E434: Warren Gibbon on How AI is Changing the Private Markets

28:35And I think this is a risk for venture in terms of those larger tech companies. We're in a market where retail investors are very engaged. They want to buy. They're willing to buy. We saw the SpaceX IPO, right? Large retail component there. And that isn't always the case. There's periods where people are just kind of down on stocks. They don't really see. We're not in that period today. For sure. So getting back to your point, I think, yes, I mean, the passive active debate is something someone who ran a fund trying to beat the S &P 500, I know how hard it is. And, you know, but at the same time, philosophically, we hold the view that there has to be some perception of value, right?

29:20If you buy an index fund today, it is blindly buying the stocks in the index, irrespective of whether they're going to be good buys or not. And at some point, at least in my seat, I think you owe your clients a little bit better than that, which is, no, we have a view. We're not outsourcing everything because obviously the S &P has become much more concentrated. It's not a diversified basket of companies across corporate America. It's highly concentrated to the big tech names, which, by the way, are generating the most profits. So there's a good reason for that. So at BFA, we have a mix. The other thing that's wild, second order effect of everything being passive is that if a stock goes up, let's say Apple goes up, now the index needs to put in more money into it.

30:05One could argue that the beta of stocks or the market has become more volatile than it was before. What do you think about that? Yeah, I think you're onto something. I think academics today are very, there's been a ton of academic research about the impact. It's one of the areas where academics are first before the traders. Yes, right. And that's why a lot of hedge funds are hiring these folks directly out of their PhD programs. But it's interesting to me in my career, I could think back to around the COVID period where people were talking about peak passive, right? And this is, we've entered a tipping point.

30:36And to be clear, there's a lot of beneficiaries to the index approach, right? It's low cost, it's highly tax efficient. And the fact is that active long-only managers just weren't really doing a great job. and there may be some perils today in private markets right where p's are getting more discriminating about who is actually adding value because i'm not just gonna i'm not buying your middle market fund your large cap buyout and i'm not buying a special opportunity strategy because you can't be good at all of that 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.

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32:29Whether 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 as 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. 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.

33:01You can 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 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.

33:32Run 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. Check out us fast, receipts are instant, and sometimes I even get loyalty rewards automatically.

33:59There's something about businesses that use Square. They just feel more put together. 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 can 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.

34:29And 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. It's too expensive to pay for bait on it. That's right. Exactly. Well, so the index dynamic of effectively buying, the index approach buys more as something goes up and it sells more as it goes down. If you just think, well, I probably want to be more interested in something if it's cheaper and I'm less interested if it goes up.

35:08That's not the way it works. So I think it's a balance. We like active management today. We've been more active in hedge funds, actually, with long-term equity, because we think expert investors in their sector can spot opportunities. And we're willing to pay for that if they can show performance. But that's kind of one of the outputs of this. my business partner curtis keep track of all these things that lps complain about but yet do anyways and one of those things seem to be investing into these large hedge funds are charging in many ways crazy fees but seem to be delivering real alpha do you see that in your business you're referring to sort of the millenniums yeah the pod shops yeah we don't invest with them we actually do have an investment with a much smaller firm that's kind of competing a little bit against that in terms of something they've built we're attracted to the risk reward profile the issue is fees tax inefficiency and even the pod shops David I mean this is the other thing effectively if you you know ask them and really what they're doing is they're betting on the quarter right is what those managers are doing they're saying Exxon's gonna beat the quarter and Chevron's gonna miss the quarter so I've had that trade-on um it's not really about well I think this is a good stock I'm gonna own this stock because in I see a year and a half it's not a Buffett way of investing?

36:27No, no. It's an alpha horizon that's pretty short. So you can add that to the algorithmic. And we've got a very short horizon in terms of how people are looking at the stock market today. So, you know, but that said, it's been challenging, right? It's been challenging. If you've been looking for longer term alpha, that's been a tougher place to be. and you know again people vote with the dollars right one thing we've seen in markets and i think we'll see again and we kind of just had an example of that right with a situation that's been in the news liquidity we will have deleveraging events there'll be shocks of the system and i actually think one message i have this i think very important that we're thinking very seriously about today is liquidity and making sure that you are equipped to deal with shocks to the system.

37:21And that can be across a range of metrics, right? It's not just family by family, but entity by entity, thinking about your unfunded commitment, thinking about what cash you have, how can you deploy cash into weakness? Because I do think there's going to be opportunities. Actually, in private, we do still like secondaries. We think if there could very well be more opportunity there has been, and I think could stay that way. So I think liquidity is something that's going to be, if people aren't already thinking about that, they should be paying close attention there. I'm always curious about how to deploy this heroic trade in the next downturn.

