E344: How the Top Family Offices are Investing Today

0:00So Doug, you're the CIO of a$10 billion multifamily office. How should large family offices go about investing their wealth? It's a good question and tends to be part of the difference making on how we approach investing for the ultra affluent. But it comes down to a pretty simple thesis that the ultra high net worth really can and should invest more like an institution. And what I mean by that is, is that ultra net worth families have the scale, the time horizon, ordinarily a tolerance for illiquidity that's more akin to sophisticated institutional investors and less like massive fluent investors.

0:40So we at Kellan Family Office, we built a framework around that idea, and we've gathered what we think are the important elements that support the access and portfolio construction to bring those kinds of opportunities to them. And then bring it to bear inside of a taxable environment. It's interesting because I just spoke to Jason Pritzker and his grandfather started the Pritzker family and was the Gen 1 in the family. And at that point, there were 70%, 7-0 capital gains. He was working under that constraint. So he figured out, I want to invest into companies that I'm not going to flip in three years, like traditional private equity today.

1:14But what are the companies that could compound for many decades that I wouldn't have to sell that could basically compound tax-free? And then he went upstream of that. What are the kind of decisions I would make if I was investing to companies that want to compound for two, three decades and essentially came down to the right sector, the right business model, but also the right team? What kind of partner would you want for 20, 30 years? It seems very simple to think about a taxable versus non-taxable portfolio, but the downstream consequences of this one difference in the portfolios changes the portfolio dramatically.

1:45You're exactly right. And for families that have ultra affluent balances in the means and the long-term perspective, it's not uncommon to find them involved in venture capital. When you look at the preponderance of the seed investors, the angel investors, the pre-seed investors, it's not uncommon that you'll find ultra affluent families like them, among others, especially our clients that want to participate. And there's a lot of reasons for that. Obviously, there's hockey stick like growth potentials when you've unlocked something that's critical. But what most people don't quite understand is that the tax code also gives you an opportunity to take those swings.

2:21And depending on the nature of the business can qualify as a small business stock. So the category of QSBS, which is a very popular early stage category for taxable investors, can really create amazing compounding effects for early stage investors. And so what I mean by that is that if you, and I'm no tax lawyer here, but we have some on staff. But if you look at QSBS, you're able to exclude a great deal of capital gains recognition when you're in early enough. and just last year with the enhancements that came to the code through the one big beautiful bill, the threshold for how you would recognize the enterprise value of those companies and the amount that you can enjoy in games without paying taxes all went up, right?

3:07So before it was$50 million for an enterprise value of a company, now bumped up to$75 million. So that just means now the company can be larger and still qualify for that status. And then your ability to exclude a certain amount of your capital gains went up from$10 million up to$15 million. Expert calls have always been one of the most powerful ways to build conviction, but today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their TGIS call service team sources experts based on your research criteria and lets the AI interviewer get to work.

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4:58Take advantage of AlphaSense AI-led expert calls now. The first to see wins. The rest follow. Learn more at alpha-sense.com slash how I invest. Right now, you have an interesting venture environment, to say the least. How should a family office go about starting a venture book from scratch today? If you're starting from scratch, you need to have an overall game plan. And that game plan is going to lay out what we call private capital pacing. So you need to think about what's the end state of the portfolio to look like? What are the components? What are the industries? What are the geographies?

5:32And you think about how you're going to get from here to there. If it really was somebody starting from scratch and you said, boy, we'd like to get going. Typically, that will be accompanied with a desire to get to work right away. A real seasoned book takes a long time to build, takes years to build. If you're trying to jump in, then you're probably going to start with some secondary positions, and you'll probably start with some broad-based funds and try to get some capital deployed fairly quickly. But then you line up your rifle shots, and you really think about where you want to place capital and with whom and how.

6:08There's a very important decision to make, which is, are you going to lean in and be participatory with these investments or are you just allocating? And there's a big difference. For people who are serial entrepreneurs, especially former tech founders, they like to lend a hand and be involved with the investments one way or the other if they can make something happen that helps further their return or further the portfolio company. Others are saying, no, I actually just want a broad-based basket and I want to participate in the ride and I don't want to be involved. You have to answer some bigger questions before putting pen to paper, but ordinarily you have to have that final state and a pacing plan between here and there to really figure out what you're going to pull the trigger on in 26.

