E412: UPENN Endowment: Why AI Will Create a New Generation of PE & VC Firms

30:22But in the perfect world, you can front run that process and you don't do that last fund where suddenly the business model was broken, the AOM was too big or the partners weren't quite as focused or the successful planning never happened, et cetera. And that already got competed away with something new because you've always been open to something new. Reminds me what Mel Williams told me is that when he gets net new capital, everything competes for his, I believe, 11 core managers. And the best thing most of the time is more money into those managers. Once you have alpha, you just pour as much capital as you can.

30:56Obviously, you have to build a portfolio, but alpha is just so scarce. Sometimes it's not just looking for something new. That makes sense to me. Both in my venture and buy-out portfolio, our top 10 relationships speak for the vast majority of our capital and uncalled capital. But they don't start off in a top 10 position. They grew into it. One, because we got more familiar, because successful firms tend to build on that success and we have quite a lot. It's a Stanley Drunkenmiller, invest and investigate, write a small check. And as you gain more conviction, you... I'm not sure I fully agree with this.

31:27Tell me more. And there are very, we have peers who've been very successful in this, but sort of this farm team approach, plant a lot of seeds and then really double down. One, I don't think that makes us a great partner. So just from a... You're an optionality. They're an optionality when really what we should be is their cornerstone. And really, I mean, we're really good at supporting young organizations in franchise building, right? I think a lot of investors who are raising Fund One totally underestimate how complicated it is to build an investment organization. and I always say you run an operating company first and a pool of capital second and hopefully we can be really helpful to you in that operating company building phase and at some point they're really good at it and they don't need our support to the same degree.

32:16If you have a farm team it is very hard to build that kind of relationship because you just can't spend that much time and it's like they're always on probation. So I think generally speaking we want to write a high conviction check from day one on I'm still over diversified it is I'm far away from being over concentrated so I can afford to do that it raises the bar for me on when to pull the trigger it is if I had the option to write a whole bunch of little checks and see how it goes it is very very hard to maintain the investment discipline all fronts so I would rather have a high bar make it really difficult to get into my portfolio then things slip in you have a rising star on your team you're like i'm not sure about this but they're really excited about let's write a small check there's some really difficult dynamics to contend with when you support for today's episode comes from square the all-in-one way for business owners to take payments book appointments man 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.

33:29I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Check out is fast, receipts are instant, 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.

33:59And 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 so 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.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, man staff, and keep everything running in one place.

34:32Whether 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. Check out is fast, receipts are instant, 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.

34:58In-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 so 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.com slash go slash how I invest.

35:28With 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, man 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. They use Square and everything just works.

35:55Check out as fast, receipts are instant. 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 sale, you don't have to wait days to get paid.

36:22Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing so 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. This over-diversification, it's a common investment theme. I had a former investor from the Cornell Endowment explain it that a lot of investors were actually double diversifying.

36:58So they want diversification on the portfolio level, but they also want on the manager level because they're so sensitive towards any one manager not doing well. Do you think in general, LPs double diversified versus looking at it as a complete portfolio? This is absolutely true. I sit on over 40 LPACs. And I can't tell you how many times LPs are asked a question of diversification within one manager's fund. And I'm like, why do you care? I mean, I get that the manager doesn't want to put all their eggs in one basket or too few eggs in their basket. I want conviction. That's all I'm looking for.

37:41And if my manager comes to me and says they want to put 40 % of their fund and they have a big GP commitment into one deal, I love it. But even with having sort of that approach to conviction and concentration, when I look across all my relationships, and we don't have very many relationships, we're over diversified. And really, you should not look at just your asset class, you should think of diversification. If you do your job really, really well, and you have our type of setup, diversification should be just on the endowment level across all asset classes, It's really hard to do, but that should be sort of the real goal.

38:17So I love co-investing not because we might pay a little less fees and carry. I like co-investing for a couple of reasons, one of which is I can get really big look-through positions into some of the highest conviction companies of my partners, and I'm okay. We have a couple of businesses that are 1%, 2%, 3 % of our entire endowment, and I can live with that. Most LPs can't. I saw a headline, UNC endowment was 10 % in SpaceX because it had gone up some absurd amount and everybody saw it as a crisis. I thought, what a great investment. Don't spend that money before you've harvested it. But I mean, it's a good problem.