38:06Have you thought about this, and what's your game plan? If you look back, we had a real, I would say, a generational time to buy tech stocks was at the end of 2022 when tech was out of favor. Inflation was really ramping. Interest rates were moving up. And tech revenues, growth dipped. That was a great time. If you're on the lookout, you will get these opportunities. The tough thing right now is show me an asset class that's out of favor. and you may say well long-term treasuries uh you know maybe they need to get more out of favor but yeah i think this is one of the things we're finding right now is what is really compelling or what where do you hide out other than cash today to prepare for a bumpy time ahead um you know so i think that's a good question we're definitely looking at strategies today They're allocating the strategies that can benefit from volatility in credit markets or in equity markets.

39:13And so that's how we think about some of the allocations we're making. And I think where the opportunities are going to arise, it could be AI, it could be tech. If we get a sequence of bad data points, a real scare, we sort of had that a little bit in July, you know, bounce back this month. there could be some opportunities there because the direction of travel is still pretty clear. We may have got over our skis here in the near term but we're not going to be using less tech input in our lives in five to ten years. So that could be an area to focus on. I see some of the smartest investors in the world deploying Portable Alpha in their strategy.

39:59What do you think about Portable Alpha? We haven't done a lot of that. I think what it really comes down to is how resilient is the alpha.

40:10And one of the strategies we actually allocate to today, they have that as a solution that they offer. And it's been tougher for them recently. So the alpha hasn't been there as much as it was. That's basically saying, look, I can get my cheap beta, but I'm going to find specific managers and I can just isolate that alpha and bolt that onto what I have. So I think in theory, it holds. I think you need to, how resilient is the alpha? And then just operationally, can you implement that easily in the portfolio? Can you unwind it as well? The way that portable alpha works, at least a lot of these smart investors are taking equities, levering them.

40:52So they only have exposure to the future. So S &P goes up 5 % or goes down 5%. And then investing that into strategies that are uncorrelated. to the S &P 500. And the idea being that instead of coming in and putting a hedge on your portfolio in case of a market crash, you actually get exposure to the S &P 500 on the way up and then on the way down your hedge. Is that kind of how you see being implemented? You're never going to get away from if we have a, let's call it a 2022 scenario of a, say a 20 % drawdown in the S &P, you're going to, you know, you're going to experience that. But I think what that points to, what that example points to, is the need today.

41:31And this is kind of the catch 22 is that allocators and investors today, you want what I'm going to call uncorrelated asset classes. Equity markets are high, have done very, very well. Bond markets have some risks. You do want strategies in the portfolio that offer a different returns profile. so we're looking for that and everyone's looking for those and so that's kind of the good news for gps right that depending on where where they're focused if they can show that and fulfill that role in the portfolio there's some real value there infrastructure is a place that's obviously seen a lot of interest right as a more now it's debatable because some of the thesis around infrastructure is related to we need more power generation we you know we're short for the ai build out.

42:24So there's a correlation there, clearly. But I do think today that if you can have less or less correlated sources of return in the portfolio, that is clearly something that people should be looking at. Going back to venture, you alluded these 12 firms. Some say there's, you know, five to 10 firms that are capturing 75 % of LP capital. How do you invest in a market that's behaving in this way. We look to access those firms, but in a smart way. We have a good relationship with the firm that I think is in that group. So we see the opportunity there. And as I said earlier, it's about understanding it.

43:02Does that, what happened in the past, can you underwrite that for the future? Persistence. Persistence. And so we've spent time really understanding where their next leg of opportunity is going to come from. and there's been some very big winners you know there are right now and so how is the next vintage gonna you know do um i think that's one strategy the other strategies as i said earlier we discussed earlier looking outside of those biggest firms thinking about what gps are showing some traction and you kind of alluded to it, David, which is we invest, obviously we spend a lot of time on track records, but if a manager's been showing reasonable performance from just their core business and everyone is super incentivized and their experience and their know-how has only increased, that could be very interesting because you want to be in there when it becomes the breakout vintage.

44:09On the flip side, you can have good buying numbers, but yeah, the firm has shifted a little bit. The senior people, maybe less focused. The younger people aren't quite ready. There isn't the drive there. That track record is, we want to think about that outside of some of those big AI driven names is of interest. I have some strong opinions on venture. One is you referenced this, that venture, all this capital is going into these handful of firms. Some people call venture capital an access class, that LPs are actually trying to access the best managers, not the other way. Every other asset class is not very capital constrained.

