E350: How Family Offices Quietly Build Generational Wealth

0:00Single-family office is in some ways much more pure of an investment arm than the multifamily office. As you start to bring in other family offices, what dilutes in terms of focus? I don't want to bemoan the multifamily office strategy. I think it's a great approach for maybe the$100 million to$500 million asset-based families, where building out their own team does get cost-prohibited. and the private banks are largely not set up to serve that cohort very well. There's a reason for it to exist. It's the specificity that comes with putting your time and attention and the team's time and attention into solving the needs and issues of one particular family.

0:45And when you start layering in five to 10 operating businesses, there's only so much resources to be spread around with lean teams. Do the principal agent problems become greater when you're dealing with multifamily offices and single family offices? Or is it the same situation where you're simply the principal is not the agency, you have this conflict? That's inherent regardless of the asset owner type. The principal agent issues get exacerbated when we commingle assets with different pools of capital that have different liquidity provisions, different time horizons, different tax situations.

1:20There's enough to do with managing the family dynamics of one family. Yeah, I don't envy the multifamily office CIOs and portfolio managers that have multiple families that they need to contend with and sources of liquidity concerns, drama issues, whatever. So TF Enterprises, you have a large single family office and you've decided to go with a TPA approach versus traditional endowment approach. Why? I call it a TPA-like kind of approach, since the textbook strategic asset allocation process doesn't allow for sufficient dynamism to be a liquidity provider in times of heightened volatility, broad market stress, which are typically the most compelling entry courts for long-term investors.

1:59While you can use strategic asset allocation to rebalance out of what's working and into what's not working relative to your targets, it really stops there. And it also, on the flip side of that, serves as a good governor against momentum, which interestingly has been the best factor trade of the last three, five years. What do you think is behind these momentum trades in the market? Is this a psychological phenomenon? Is there an economic rationale behind it? Double click on that. When you have low rates and a technical innovation breakthrough like we've had with AI, it does create a winner-take-most kind of environment that permeates beyond just big tech and plays itself out into other areas of the market.

2:40There's an anecdote I read last week where you mentioned SpaceX earlier. If SpaceX, OpenAI, Amprofic, and Google were to go public this year, once they're eligible for the conclusion of the S &P 500, concentration of the S &P 500 goes from. 40 % to 50 % of the top 10 names. The market concentration issue isn't going anywhere. And I think investors seem to be very cognizant of where those concentrations exist and how diversified they want to be relative to the go-forward prospects in those names. One of the managers I love in today's market is Brad Gerstner. So his previous podcast guest, Brad Gerstner of Altimeter.

3:16And what I love about his strategy is, first of all, he's obviously incredibly bright, but he is smart enough and humble enough not to say open AI versus Anthropic or Anthropic versus SpaceX. He's essentially indexing in a capacity constrained strategy into all the top companies, knowing that one of them is going to win. And I think when I look at a lot of errors that people make in these tech revolutions, same with the dot-com boom, is this, for lack of a better word, picking bias, where I need to pick open AI and Anthropic. I'm going to put a billion dollars into one of them. And if I'm right, obviously I do really well, but the rational investment is to put half a billion in both of them.

3:55Is that the right way to think about it or is there a flaw in that rationale? It's fascinating because even I would beat up our public equity active managers when they would pick a space to make it easy, beverages, and they don't Coke and Pepsi, right? Because they like the space. And I would always push them to defend why they wouldn't pick one because as a fee-paying client, I'm paying them to underwrite not only the subsector of the space, but also the balance sheet of the company, the governance structure, the gold-forward return prospects, the entry point, what their target return is. It does get more complicated when you look at late-stage privates, particularly the large LLMs, because the space is changing and so dynamic.

4:38And I heard Zach Krass speak, who is OpenAI's Go-To-Market head. he framed it like cheering for the newest model release is like like losing your mind for a basket made in the in the first quarter of a basketball game like they're they're going to continue to one-off one another we don't know who the ultimate winner is going to be there can be scenarios where you do have a preference for for one versus another maybe not on a product or capabilities basis but what do the customers say well who are their customers from an enterprise versus a consumer lens, you can take a view that way and say one has had much more success selling through to enterprises and actually making large language models driven by a revenue model and meeting those customers where they are.