38:57It's a wonderful, I mean, that's why you're in venture, right? In venture, you can get these outsized returns that can be transformative for a pool of capital like that. So it's a luxury problem. there's some sort of endowment management and portfolio management things you have to work through on the interim spaces until you've sort of fully harvested that position. But I mean, good for them to have that problem, right? Concentration versus diversification. Why concentrated portfolios on average outperform overly diversified portfolios? And my understanding of this is the way that I explained it on the most simple level is if you're a manager and you're looking at 250 opportunities in a year, you have a top 10 opportunity set.

39:42And within that top 100, you have these top 10 that you really like. And even within that 10, you have the top three that you really like. If I'm forcing you as an LP to invest into 15, your average, you're going to go down to your number 12, 13, 14, 15th position versus if you have a portfolio of 10, you get to pick your top 10. Is that really what it comes down to or is there more to it? You have to believe that you select better in a continuity your portfolio. Otherwise, it doesn't change your returns, right? You actually know which part of your portfolio is better. If every deal did the same, it doesn't matter if you have a lot of them or a few of them, right?

40:15I agree with you. I think selectivity matters. There's only so many good deals. In certain strategies, there might be only so many good deals, right? Venture is complicated, especially early stage venture, because you need to be in the right businesses, but it's very hard to tell what the right business is. So you do need enough shots on goal. And so it's a bit of a separate conversation. But in buyouts, I do think concentration forces a lot of discipline around not having the marginal deal slip in. It means there is no room for the mid-level person who wants to make a career and knows they get promoted based on deployment because the slots are so rare.

40:56Now, you do have to ask some other questions sometimes. Some investors become risk averse, right? They worry too much about the downside protection. and talk about my lessons learned over the last decade. I mean, that's one, right? Overweighting downside. You go back to what we talked about, this rules-based, you need every deal not to be bad versus really going for the big deals, for the winning deals. I'm the opposite. But you're saying that's the risk of a manager. If you only give them 10 positions, they have to justify every 10 position. They can't take any risk of anything. They're worried that a single write-off impacts their portfolio too much.

41:31Here again, I think if they focused on making sure there's enough right tail, you don't need that many deals too. If you can get three to five X outcomes in a buyout strategy, if you have only eight deals, you can actually afford a couple write-off services. But that is human nature. That's a hard thing to live by. I've had several allocators say today, the venture capital ecosystem is more confusing than any time in their 20, 30 year career. Do you find that to be the case? You can't compare it with 10 years ago, let alone 20 years ago. It is scaled so much. It is a totally different ecosystem.

42:12The capital inflow has gone through all the way from growth all the way down to seed. You can see that in valuations. The amount of capital that's been available on companies staying private longer creates a whole different dynamic. We have an early stage bias. That hasn't changed for us. you only read about the exciting parts of venture I think for most investors be very careful whether you want to include venture in your portfolio you need to be able to get into the best firms it is close to impossible to build a high quality venture portfolio if you don't have access how do you define the very best firms combination of firm brands and individual partner brands and If you came up with a list, if I asked you to name what are the top 10 venture firms, and I didn't pick anyone else who's remotely interested in venture, I guarantee we overlap on 80 % of it.

43:13There's consensus at the top. I think there's consensus at the top, and it doesn't really matter that we think that. The entrepreneurs think that. And the entrepreneurs are smart. And they're like, who is maybe going to help me? But who's going to really help me raise the next round of money? who increases the likelihood that I can raise a Series B after my Series A. And I should have them on my cap table. And then maybe I'll take someone else, someone that I feel resonates with me or understands my industry even better. And entrepreneurs have gotten smarter, right? They're not giving 20 % to one single firm.

43:50But the way you know if someone's a top-dear brand is, go and speak to all the entrepreneurs and which entrepreneurs tell you all. All else equal, I will take their money at a discount on valuation because I think that's actually still accretive to me. That's the sort of the mathematical test of who are truly the top tier firms. Professor Ilya Stribula from Stanford actually did a study on this, whether there was a brand discount for highly branded firms. And that's what he found is that founders are willing to take a lower valuation from the top funds versus just a regular fund. The other way to look at it is repeatability of success.