44:51They could always take in more LP capital. Venture capital managers are famous for saying no to LP capital, even endowment capital, which is the most desired. But that access capital aspect goes down to the founders. So it's the founders that are choosing the GPs and the GPs that are choosing the LPs, completely different than every other asset class. And the founders more or less have chosen to go with the top name brands past a certain stage, seriously at the Series A, Series B. Why? There's many different reasons. One is branding, both for customers and recruiting. Two is just the capital itself is a moat, meaning if Andreessen invests$100 million into your company, most of the time they're not going to let it burn.

45:41There's this whole concept in venture where the top quartile companies doesn't matter. They can raise from anyone. The bottom quartile are default debt. And then the middle 50 % is where your capital partners matter the most. one future that i think a lot of lps don't think about is that venture capital may continue to persist there's a famous professor steve kaplan study on this that 52 percent of top quartile funds in venture continue to be top quartile and 75 percent continue to be in the top 50 percent so if you invest in these 75 percent 75 percent of time you'll be better than the average historically.

46:24What may end up happening is that the returns may continue to persist on a gross level, but the fees have gone so high, 2.5 and 30 now at the top firms, some are even 3 and 30, that they may just be average on a net basis. So there's this world where they persist on the gross side, but don't persist on a net basis. It's a very interesting thought, David. I think the firm that we know pretty well. It's interesting if you look at their track record, you know, I was talking to a client about it and you look at their net numbers and you're not sophisticated on venture and you haven't really been following this.

47:03They don't knock your socks off. I mean, it isn't a, oh my goodness, how on earth can I get into this? They're good. They're there's going to be some... Start 10X. It isn't. My question is, yes, exactly. It is different if you're a large pool of capital, pension fund, a large endowment. You have to make several of these checks. And I think they're always going to be looking at that cohort. It is a little different when it's a family office, a multifamily office, because you're not compelled to. It's really opportunity cost and again when you look at the net numbers you know is that something that isn't going to be too painful if you miss out on our view is that the portfolio approach within venture you have to be looking there and as i say that you can think about other opportunities in smaller managers, more emerging managers or whatever it may be.

48:03But that, I think, at least there's enough data set there that we think you have to focus there. But going back to private equity and venture, I mean, that is something that hasn't happened. We haven't seen a lot of fee compression, right? There's also an argument that you, quote unquote, need venture in your portfolio. Why? Because although there's equity exposure and equity correlation, It is a different part of the market, and it is in some ways uncorrelated to either private market or the public market. Yes, exactly. And I do resubscribe to that view, David. If you look at innovation, smart people trying to build something, that in itself is clear evidence that you have that in all cycles.

48:51And some great businesses have been founded in downturns, right? You do want access to that innovation drive and that value creation. That is something that isn't dependent on. Now, the later stage you get, obviously, there's going to be a large impact on exit multiples and what the IPO market. But at the earlier stage, I agree. Yeah, and I think it is important to have that in the portfolio. And then you've talked about it on prior podcasts, but from a taxable point of view, having QSBS recognition is important too. It's valuable. Sacred Cow, we're not allowed to talk about as DPI, the negative side of DPI.

49:32DPI is a taxable event for taxable investors. So if you get your capital return in two years and you're paying 35 % tax as you are on the coast, sure, you get a print. but in contrary to institutional investors, you have to, that's a taxable print. That destroys your compounding. Yeah, that's right. You're not compounding that. Yep. That's kind of maybe the one silver lining in the kind of a lower DPI environment. That's what people in their 15th year of their fund cycle. That's the pitch. Right. You mentioned emerging managers and looking at that part of the market. What are you looking for emerging managers today?

50:06Emerging managers is a very interesting space. We've spent a good amount of time there. A lot of our families and clients come from the GPs themselves, both the large and small managers. But I think for me, for us, it is about, we like specialists. We like experts in their field and they're just looking. And it's really, I think, on the allocator side to figure out, right, does this make sense for now in the next 10 years? Can we underwrite that? And then if you do think that makes sense, are they the right manager? can they do the job and that we look at obviously spend a lot of time on track record we spend a lot of team and then just the thesis right where is the value creation going to happen here because it's not about just riding a train of well we see a lot of expansion here a lot of multiple expansion one of the things we push at when we're in meetings is what you can have a situation where a manager, maybe fund two, fund three, is doing very well.

51:12But then you actually look at what's driving that. And then how did that manager access or come to have those portfolio companies? And sometimes there's a certain randomness there, which is, well, we got introduced through the prior founder that we know well. It's not. Then if we're looking at a firm that's based in the Northeast, well, this company's in Texas. Well, yeah, we don't typically invest in Texas, but it's not quite... The verticals we traditionally... It's not just repeatable. Exactly. Exactly. And so it's harder for us, for any LLP to say, because that's the point of a track record, right?