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7:20Learn more at alpha-sense.com slash how I invest. Tell me about your single family office. how are you investing into different assets and what's your portfolio construction? I did my best to throw strategic asset allocation under the rug. That is what we use as a starting point for asset allocation. And so we really look at it from the starting point for us is a 70 % growth or equity beta late allocation, and then 30 % or spying alternatives or really anything else. And that growth bucket split between uplicks and privates. Private side has its own sub targets across strategies, but also fund structures, which we think is important as well.

7:58And then one not to be lost if you're truly being intentional about what your target returns are in cash flow profile, liquidity, et cetera. So in terms of strategies and sales, we obviously have splits between venture growth and buyout, but also primary commitments, secondary commitments and co-investments. Like most families, our public exposure is largely semi-passive tax managed, directly indexed equity, but we still maintain some active management exposure in managers that we think have a slight edge or differentiated complement to what we have in passive. The point that's lost on passive is you are betting on a benchmark right at that point.

8:31We already mentioned how concentrated the large benchmarks are. And there's issues with the small benchmarks as well. I just came off of doing a deep dive into the small and mid space. And it's evolved a ton in the last 30 years. And I think a lot of folks in our seats kind of anchor on the Fama French models and, okay, you should get a small cap premia, you're taking incremental risk, you should be compensated for that. We haven't been in the last 25 years. And so what is it about the microstructure of markets that have shifted, both on the private side and also on public, that have created that environment?

9:05Private companies are staying private longer. Private markets have evolved to create liquidity for founders and management teams that didn't necessarily exist in the same way they do today, 20, 30 years ago. And the IPOs that we do see, which were historically the growth engines for small and mid-cap indices. The IPOs are skipping those and going straight to large cap. We saw it with Palantir. We've seen it with Robinhood. We'll definitely see it with SpaceX and Andrel and Anthropik and likely OpenAI. As a result, the SMIT indices, which the quality there continues to sour because I think there is some adverse selection in the companies that choose to go public at a smaller scale, especially given the compliance and reporting costs of being a public company.

9:48And so you see a lot of profitless biotech and materials miners in that cohort. And we see that data reflected in the Russell 2000 is 40 % or so of the companies in that index are unprofitable, which is up 3x from 30 years ago. It's being intentional on what benchmarks you're choosing, if you choose to be a benchmark relative investor, and ensuring you have the types of exposure you want. Ken Fensch was my business school professor. So one of the smartest people I've ever met. I think that model was right for the last generation. But I do think small value is just fundamentally a different asset class.

10:23I had an entire podcast with this with the CIO of Hurdle Callahan, Brad Conger. And he talked about what is small value today. Small value today is companies that are fallen angels, companies that were once large value, and now just somehow are smaller and their market share has decreased. A lot of these small values are broken, go public transactions, most notably around SPACs that might have gone badly. And then what would have been great small value companies earlier, to your point, these private companies are staying private longer and oftentimes just for going to public markets. So it's not that the analysis, the five-factor analysis was wrong.

11:00It's that it was just over a different data set in a different time where it was easier to go public. Companies were going public earlier and there wasn't as many companies that had gone public that shouldn't have gone public. You know, when you go back to the 70s, 80s, 90s, private markets weren't as efficient as they are today. There wasn't trillions of dollars of dry powder sitting on the sidelines waiting either to extend the cash runways of the more venture-backed companies or to reinvigorate the private companies that were either looking at a generational transition or a management team turnover or a buyout or even looking at corporate carve-outs.

11:35I mean, the small cap indices have been starved of what their historic growth engines have been. And I mean, you could talk to small cap managers and I don't think they can argue against that sentiment. It's a pretty pervasive fact in the data. I think the basic fallacies of asset management is that people would have positive or negative tilts on asset classes as if the asset classes themselves don't have capital markets provision. So if small cap value, if everybody now agrees small cap value is bad, and this proliferates, this meme proliferates throughout institutional markets for five years, in five years, it's going to be the perfect opportunity to buy something.

12:10It'll be a buy point. Exactly. Absolutely. Yeah. Sentiment has a massive impact on multiple appreciation or degradation. And so the multiple that investors are willing to pay is going to be informed by market sentiment. And I mean, you can make the argument that once the, you know, Pharma French three-factor model came out, that that premium got squeezed to zero because investors bought into that narrative and said I should be earning 11 % to 12 % rather than 9 % to 10 % that I do have historically in large caps. But that also misses what you were alluding to, too, is the changing macro environment where you do have ample liquidity, sufficient private market participation.