44:27And you can actually go back in time. And we did this. You can prove out that brands matter because - The persistence. The persistence, except for seed. And seed, you cannot, except for Y Combinator, which is a structural advantage on the seed space. Why do you think there's no persistence in the seed space? A couple of reasons. One, it's really easy to raise a seed fund. So there's just a lot of them. and then if you're a successful seed firm, most of them then aspire to be a series A firm. And so I think there's maybe some that could have built that, maybe sort of leave the market. I also think this is very hard.

45:12At that moment, I have very little to look at. And so just the curation of a portfolio that I think can happen at every other stage is very hard. And so I think this, right, these are the artisanal skill of being a good picker. It's quite hard to execute on at the seed stage. I'm not saying it's impossible, but it's versus any stage later. We ultimately do need successes in your portfolio, right? You need round-trip journeys that build your brand. You said something that reminds me, venture capital is an access class. The founders pick the top GPs in many ways. The GPs pick the top LPs. When you're looking at how these top founders are putting together their series A, series, B series, C rounds.

45:53There's always the lead check, but what do you think that those founders are looking for from the non-leads? Different founders look for different things. Domain expertise can be one. Trust of conciliary is another. A lot of these founders are still very young. Many are doing this for the first time. They might be really, really smart at what they're building. But that doesn't make them necessarily fully secure and not wanting to have someone around them that they can bounce ideas off. So I think there are a couple of the very successful partners who think people choose them because they want them on their board and they want them as a sounding board.

46:32And sometimes you just pick a second relationship because you know you want another balance sheet in the background that might step in. That's a rational behavior pattern. Do you risk your next fundraise? What about network centrality? That's what I've been on the list. And how would you explain that? A lot of founders tell me they want GPs that have network centrality. This sort of ties into how do firms stay relevant as partners age and all of those type of topics. But when you look at the entrepreneur community in the cutting AI companies and who are the arguably relevant founders that you should know, this is we're not talking about thousands of people right that's probably measured in hundreds that in the grand scheme of the world's economy that's a minuscule group of people

47:30and many people know the names of these people but not many have close relationships to multiple ones of them so for me network centrality can be also around some diaspora from some of the most successful companies and everything. Do you have the mind share of this small group of, let's call it a thousand, probably less, most compelling entrepreneurs or soon-to-be entrepreneurs, right? Some of them might still be within another company that are disproportionately more likely to go on an entrepreneurial journey, have the insights, the credibility to go and raise money and venture as much as it gets a lot of coverage and build some amazing business is actually, at its core, still a very small community.

48:25The best answer that I've heard about this networks and GPs not aging out of their networks is you need to find the next one. So you were in PayPal, then somebody went and they started SpaceX. Now you're in SpaceX. Now somebody else went and started Castilian. Now you're in Castilian. So if you're making the right investments, you're going to get these not only companies, but these alumni networks and these great companies. That's right. And personality matters from a GP side. I think there are just some people who are just extremely good at talking to entrepreneurs. Sometimes it's because of the technological depth and they can have a mind meld, but sometimes they just understand the insecurities, the fears, the concerns of the entrepreneurs at that moment in the journey.

49:15And that goes a really, really long way. That's why I got my master's in psychology. I thought if you could understand the entrepreneur's mind and the LP's mind, you have a specific competitive advantage over others. I think that's right. There's this famous essay by Paul Graham about how nice guys could still finish first in terms of VCs. Do you believe that nice VCs could be successful? Yes. And why is that? Business acumen has nothing to do with being nice or bad. So if you believe understanding business models matters, right? Maybe at the early stage it matters less, but I think as you go on, especially as the later stage rounds, understanding business models really matters.

50:00That is irrespective. Bad guys can be good at it. Good guys can be good at it. I also think different people select for different things. I like smart, nice people around me. I can respect or have a business relationship with someone who's a little less nice and really smart. But if I get to choose, why wouldn't I? Venture is unique. A lot of it matters getting on the cap table. and then we can have a debate on how much value-add you can do beyond that. So there's sort of the nice people can have a very strong entrepreneur resonance. Sometimes very dramatic people can have strong resonance too and can be really impressive, but I think there is room for nice people.

50:43I think having founder empathy matters, and this goes back to the comment I just made, like understanding a founder's insecurities and fears and being able to support and help those, sometimes without describing them as fears and insecurities, is really important. I think it's good guys can come in first. I like to look a lot of these things from a morally neutral perspective just to try to get to ground truth, and then we could judge whether it's a good or bad thing. And there's a bit of a paradox, which is a lot of the people that have questionable ethics, they'll say and do whatever to get into the round.