6:48The private capital pacing is such an underrated point for venture specifically. And there's a couple of reasons for that. One is a lot of people know about the power law and venture capital where you have one of every hundred startups accounting sometimes for 50, 60, 70 % of that basket of a hundred. But you also have high dispersion between different vintage years. So everybody's aware of the dispersion between top quartile and second and third quartile managers. But there's also dispersion in years where the top quartile sometimes during difficult times is 4%, 7%, 10 % versus in boom times it can be over 40 % on the IRR basis.

7:20So making sure that you're diversified by vintage year is really critical for venture capital specifically. I've had different people say different numbers on that. It seems like there's a consensus that if you're in six different vintage years, you're doing pretty good from a diversification standpoint. And then the second aspect of capital pacing that's very underrated unless you've been investing in funds is one is, of course, you have to manage the capital calls. Sometimes you have 10%, 20 % being called on the first year, and then it could take up to three, four years for other capital to be deployed.

7:48If you don't invest into the next fund and the fund's doing well, there's a reputational aspect to that where, A, you're not going to get access to that fund again, but also GPs talk to each other and it'll be harder to build a platform. So having this capital pacing model for venture specifically is extremely hard. And a lot of people don't even think about their capital pacing model in venture, which is not advised. If you said how many vintage years, our canned answer would say seven, but it's not much different from six. But there are some people who think that vintage is just between this year and next year.

8:18And it's like, that's not the right answer. But you're right. There's a couple of things have been happening. First of all, you do end up with these episodic moments that just hit all capital markets and there's nothing anybody can do about it. When you look at the vintage years of 21 through 23, and you have COVID in the middle of all that, it's a very different experience versus somebody who was fortunate to maybe be allocating between 2012 and 2015. So it's a very different set of experiences. And to your point, you need to stay at the plate, you need to be able to continue to play inning after inning.

8:47Because when you walk away, you just never know when you miss the grand slam home run. And you don't, that makes all the difference. And I've looked at the Cambridge data, it's not always the case, but I'd say 80 plus percentage of the time, the best vent vintages do actually follow the worst vintages. It's even more brutal than the stock market, where if you actually sell at the bottom, you have this V-shaped recovery, but in venture, sometimes it's even more pronounced. And the intuition behind that is pretty simple, which is when you have sharp downturns, a lot of capital leaves the space for the same reasons.

9:18They don't want to continue investing in asset class that's on the low. And then the valuations go lower, people invest, and then they re-normalize. And then the opposite happens as well. I think venture had like a 13 year bull run or something crazy like that from 2008 to 2022. And then of course, so much of what's known derogatorily as VC tourists came in, started putting in so much money into companies like WeWork at the exact wrong time. And then obviously they lost that money as well. So there's this momentum trade and venture that's a little bit less prominent because it's vintage by vintage, but still kind of follows those same principles.

9:54There are definitely Hall of Fame periods, and those come right after the tragic periods. So I remember after the dot-com era, everything that started in 99 and 2000, you felt great when you got your money back. But boy, when you started to lean into the space, call it 2003 through 2006, it just seemed like everything you touched turned into gold. So same thing, post-financial crisis, everyone was limping around. But if you had the fortitude to continue to keep swinging at it, you saw amazing results in the late 2018, 19 into 20. And to your point, that draws in capital that maybe have been misguided.

10:30We're living in a time right now when you need the same level of fortitude. And it's difficult because there are some things that have happened that have been discouraging to investors either in the early or even late stage growth. There's been a combination of effects. Number one, the DPIs that are coming out from the funds have been historically low. And so for a lot of folks, they like to see capital get recycled. Well, when you're not getting the cash flows back, you're not able to recycle as much. You're kind of at a push decision. What are you going to do? The second thing that has happened is a number of these companies have been so dramatically successful that they decided not to go public.

11:06So it's not the MAG 7, it's the Magnificent 15, but they're all private. And I think people have really mixed responses to that. Did you need the liquidity or did you want the growth? And so for those who have their piece of Databricks or XAI or maybe SpaceX, I mean, there's so many that you can participate and be in the growth. And I think, frankly, people probably need to start re-underwriting their thought process regarding continuation products or SPVs that just participate in individual names. And the reason is because if Airbnb is any sign of the times, it achieved most of its value while it was private.