12:53And then the costs and regulations of being a public company, I think it doesn't have the same shine that it had 20, 30 years ago when you talk about all the reporting requirements and stocks regulations. And it's a very different market structure today than it was 30 years ago. Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground.

13:26I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically there's something about businesses that use square they just feel more put together the experience is smoother for them and it's smoother for me as a customer square makes it easy to sell wherever your customers are in store online on your phone or even at pop-ups and everything stays synced in real time you could track sales manage inventory book appointments and see reports instantly whether you're in your shop or on the go and when you make a sell you don't have to wait days to get paid it gives you fast access to your earnings through square checking.

14:05They also have built-in tools like loyalty and marketing. Your best customers keep coming back. And right now you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest. That's S-Q-U-A-R-E dot com slash go slash how I invest. With Square, you get all the tools to run your business with none of the contracts or complexity. Run your business smarter with Square. Get started today. Support for today's episode comes from Square. The all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place.

14:38Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground. I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically. There's something about businesses that use Square, they just feel more put together. The experience is smoother for them and it's smoother for me as a customer. Square makes it easy to sell wherever your customers are, in store, online, on your phone, or even at pop-ups, and everything stays synced in real time.

15:13You could track sales, manage inventory, book appointments, and see reports instantly whether you're in your shop or on the go. And when you make a sale, you don't have to wait days to get paid. Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing. Your best customers keep coming back. And right now you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest. That's S-Q-U-A-R-E dot com slash go slash how I invest. With Square, you get all the tools to run your business with none of the contracts or complexity.

15:46Run your business smarter with Square. Get started today. Support for today's episode comes from Square, the all in one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground. I was actually thinking about this the other day when I stopped by a local cafe here. You square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically.

16:17There's something about businesses that use Square, They just feel more put together. The experience is smoother for them and it's smoother for me as a customer. Square makes it easy to sell wherever your customers are, in store, online, on your phone, or even at pop-ups, and everything stays synced in real time. You could track sales, manage inventory, book appointments, and see reports instantly whether you're in your shop or on the go. And when you make a sale, you don't have to wait days to get paid. Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing.

16:46Your best customers keep coming back. and right now you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest that's sq u a r e.com slash go slash how I invest with Square you get all the tools to run your business with none of the contracts or complexity run your business smarter with Square get started today one of the biggest trends in private markets is now the rise of the retail investor which really is the rise of the 5 million plus net worth qualified purchaser what What are the second order effects of, by some measures, the tens or even$100 trillion from qualified purchasers that are going to enter the market over the next decade?

17:26Qualified purchasers and retail capital is not going to flow into small buyout strategies. It's going to go to the KKRs and Carlyles and Blackstones of the world that have the infrastructure to accept that capital and the means to deploy it quickly and at scale. What that means from a second order effect, the small buyout managers that aren't getting the benefits of the retail inflows should see a higher bid for their assets when they take it to market to sell to the bigger fish. There's a lot of pearl clutching and hand wringing around, what is this going to mean? Is it going to drive down the cost of capital?

18:02Yeah, it will. But for the large buyout strategies, for the direct lending strategies that are uniquely set up to deploy that capital. The smaller, nichier parts of the market will even be more compelling than they are today because there's just going to be more dry powder at the top willing to take out those strategies. ties together with what you were saying around the Fama French model. Once that research came out, the institutional bid came in and bidded it up and maybe took away that alpha. And the question is, well, why won't that happen when the retail investors come in? It's because retail investors, without being disparaging, are not going to be primarily driven through first principles alpha decision-making.

18:42They're going to be driven by brand. Yeah, I think that's right. More specifically, the agents sitting between the funds and the retail investors, the RAs, multifamily offices, private banks, everybody's part of this system. They're going to be driven by telling their retail investors to access the KKR, the Blackstones of the world. On top of that, if you look at what's already happening, 95 % of funds from retail today have actually only gone to five firms, those top five firms. So it's already happening. The question is, will something change in the future? and maybe it'll probably go down to maybe 90-10.

19:18But if you think about the incentives driving the mechanisms, if you think about the bankers, the multifamily offices, are they going to want to go to their client and say, well, great, now you can invest into private equity funds, invest into KKR or Blackstone, or are they going to say, invest in this lower middle market firm? And although there are some, there are a handful of very sharp, very kind of aligned, principled private bankers, the majority are not going to stake their career on an unknown brand because one of the biases that come in is attribution bias. So let's say KKR and a lower middle market investor invest into the same exact company.