51:25And this is a common thing, VCs overpromise. And then there's the nice guy or the ethical guy or girl, however you'd like to frame them. And they might undersell. And the way that I look at this aggressive, the overpromising strategy, it's a high beta strategy. It could work in the short term. If you have a couple of hits, you could kind of get this persistence flywheel of you're in the top deals. Now you can talk about the top deals, but if you don't, your reputation burns out very quickly. And this nice guy or girl can actually compound over time, maybe a slower start, but they start to have this reputation where when founders reference each other, which founders always get their information from other founders, at least the great ones, they start to kind of build this reputation as being founder-friendly.

52:06I probably wouldn't frame the world quite that way because I don't think being nice means you can't be aggressive or you can't be very direct. I actually sometimes think the nicer thing you can do is be just incredibly honest and stepping on some toes early on but people know that what you say is what you mean is a great way to build a relationship and is actually being a nice person in life and in business you don't want to have to say second guess your partners and so for me being i mean a little bit of definition of i guess what is nice is this actually being brutally honest is part is a really important trait because it's very level setting and people don't know they might disagree with you but they know where you stand and so i'm not even sure you start slower or not it has to do with sort of a trust building exercise and i agree with you there's many people who will say anything to try and get in a deal and then disappoint and i think that part i totally agree with and reputation matters this is a game of many, many repeated at-bats and eventually people do learn whether you are a serious person or whether you're an honest person.

53:19It's also a great self-selection aspect to telling people what you feel to be the truth. You get to see very quickly how somebody reacts to feedback and whether that's somebody that you want to compound over many years or whether that's somebody that's just, there you go, so fragile, that's always going to be a fragile relationship. That's generally true. I mean, sometimes you might say, It's a really complicated topic because at the same time, I've had many conversations around the best entrepreneurs don't really want or need feedback. And that might actually be statistically true. Alex Carr, Peter Thiel, Elon Musk.

53:52All of them probably absorb information really, really well. It's how they get their feedback is probably, you just need to be quite sensitive to that. They don't. They're okay taking the responsibility of the decisions. My guess is all of these guys are extremely good. and actually how they build their knowledge base for many of their decisions. And so they do take feedback. They don't want it forced upon them. Reminds me of the story of how Mark Andreessen first met Mark Zuckerberg, and Mark Zuckerberg was very quiet and didn't really say anything. And Mark Andreessen came away from that meeting thinking, one of two things is true.

54:26One is either this person is extremely socially awkward and just very shy, or two, he is just the ultimate sponge. He was just listening to everybody in the room trying to absorb information. And as soon as he figured out that he's just the ultimate sponge, that's when he decided to invest and join the board. I can think of a couple of our partners who run firms where their superpower is actually listening and knowing who to go to get their questions answered. This generally is a really important skill set. It's not because you're top of the firm that you need to know all the answers and do the math behind the decision.

55:02Sometimes it's knowing who to go to, And especially in the venture world, which is so dynamic and you're looking at so many different questions, are you really, really good at identifying the right questions and the right experts to answer those questions? And that's a very de-risking capability. Some people don't have that, the right sort of internal setup to do that. Our advisor, Britt Harris, who is formerly CIO of UTEMCO, and he was CEO of Bridgewater for a while at Ray Dalio's firm, and he always talks about this believability, which is who is the biggest expert in a specific field, and knowing, it's a meta question, it's not knowing the questions to ask that's important, it's also knowing the questions of who to ask and who has that believability.

55:47Yeah, 100%. How is AI going to transform the private markets? The biggest challenge right now a good investor has a clear view of what is the business they're selling five years from now i think this is very hard right now for a lot of businesses what modes will persist how do you think about technology obsolescence what modes remain or what are new new modes switching costs all those type of topics i think they're harder to interpret than ever so how does that translate into how do private markets look different. There's a downside scenario where you say you shouldn't have been in private markets.