51:48It's to indicate persistence. It's to indicate skill, repeatability. And if, well, yeah, that was a good outcome. You had several, these are doing very well. How are we going to have that in the next portfolio? Well, I need to get lucky again because I need to have those kinds of connections or whatever it may be. And so today, more than ever, you alluded to it, David, it's the number one question I ask emerging managers in venture is, how are you accessing the best startups? Why are they coming to you? And I think there is something around, well, we're experts in this field. So if you're in this field, you pretty much want to talk to us.

52:25Okay, there's something there. But you really need to think about why they're not going to. Because if it's that good an opportunity, obviously, you can put a lot more capital in. And so that's the question we spend a lot of time pushing on. What's oftentimes overlooked is check size contrary to value add. So I think there are some strategies, Switzerland strategies, pre-C investor. I think it's up to probably about$250 ,000. You could get into almost anything. And those could be great strategies. They're just not large funds. and then as you deploy let's say 10 million dollar fund like that or maybe even less seven and a half million dollars and you might have a 5x and then you go out and raise it 25 million now you're writing 750k checks depending on the size of seed rounds at the time it could be black and white in terms of the competitiveness of getting into these companies and that's when you really need a right to win the right to win is exactly right i think there could be a regional right It's like we're looking in the northeast markets.

53:31That's where we focus. We have great relationships with whatever field it's with, it's healthcare, biotech, or there has to be some right to win there. But I think there is a story to tell, which is, look, we're willing to roll up our sleeves for you. You're a small startup. You're not a big AI name. And if you're not a big AI name, you're going to be actually better off with us because we're really going to work hard for you rather than being just another name on the portfolio somewhere else. I think there is something there. And I think, as I said before, this is leading up to the potential buying opportunity.

54:06Not that you can get tactical with venture because vintage diversification and pacing is so important as well. How much do you think about your seed managers being feeders to the multi-stage firms? We do spend time thinking about if you can get in front of some of these bigger firms, have they heard of these other managers? managers. That's a good because if you can roll up your sleeves and really impact a startup and show that it's on the right track, that is something that's going to be of interest, right, for other firms. And I think that there is a lot of capital that has to be put to work, right?

54:43And GPs want to de-risk everything as much as they can. And so coming through a venture manager that's pretty expert in, you know, a name known in their space, maybe not a household name, but known in their space that I think can make sense. My OG mentor going back to 2015, when I made my first venture investment, Gil Pinchina, he told me that he would underwrite a seed company that he knew would raise an A, almost regardless of the quality of the company. Now it's provocative in nature. But I have thought a lot about this thought experiment. A, does that make sense? Unexpected value if you had 100 of these companies.

55:26And two, how much of a company's success becomes reflexive in that it is now successful because a Sequoia or Andreessen or a Founders Fund backed it. And I could tell you it's not zero. Is it over under 50 %? I think it's hard to say because these are parallel universes. But there's something about if a seed manager has access to enough top investors where they have unlimited shots, as long as the business has a certain type of quality, it becomes reinforcing. And I think this is one of the reasons for persistence in venture because of this reflexive nature of name brand funds investing into startups.

56:06Yes. I think that's right, David. I think there's so much force today. And you do hear this, right? You may have three or four startups in a certain field, and they're all kind of on the same playing field. But then one just gets a little bit of traction, gets the right VC support, and then is in a different stratosphere. And then they get more capital. And it's sort of a self-fulfilling dynamic. And so I think there's a lot to that. Tomorrow, Warren, you get a phone call. I just had$100 million. Liquidity and cash. I want to invest it today. How do you allocate that portfolio for that investor?

56:39That's always the allocating from cash. We've actually been doing some of that recently at BFA. I think you want to be patient, right? I'm in the camp that you want to get, well, certainly you go through the process of understanding what the investment goals and objectives are and the risk profile. But I think you want to get some exposure to the allocation you want and then think about how you time that in the sense of not trying to time markets, but just be patient. You don't have to be fully invested day one. And at least that's how we think about it. And I like having the ability to deploy on weakness, right, if we see that.

57:22We have the portfolio. We have a good sense of how we would invest across public equities, across fixed income. And then in terms of the allocations on privates, I mean, I think today we would really emphasize these strategies today that can exploit bumps in the road. So whether it's in credit markets, so kind of an opportunistic credit, you know, opportunity vehicle on the hedge fund space too within credit markets, right? Some of these strategies have a proven ability to be able to jump in when we see dislocations. And that's kind of the world we're in right now. I mean, if you'd asked me that question, David, a few years ago, we were much more optimistic on equity returns over the near term.

