#135 - Luke Sarsfield: Finding Alpha in Private Markets

22:32But importantly, The insiders, folks who are employees of RichPost, own a substantial amount of the stock and a substantial amount of the company. And so there is real tight alignment between how we think about growth vectors, how we think about opportunities, how we think about capital deployment, and what I believe our public shareholders would think about because we're very much aligned in that. And so I think that alignment through ownership, really important. We obviously try to think very strategically. these are long cycle businesses, as you know, right? You just think about an average fund we raise, right?

23:08A closed end fund can have a life anywhere between, you know, seven and 13 years. And so every time you do that, that's, that's a long, that's a good long period of time, right? And so we really try to think about not just, you know, what's going to happen next week or next quarter or even next year, but you know, how are we positioned in the long run? How are we positioned to serve clients? And again, coming back to this point, if we do right by the clients, We think that's ultimately going to accrue to the benefit of the franchise and accrue to the benefit of the shareholders. One of the key reasons we really embrace being a public company is the fact that we are engaged in targeted M &A activity to add new investing platforms and new investing capabilities to our platform.

23:54And so since I've been here about two and a half years now, we've done two M &A deals. We bought a private equity firm in Europe called Qualitas, and we bought a private credit business in the U.S. in Texas called Stellis Capital. Again, both very much on mission, both very much focused in the middle and lower middle market, both very well known to us. We'd worked with both of the franchises. We knew the principles there. We thought very highly of them. And one of the important things as a public company, it makes it just a little bit easier, one, to do the M &A deal because you obviously, you're going to have a one-sided value discussion.

24:33They're private, so we're going to have a negotiation. But you know what our stock is worth. It trades on a public exchange. We don't have to have a two-sided value negotiation, which does come with added complexity. And then it really creates the ability to drive alignment, right? And so when we do M &A, one of the things that's really important to us is the individuals who built those franchises are a key part of why we want to own those franchises. And we want those individuals to stay with us for an extended period of time. How do we create that alignment? We give them a lot of stock so that they're aligned with us.

25:09And we do it in a way where that stock vests over an extended period of time. So they must stay to really see the benefits of that. We think that's really important. We think it drives alignment between us and them. We think it drives alignment between our public shareholders and the broader franchise. And so we're really focused on driving alignment in everything we do.

25:30Luke Sarsfield:You mentioned this a few times, but you've been focused on the middle and lower middle market. But what is the simplest way to understand why that opportunity still exists? Not only does it exist, it exists in spades, I'm here to tell you. And so when you think about it, right, and let's just be a little definitional here as to how we define the middle and lower middle markets. So we generally think of, if you think of it as the end companies that we're engaged with, right, that we're investing in, that we're lending to, that we're financing, we generally think of the middle market as, middle and lower middle market as companies that have between 30 and about$250 million of revenue.

26:07And I think the really important point is when you think about the addressable market of investable companies, the companies with revenues between 30 and 250 million, that's about 85 % of the companies that exist in the US. And we believe in the world, but we have really good data in the US. So let's just say 85 % of the companies that exist in the US. What's really interesting is, if you look at where many of our larger peers are deploying their capital, they're deploying it at the upper part of the market, i.e. companies that definitially are more than$250 million of revenue. But the challenge there is that's only 15 % of the companies.

26:49However, if you look at the capital, it's actually reversed. So of the 15 % of companies greater than$250 million of revenue, about 85 % to 90 % of the private investing capital is being deployed against those companies. Very crowded, very competitive. doesn't mean there's not some great value creation opportunities, but it's much more crowded. What do we know about sort of efficient markets and supply and demand? Generally, less crowded markets yield better outcomes. And so in the middle and lower middle market, it's much less crowded, right? You've got 10 to 15 percent of the capital going against 85 percent of the opportunity set.