11:41When it came public, it went down. It's only just now getting back to where it was. or it had. So the times have changed. And I think people have to view the landscape quite differently just to pivot and create a match and compare. One of the things that we often help educate for anyone who's new to private equity investing or private company investing in the early part of my career, I remember when there really was 5 ,000 stocks in the Wilshire 5 ,000, it hasn't been above 4 ,500 in three decades. And so it's an ever shrinking resource of public equity. And yet during that same period of time, if you said how many private companies have had some form of transaction, either in equity debt, it's north of 50 ,000, it's a 10X.

12:20So you really do have a much broader swath of opportunity, pre-seeing more talented management teams, more innovation for sure, significantly greater flexibility. And so I think everyone has to rethink how they approach public and private markets. But in that vein, once you come to grips with those facts, then you realize you can't really afford to leave the plate if you want capital to grow over time. I got a stat for you. 50 % of funds from 2020 vintage venture capital funds have under a 0.1x DPI. So have given back less than 10%. This is six years in. So there is a DPI crisis. Taking a step back, I think oftentimes great ideas start out great.

13:01David Swenson came up with this private asset allocation model, but it was in the 80s. And then people, instead of realizing that it was a model for the 80s, 90s, 2000, they just take it at a basis without thinking about it from first principles. And if you stick to the same model while the market is changing, you might have unintended consequences. I'll give you a couple examples. One is you mentioned small cap value. I had the CIO of Hurdle Callahan, Brad Conger. And one of the things that he believes is that actually small cap value, the companies that are small in the public markets are fundamentally different types of companies than they were several decades ago.

13:36They might be SPAC targets that have gone down. They might be fallen angels, large companies that are now small companies. And to your point, some of those companies that would before be small companies today are just large private companies, almost to an extreme where you have now SpaceX and maybe Anthropic will be listing immediately into these indexes. So it's immediately as a large company. So you have to step back and think, okay, maybe 60-40, maybe a largely private portfolio. Maybe that still makes sense. But when you double click on it, what assets am I actually buying? When you invest, you should be thinking about what do I own versus what I allocate?

14:07So you really want to think about the underlying assets. What am I buying? Sometimes public companies today are a hundredth or a thousandth of the valuation of a private company. So are you really more risk on when you're in the private than the public market? And just rethinking these from first principles, it's not an easy task, but it's something that I encourage everybody to do. No, you're correct. And we were pretty big fans of Swenson. He was involved with our group several times in the past. And the first principles of investing do need to be revisited. I think one of the things that's been so disingenuous to your point have been all of the labels that I think people like to put on things and calling something an asset class or calling something a strategy.

14:51But the truth of the matter is there's really only two asset classes. There's really only debt and equity. There really isn't a third. And when you realize that you're in one of two camps, you're either in a camp that has defined cash flows like debentures and fixed income products, or you're in an undefined cash flow and you're an owner of or a claim of owner on future cash flows and earnings. And so there's no third door. And I think people mistake different ideas and say, well, this is just an asset class or this is that and the other. And be like, nope, actually, you just own equity or you just own debt.

15:22They wake up one day and say, oh, this didn't behave according to some historical pattern. and they get disappointed and be like, well, it's because the business didn't do well or the cash flows were interrupted or something that's pretty foundational and they struggle with it. I agree with you. There needs to be a wholesale renewal back to the basics so that we call things and label things more accurately. And I'll tell you where that's most apparent is the mislabeling of risk because risk does come in multiple forms and it can you do have different types of boogeymen that are out there that will come out and destroy return or threaten capital.

16:02And I find that when people move away from the basics, those risks have a better chance of creating impact. The worst thing you could do is to take equity-like risk with debt-like returns. That's waiting for the market to turn against you. I don't know how that could possibly work over the long term. That's a good quote. And frankly, I think that's what you're seeing or has happened in private credit. I think people thought you have these elevated cash flows, what could possibly go wrong? And then they realize, oh, wait a minute, these companies, they're not guaranteed that that coupon payment can go down.

16:38And so I think the fact that you've seen default rates rising in America and then not to go too far afield, but just the rise in LMEs and people don't even know what a liquidity management exercise even means, but it's default in another label. And those have been rising as well over the last year or so. So I think you're watching this unfold right in front of us with private credit and the knock-on effect that came from all the deregulation that happened post the financial crisis. And it sort of ushered in this whole new wave. I think we're encroaching on$2 trillion in private credit. And that was all in exchange for middle market lending that used to be done by banks.