58:13And today, if you look at the three-year rolling return of the market, it's pretty elevated historically. So that should give you some pause. So my experience of being in the seat is there's times to lean in and there's times to just let things play out a little bit. So I think that's kind of the mindset we would have. Patience is one of those things easier said than done, especially when you've had an entrepreneur that have built their career, taking risks, pushing forward. The best operationalization of this that I've seen is Frank McHale from North Dakota Land Trust. And he does not shy away from beta because he uses it as his alternative to any new investment.

58:56So he tries to find the beta in the public markets that mirrors the asset exposure he's looking to do. So, for example, an evergreen fund for private equity. And then he goes out to meet private equity funds. And if and only if that private equity fund beats that beta, he sells the evergreen fund and he invests into that manager. And I think that's such an underrated strategy, which is by default, you are invested in the market and you only look for things. So you don't have this desire to deploy quickly because the problem that a lot of people experience when they make a lot of money. First of all, when you have$100 million to invest, you've built a billion dollar company.

59:37You're one of the most exceptional people in your space. And you're obviously extremely smart. That being said, the level of experience that you need to be good as investor into GPs, it's just a different skill set. It's like saying the best NBA player in the world is not going to be a world-class surgeon. It's just a different skill set. So oftentimes you feel compelled to both move fast and also you deploy at the point of the highest ignorance. Alex Hermosi calls this ignorance debt. So you have the highest amount of ignorance that you will ever have. and a lot of investment firms actually operationalize this into their funds is they don't let new investors make investments.

1:00:16They make them kind of take 100 meetings or 500 meetings just to see what good looks like. So this is the best hack that I've found for kind of avoiding this bias to act and also avoiding bad mistakes early on in your investing career. That's very well said. It's such an important part of the client relationship work with the advisor, right? Because we see that too, right? You had an entrepreneur who's been very successful. They've worked extremely hard. They've crystallized value. And now they're aware of markets, aware of investments, but they haven't experienced that, right? Until you have created wealth and then you have it invested.

1:00:55And then suddenly we see people taking notice of headlines. They wouldn't normally notice or take any attention to pay any attention to. But now it's, OK, how could this affect this capital that I have? And so, yeah, it's really my job to walk clients through that. And it's a great point. We do that, too, which is we get exposure that we want, that we're comfortable with. And then from that, we can think about how do we, you could do that with ETFs, right? Passive, you can say, OK, we have some exposure. But as we allocate to the managers we want, we can pull that from there. I think getting the right beta exposure is key.

1:01:35And there are certain times there, and maybe today's one, right, where beta is we want to be careful there. Going back to what we discussed about the index funds. Yes, exactly. And you're absolutely right also. There's two pressures, right? I mean, there's two risks. One is that you're underinvested as things do well. And the client asks, well, why are you being patient? The other risk is that there's red ink, right, where you put money to work and there's mark-to-market losses. So obviously, we talk to our clients about we're long-term investors. We're not really tracking in the next two weeks, two months.

1:02:09We're not building it to that. And so I think we like to find a way that manages that. You're absolutely right, though, that successful entrepreneurs, for the most part, are not people that, at least our clients, they expect 100 % attention, 100 % activity. They expect a lot of communication. What are we paying you for? Yeah, absolutely. I think that's right. So communication is key. The way we built our firm is that we want to be very collaborative. We talk people through what we're going to do before we even know we have discretion, if we have discretion, because our clients are partners. And that's kind of partly why they joined, came to us.

1:02:54We're not the shop, which is like, hey, these are your numbers and let us know if you have any questions. And so, yeah, that's kind of the way we approach it. If you could go back and give yourself one timeless piece of advice when you started your career, what would that be? The advice I would give my earlier self is that investing in many ways is a simple business. It's very hard to do well, but you don't need to overthink it. the best investment opportunities, the best investment ideas are actually pretty explainable and pretty simple. And if it needs more than three sentences to explain why you're doing it, then that may be a problem.

1:03:35There's a tendency for a lot of folks, I think my earlier self, to overthink things, right? To look for that additional bit of information, that additional confirmatory signal. And at the end of the day, that's kind of a losing game. Because you need to understand the thesis, you need to corroborate it, you need to build it out, and then you need to act. And then you can move on from there. A lot of investment managers also act like they're lawyers, like they're being paid by the word, and oftentimes unnecessarily make things complex, maybe to justify their fees, as we were discussing earlier.

1:04:16But this has been an absolute masterclass. Thanks so much, Warren, for coming by. I appreciate it, David. Very much enjoyed it. Thank you.