27:27We can be much more selective. What does that yield? There's a few really important things. The first is it's much less intermediated, right? When you're dealing with these big companies, they have sophisticated advisors who they're bringing in who are extracting top dollar for the assets. In our part of the market, usually you're often dealing with the founder entrepreneur who founded the business. Not to say they're not very sophisticated in what they do, but they're not M &A practitioners. And so we're able to buy the businesses generally at lower values. In the upper part of the market, when you look at what is the transaction multiple of EBITDA, which is what people use in the shorthand, probably 11, 12, 13 times.

28:10In our part of the market, seven, eight, nine times. The next thing is leverage, right? To support those high multiples at the upper end of the market, there's heavy use of leverage in those transactions, right? They're often leveraged six or seven times. In our part of the market, we can use a lot less leverage. So we're just not as, you know, sort of tied up in the credit cycle. We two, three, four times are the leverage levels we're using in our part of the market. And then, you know, in the upper part of the market, you're often buying things that they were either public companies or they were owned by another sponsor.

28:45And so somebody has done a lot of work to optimize those businesses and extract economic value from those businesses. In our part of the market, We're generally buying from a founder who's world-class at what they do, but they might not have that sophisticated knowledge of how to build and industrialize and scale a business. And so we're able to help them, whether it's helping them build out the team or helping them improve the sales pipe or helping them add and leverage technology better. We really have the ability to add meaningful economic value. And when you look at all that, you bring it all together, and you look over the last 20 years, the net effect of all those things we just talked about, less competitive, less intermediated, lower prices paid, more opportunity for value creation.

29:29It has yielded, when you look at sort of the middle market buyout space versus the upper market buyout space at the median, about 200 basis points of outperformance.

29:39Luke Sarsfield:It sounds compelling. It sounds reasonable that there would be less efficiency there and potentially more opportunity. So why hasn't competition come in and arbitrage a lot of that away? It's hard, right? These are unlike the upper part of the market where generally the companies are well known. These are brand name, household name companies. You can read about the transactions when they happen often above the fold in the journal. And you can know what the financing package is and you can know what the multiples paid were and all that. In our part of the market, it's much more opaque and much less transparent.

30:15And so I talked before about our data advantage, right? We have literally been tracking data around companies, around investors, around firms, around multiples and growth and leverage levels and everything for 20 plus years. And that data advantage just gives us a massive competitive advantage. The second is, you know, you could build it over time, but it takes time. And we've been at this a really long time. When you look at our strategies, right, many of them have been at this two plus decades. And so they have, you know, a knowledge and an insight from operating in these markets. It's that it's that virtuous cycle of kind of being in the flows over two plus decades that I think is really powerful.

31:00The next thing is you have to be really disciplined. And I think there is, because of the economic incentives in private investing, there's often this desire to get larger. Because when you get larger, there are, I would say, operating leverage in economies of scale that you as the investor, the owner of the firm can benefit from. We've stayed very disciplined in our markets. And that discipline has come by not chasing size and growth for size and growth's sake, but by being very disciplined. I think there's a very interesting statistic I like to use. When our largest business, RCP Advisors, was founded in the early 2000s, the other way they thought about defining their market set was the size of funds they would invest in.

31:48And they said, we define the middle market as being funds up to, the funds now, up to a billion dollars in size. And we will not invest in funds that are beyond a billion dollars in size. And guess what? Today, almost 25 years later, they still say, we define it as being up to a billion dollars in size, and we will not go beyond a billion dollars of size. I think what happens, candidly, is there's a lot of firms that start off, they see the same things we see, they understand these same dynamics and statistics that we talked about. They start off in the middle market, and it's a very attractive place to play.

32:23And then they see the opportunity to grow and scale the firm, but with that comes the pressure of then having to deploy more and more and more capital. And the way you deploy more and more and more capital is you do bigger and bigger, bigger deals. And as you do bigger and bigger deals, if you don't stay disciplined, you will grow out of that middle and lower middle market. And I think one of the benchmarks of our franchise has been our focus on staying disciplined and really continuing to execute on what we know how to execute on and doing it in a world-class way and doing it over a span of multiple decades.

