their entire career. The David Swenson's, the Dean Takahashi's of the world were rare in their time and are rare still today.

31:19David Weisburd:What are some other ways that there's a principal agent problem between the allocator and the pool of capital that they're managing?

31:27Alex Ambroz:The biggest thing for the allocator is the risk that they're taking in the portfolio and their understanding of the managers is so much deeper because they're in the markets every day. They're seeing what's going on in the news and they're making investments that they think in the decision that they're making are the best ones from a fund perspective, from an allocation perspective, from the asset class perspective. But from the institution side, the institution is forever. And so if there is incentive compensation involved, then there might be an incentive to have great performance this year for the next couple of years.

32:01Alex Ambroz:But if the incentive performance compensation is based upon relative performance, not realized relative performance, then there can be an incentive to make lots of illiquid private investment decisions that may not pan out at the end of the day. It's tough, though, because everyone I've met, at least in my career, from an allocator's perspective and almost all of the funds that I've met with are sincere, hardworking, dedicated investment professionals doing their absolute best. it is rare. It is rare, especially today. So you might meet some sketchy or shady people or interesting people back in the early 2000s.

32:39David Weisburd:But post Bernie Madoff, post Amaranth, post Bayou,

32:42Alex Ambroz:post Galleon, post all of the frauds and the blowups that we saw in the 2000 to 2010s, they are much, much more rare today. Something like what happened with Ken Leach at WAMCO is almost unbelievable because so many processes and procedures have been put in place to prevent any bad actors. So for the most part, the LPs are trying to work in the best interest of the institution. The investment office, the team themselves are trying to work in the best interest of the institution itself.

33:08David Weisburd:We started talking about AI tools and whether they'll replace us. The last time we chatted, you mentioned Mike Trotsky of MassPrem recently said that AI tools can be used to outsource work, but not to outsource thinking. What do you think he meant by that?

33:22Alex Ambroz:Yeah, I thought it was a great quote. One fun fact, almost no one who has joined the MassPrem team has ever left, which speaks to the quality of the work and the quality of the people that they work with. But his quote about AI tools and outsourcing thinking, you know, we can outsource a lot of work. So AI tools, I'll give you a few examples of where we see allocators using them. They can be useful, but we can't just offload the most important part about being an allocator, which is the analysis side, what we're doing up here in analyzing the markets, the investments, the firms, the people, everything.

33:55So AI, as an example, on talent and recruiting,

33:59Alex Ambroz:it's made things a little bit more difficult. So back in the old days, meaning just a few years ago, you'd get a lot of different and a spectrum of the quality of resumes. But now everyone can use an AI tool to have a perfect resume. In operational efficiency, it's really helped. This has been one of the greatest places that AI has come into play for allocators and for a lot of other folks. So for example, it will take notes for you. It will take meeting minutes. It will draft emails. It will sort all of the incoming files that come in. So it's allowed you to not have to do a lot of the drudgery work.

34:30Alex Ambroz:The key phrase that we had at the Cleveland Clinic when I worked there was maximum value per unit of effort, max view. So max view, in terms of operational efficiency for an office, means that a managing director, for example, should always, for the most part, be doing managing director work. And if there's something that the managing director or the CIO is doing that could be done by an analyst or an intern or could be offloaded to a third-party tool, then we should go for that.

34:55David Weisburd:And AI tools really help with that. So before we started recording today, you said that the five-factor analysis could be completed in under a minute. How can investors very quickly ascertain the factors in their investment?

35:10Alex Ambroz:The first thing I tell you, and this is, I just want to reference a great white paper that all allocators should take a look at, which is from Barbara Huang and Odeon 2019. And one of the key things they found, and I've seen this my whole career,

35:22David Weisburd:is that a lot of Alex Bader performance and risk factors,

35:25Alex Ambroz:do me a quick favor.

35:26David Weisburd: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. We're highlighting the first factor

35:36Alex Ambroz:that was really discovered and understood in factor model analysis. But we're ignoring every other factor research, every other factor insight that's come out since then. And this white paper that I mentioned, Barber 2019, they noted that almost all allocators, almost all investors, they pay attention to beta, cap M, first factor, but they ignore every other factor. And Fama French came out with a three-factor model and then they expanded it with a five-factor model. And there are tools, portfoliovisualizer.com, finpilot.ai, Excel, where you can run this five-factor model research. You can get all the data for free.

36:12Alex Ambroz:Fama French still put it on their website for free. you can run it within minutes for a given fund. The key insight though, from this white paper was that nobody's doing this. They are not running this research and they're relying just on the CAPM beta and attenuating to alpha, what is actually beta? What is actually factor exposures from the other four factors?

36:36David Weisburd:On that note, Alex, it's been absolute masterclass. Thanks so much for jumping on. Looking forward to doing this again soon. Thanks so much for coming on.

36:43Alex Ambroz:Absolutely. So good to see you, David.