56:30Actually, the opportunity set was better captured in strategies where you can move in and out quicker and that long-term illiquidity is not the same advantage as it did in the past because you just, you have to be more responsive. The optionality is just much more valuable. The optionality is much more important. look i think overall private markets has less to do with ai every alternative asset class i mean capitalism works in this country it works incredibly well and so putting ai aside you have cost of capitalists come down in venture it's come down in buyouts you should assume base case returns are going to be lower so you have to be creative and you have to being a median or mean it's not where you want to be you never want to be in venture in that place and i think being top quartiles become even more important to the questions what this top quartile mean and buyouts i'm more comfortable to predict because i think it is who has operational value add that's going to be more differentiating again so if you go back 20 years or whenever the sort of the operational value add playbook started to be part of the buyout industry It wasn't just about financial engineering.

57:46And there were some early firms that then made a name in that space. But these playbooks were quite easy to copy, right? And nowadays, most firms have some sort of operational. There are very few unique playbooks. I think we're going to go through a period where playbooks look more unique again. And we're going to be able to separate out firms who have done well on upfront. There's an argument to be made. that you can actually create IP in a way that maybe you couldn't with the traditional operating playbooks, where going back to that example of a partner who's really creative on dispatch management and route planning, the AI that started to take that over, you can hear about that.

58:35Because there's no one to hire. I mean, there's only five people who built it, so if you can't get one of those people, that IP might be yours to keep if it's truly unique and have some novel ideas and might not be, maybe it's easy to copy, but maybe it's not. And I think there will probably be scenarios where people can build within very closely held operational playbooks that are quite interesting. I don't believe anything is truly unique for very long periods of time, but you ask me about five years, five years from now, I think we'll be able to distinguish who really adopted AI and created a new level of operating playbook where it's not just about productivity enhancement, where it's being able to go in and change workflow, work streams.

59:25On the product innovation side, this can iterate quicker than their peer groups, which gives them a competitive advantage and ultimately delivers a much better customer relationship. so that i don't think to be more necessarily more or less private equity i just think we will go through a period where we can separate it's easier to separate firms and historic performance is not going to tell you who those firms are going to be goes back to rules versus frameworks the frameworks approach today becomes more and more important given all the moving pieces? I think so, but it's my approach to how we sort of try to manage our team.

1:00:11Had a prolific career. Morgan Stanley, Parthenon, Goldman, HIG. If you could go back to when you first started at the University of Pennsylvania Endowment 11 years ago, and you could give yourself one piece of advice, what would that be? Be comfortable to take risk, right? The challenge of the opportunity really and why I wasn't looking to join an endowment, but when I was doing my referencing on some other jobs, Peter and I struck up a conversation and what was really unique was that we were really subscale and not fully institutionalized and professionalized the way some of our peers were. So at the time we were roughly 9 billion, it was less than 10 % in private equity.

1:00:52And so I faced the challenge of really drawing this private program today where 30 billion and over 40 % in private equity. This is roughly 2015. So it didn't feel like we're bottom of the cycle. So sort of you feel like you're trying to build something going into the top. Well, did I know that the cycle was going to go for another six years, right? And so there is a tendency that you overweight downside protection. And downside protection would be structural or it could be that you're really prime assets. And the opportunity, so we haven't lost any money on strategies that were distinctly viewed as more downside protective, but the opportunity cost of those is really high.

1:01:31And I should have spent all my time really establishing whether there is a real right tail to the strategy, how fat that right tail is. Is this manager investing behind the right tail outcome from day one on or only when the first two years have gone well? Take the risk. There's a manager who day one on believes in the upside case goes off to the upside case because that makes up for many sins and actually provides you with a lot of margin of error, especially because we're slightly over-diversified anyway. So that would be probably advice number one. What's advice number two? If I were in this position today, there's been a huge evolution in the markets, especially around secondaries.

1:02:12The secondary markets, which I probably scoffed at a little bit years ago and thought it was sort of a sketchy backwater of private equity, they've professionalized dramatically. And you have the ability, if you are growing a program, to immediately create a much more mature program. You don't have to go through the full J curve. You can have vintage diversification. You can have the cash flow dynamics of a longstanding program way earlier. So I will consider how do you use secondary markets to really, in a much more de-risk way, get much quicker to a mature steady state program. Then you can choose, do you keep the secondary component or do you sort of unwind that and then go back to a fully primary program or not?

1:03:05Thomas, this has been an absolute masterclass. Thanks so much for stopping me. Thanks for having me. If you enjoyed this conversation and want to hear more conversations with many of the world's leading investors, subscribe below.