32:56Luke Sarsfield:And I do think that's quite unique. And it's arguably even more difficult as a public company than it is as a private company. Look, there is an imperative to grow, whether you're public or private, and we feel an imperative to grow. We think we can grow very profitably, but we think there's a lot of different ways for us to grow. And so it doesn't have to come by moving out of our historical opportunity set. We think our current opportunity set is really meaningful. We've done a lot of market sizing work on this, by the way. We think that the middle market opportunity set just in the US right now is into the trillions of dollars, right?

33:35Two to$3 trillion is what we think of as that middle market opportunity set just in the US. To your point, we're running a very, very small percentage of that. So we could double and double and double again. We think we could do that and continue to generate world-class outsized returns. We think we could do it in a way that's supportive of and adding to what our clients want us to do. And we don't need to move out of that ecosystem. But obviously, we've seen others who started here and have decided to graduate into the upper part of the market.

34:06Luke Sarsfield:The focus is the client and generating attractive returns. And if you maintain that as your focus and your mission, then it becomes more obvious why you've made the decisions that you have. And I also think increasingly the clients are coming to us and finding us because what they're saying is we understand when we look across our portfolio that, you know, we've worked with a lot of tremendous outstanding world-class managers at the upper part of the market. But there's also a very high correlation in terms of what they're all doing. They're trading assets back and forth. In many cases, maybe they're buying assets together.

34:43And so implicitly, we have a massive correlation in our portfolio, given our allocation history to this upper part of the market. We actually want to find places that are differentiated, that are not so highly correlated, but still have the ability to generate alpha. But we need a firm with the scale, with the attributes, with the capability, with the track record, and with the institutional ability to execute for us a larger allocator. And so the clients are actually finding us and saying, we'd like to work with you as our middle market partner.

35:14Luke Sarsfield:Many firms talk about operational value add, but relatively few actually consistently deliver it. Did you agree with that statement? I think a lot of firms talk about it. I'd agree with the first part of the statement. I think a lot of firms endeavor to deliver it is what I would say, right? And so whether they have value creation teams or consultants or capital raising experts or industry executives who they can bring to bear, I think a lot of them endeavor to deliver it. How it actually is received and how helpful that purportive assistance is, I think in fairness is an open question. And so I would say it's very much something that virtually everybody talks about.

35:58It's very much something that the vast bolus of firms are endeavoring to deliver. How that delivery actually manifested itself, I will grant you, is probably in many cases an open question.

36:10Luke Sarsfield:So when you're evaluating managers or partners, what signals tell you that they can truly create value? And if you look at their data, it's not just financial engineering. You've actually got to look at their track record, right? And that's something that we do. That's something we do in a very deep, very detailed way. It's something where this data set that I mentioned really comes to bear because we can look at the different levers of value creation, right? And so if all you see is they bought it at a multiple, you know, and it had a growth rate and a margin, it grew whatever, it continued to grow at that same growth rate.

36:48It continued to stay at that same margin, but they delivered a little bit and they got some multiple expansion. they've created value. But to your point, that's largely, you know, sort of financial slash market beta value creation, right? But now if you have the data and you can say, well, look, they've accelerated the growth rate, they've increased the margin, they've, you know, operationally done things in the business that are really kind of value enhancing to the franchise. And so not only do we see, you know, kind of the multiple premium, but we saw the multiple premium off an accelerating growth rate and a higher margin, then you can say operationally, these are the managers we want to partner with because these managers really know how to create durable value and hopefully also be the beneficiary of that sort of market growth and market beta.

37:39But even if they don't get that, they're still creating the value. That's what we really focus on in our manager selection process where we're thinking about investing alongside partnering with best of breed managers. And we obviously have a lot of experience and expertise doing this. We've lived in these markets. We know the players. But again, we have the data. I cannot understate the power of the data to really make superior investment decisions.