19:51Let's say it's that one company that doesn't do well. If it's KKR or Blackstone, they're going to say bad company. If it's the lower middle market firm, they're going to say bad manager. And that fundamental attribution bias is something that really distorts thinking in this part of the market. Loss abversion plays into it as well, right? As you go down market, you're going to see greater dispersion. And so loss rates are going to be higher. And that is probably the key benefit of targeting larger strategies is tighter dispersion and lower loss rates, which I think retail is uniquely situated to invest in because we see they are driven by fear and panic.

20:28What concerns me the most about it is anytime there's financial engineering or innovation that creates new ways for the mass market to access strategies where the duration of the investment and the liquidity provisions aren't aligned. we're seeing it play out in real time with the BDCs, right? And there's good reasons that a lot of those are trading down in an interval funds in the credit space. Leverage loans, right? It takes three weeks to three months to settle some leverage loan trades. Those are thought of as relatively liquid. But if my liquidity provisions and my interval funds say, I need to be able to get capital out with 30-day notice at the end of the quarter, there's a misalignment there.

21:14And then the manager is forced to sell something that's more liquid that maybe can settle in two to three days rather than two to three months. And then you have the kind of death spiral effect that we've seen anytime these structures come out where that mismatch is at the chagrin of underlying investors. So another way, if you want to be a liquidity provider, when there's a lot of liquidity, aka panic in the market, and you want to avoid being the opposite, if you're part of a highly liquid structure, that structure could itself hurt your returns by selling at the exact wrong time. Exactly. Yeah.

21:47We see it all the time in muni markets, right? You know, muni funds are historically retail driven, given the large taxable investor base there. And when there's panic in the streets, the muni funds have to sell their most liquid strategies. And so the resulting fund looks a lot junkier than it otherwise would have been if there hadn't been the run on assets. And so it's a tale that's played itself out throughout the history of financial markets. And this is just the latest iteration of it. It makes me wonder whether smart investors are going to set up funds that essentially predict this sell-off and essentially a secondary fund that take advantage of these structural disadvantages of the liquid funds.

22:22It absolutely will feed the secondary market as that continues to evolve. It's almost like this parasite swimming around a fish waiting for that fish to go to sleep. There's this meme in the market that is there even an illiquidity premium in today's market? Is there illiquidity premium in the market today? As a private markets investor, I have to believe that there is. Otherwise, why would I even bother with it? It takes way more time, resources, attention to diligence, a private strategy than it does a public strategy. It's just a fact. The cost of doing business. While the last three years, you have seen public equities in particular outperform private equity and venture in aggregate.

23:03We think over a secular horizon, there is still an illiquidity previa. And why does it exist? It's structural inefficiencies, opacity of the market, and price discovery, right? And so if capital markets were open in a way that we were seeing lots of IPOs, credit was flowing freely, there wasn't a fear or continued hand-wringing over defaults, I think that you'd see private equity and venture continue to outperform public equities. But that's not the environment that we're in today, but we don't expect that to persist. These things happen in cycles. I mean, we think over the long term, there is still an illiquidity premium to be harvested.

23:43That said, if retail capital really buys the private equity story and comes into that market en masse, perhaps that inefficiency is ground down, like we've talked about in other markets. And that premium or alpha that you thought you were getting above and beyond what's available and cheapable in other markets is squeezed. So I think that suggests for a dynamic allocation posture and maintaining a liquid bucket to ensure you can use as a funding mechanism for your private commitments. When people ask, is there a liquidity premium? I think that's fundamentally the wrong question. And the right question is, what is the right amount of capital for a specific sector or for specific manager?

24:25So you could kind of take two extremes. One is, let's say the large buyouts. I'm not going to use their names, but let's say that there's a good way for them to deploy$5 billion in capital in their strategy. if there's$50 billion in capital they're able to raise, the nicest way to put that is, at best, their alpha is diluted on a 10 to 1 basis. At worst, they're probably actually getting negative alpha. They're deploying into the marginal opportunities. And if you keep on doing that to the extreme, you're actually losing money. You're actually underperforming a liquid index. And then on the other side, because these are dynamic situations, if now you have buyouts deploying$50 billion instead of$5 billion, now you have this lower middle market where there's 10 times more demand for the same assets.