17:15And so it's a whole different set of rules, a whole different set of outcomes. And I think people have viewed it as just elevated money market. And it's the furthest thing from that. It's truly an equity type position and you're exposed to very material risks. And I think people are waking up to that right now. Dell PCs with Intel inside are built for the moments that matter. For the moments you plan and the ones you don't. Built for the busy days that turn into all night study sessions. The moment you're working from a cafe and realize every outlet's taken. The times you're deep in your flow and the absolute last thing you need is an auto update throwing off your momentum.

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19:57Download the Plus500 app. Trading and futures involves the risk of loss. This is not suitable for everyone. Not all applicants will qualify. Put a cap on the David Swenson discussion. Obviously, Swenson was revolutionary at the time, but there's one key difference. The Swenson model was based on one assumption that was true for many decades, roughly a 24 % DPI per year. 2024 was 9%, 2025 again was 9%. When your cash going back is two and a half times smaller than your cash going in, the model breaks. That's the fundamental issue. If you don't have cash coming in, the private markets cannot function the same way.

20:33If that continues, let's just assume that continues for now. What needs to change in the private market? And what do you think will be the new normal if a 9 % DPI continues? One of the big new normals that will come out of this one way or the other is just more free exchange of positions in the private markets. It can't be as difficult or as cumbersome, really, to exchange private company interests. Today, it's more accessible than it used to be. But you need to have price discovery in a more fluid way so that different parties can come to the table and reposition, reallocate, sell and buy private company and private capital interests in a more fluid environment.

21:15You've seen multiple online exchanges crop up. I think you've seen some of the big exchanges try to create secondary markets. That whole effort needs to be supercharged. And I think it will be. And I think you'll bring down the barriers of participation and you'll create more price discovery, more liquidity and more free exchanging of positions. And there will be some safeguards around that as well. But I do think that that will help. At the same time, I think trying to readdress some of the incentives that have pushed companies towards remaining private and not issuing to a public exchange. I think some of those inhibitors and obstacles will be addressed.

21:52I'm hoping that they will be in the near term so that companies do want to come public and make their equity more broadly available and with that come with greater transparency to everybody. So I think you have a combination of elements. I think public exchanges may have a breath of new life with policy reform, but I also believe that the private markets will self-cure themselves and continue to foster these private exchanges. I have a personal theory I'm working on. I want you to poke holes in it. I want you to improve my theory. I believe that continuation vehicles are coming to venture capital, and I'll explain why.

22:25First of all, continuation vehicles as a whole, they're growing quite fast. They just passed$100 billion. dollars. TBG, I had Michael Woolhouse, who has a$1.9 billion fund focusing on continuation vehicles in buyout opportunities. He's so inundated with opportunities that he's literally reaching out to his competitors to co-invest with him, which is a sign usually of a lot of supply. But here are the factors why I think continuation vehicles are coming to venture. One is many funds, not the top 10 funds and the large funds, but are having an existential crisis where if they don't bring back DPI to their LPs, they're either on their last fund or they're never going to raise another fund.

23:00So continuation vehicles themselves are considered officially a secondary. So they generate DPI. So you do a continuation vehicles, you show DPI, and now you could go out and market it. Two, it's around the same issue of DPI. If you're an LP that's back to fund in SpaceX, for example, you might be in there for 15, 20 years. And sure, it's great to have a 15, 20 X on paper. But at some point, LPs are going to demand that. And because now it's a buyer's market in terms of LPs dictating to GPs what they want. I feel like there is going to be some pressure from LPs to GPs. And then thirdly, of course, I just love continuation vehicles.

23:35I'm just going to reveal my bias. I have no economic stake in them, but I just think there's a lot of interesting aspects of it. I think it's maybe an A - solve for DPI for LPs as well. And then also a lot of GPs have a lot of asymmetric information, especially if they're on the boards of these companies. So I think it's a very interesting asset class for outside investors. I think what needs to happen. One of the things that really creates this liquidity on the buyout side is that you have now that this whole system of investment banks are coming in and doing these, raising these funds for them.