38:06Luke Sarsfield:And how much of the analysis is qualitative outside of the data that you just walked us through? It's an incredibly important part of it. And there is a lot of it, right? And we have really, really smart, really, really sophisticated investors who've been doing this for decades. And so there is ultimately no substitute for the judgment. I always remind people that at the end of the day, like many businesses, this is a judgment and experience business. And you grow up, you apprentice in this business, and eventually you get good at it, but you get good at it through working alongside people who've been doing it, you get good at it through pattern recognition.

38:47You don't get good at it just by staring at spreadsheets or, you know, kind of crunching numbers. That's an important component of it. But ultimately, it's that judgment. It's that human instinct. It's that pattern recognition that's so important. But then if you can couple all of that with world-class data and analytics that allow you to really then turbocharge that judgment and that insight that these experienced investment professionals can put on part of it, That's the nirvana. And that's what we strive to deliver our clients.

39:16Luke Sarsfield:You've emphasized proprietary data as a differentiator. Could you share a few examples of how you're using it in practice? I'll use a couple examples. And I'll focus on our RCP group, which is our U.S. private equity business. And then our Qualitas group, which is our European private equity business. And they're very similar in their approach. Both started as fund-to-fund businesses. And so what they did importantly was they went out right at the start and they started collecting all the data that they could. And this is data at the transaction level. So for an individual transaction, an individual deal, they captured it at the company level.

40:00For all the companies, they could capture it across the middle and lower middle market. They captured it at the GP or sponsor level, looking at how did these funds perform? How did the GPs perform? And so they have this great data set where they can look at what was. So when the next deal comes in, when the next opportunity comes in, they can run it through the analyzer and say, gosh, in market environments that look like this, right, rates rising, whatever it is, these were the kind of things that worked. Here's why these were the kind of things that didn't work. Here's why here are the things to watch out for.

40:35Here are the unexpected ahas. and it makes us better investors in doing that, right? Another great example I'll give you is in our venture business, TrueBridge. For years, Forbes, the magazine, has published their Midas list, right? And who are the best venture managers? Who are the best up-and-coming venture managers? Who are the most exciting venture companies? We, through TrueBridge, have actually been the ones that have helped them formulate those lists. Why? Because we've been capturing the data for years and years. And so we can identify who are the best in breed managers, who are the up and coming managers, who are some of the great investors in the venture space and in the different segments of the venture space.

41:17What are the exciting high growth companies? We have all that data so much so that Forbes actually relies on us to leverage that data to produce their Midas list. And so I just think that's a great example of external validation.

41:30Luke Sarsfield:There's been a lot of discussion around building platforms in asset management. What distinguishes a true platform from just a collection of strategies? It's a bit of a double-edged sword because on the one hand, you want to build platforms. But on the other hand, often clients want you to be really great at the thing they need at that moment, right? And so sometimes they want a broad-based solution, but sometimes they just want the best middle market direct lender or the best venture debt firm or the best venture allocator. And we need to be able to do that. And so what I think is really important and what we focus on is when we buy firms, when firms come on the platform, first and foremost, we want to maintain that team and we want to maintain the process that has led them to be such successful investors, that has led them to be such great alpha generators.

42:23And so we focus on maintaining that integrity and autonomy of the investing process. That's really important. Having said that, though, there's a lot of things that we can leverage across the platform that not only will they not impede or impair that investing autonomy, but hopefully they will actually make them better on the margin at doing that, right? And so we think about a lot of the enabling functions. We talked a lot about data. Another big place is sort of capital formation and client solutions, right? And so we want to be able to work with clients and say, what are your needs? What are your challenges?

43:02Right. Maybe you need this kind of return profile with this kind of cash flow profile with this sort of risk correlation. And there's things you either want to lean into or lean out of in portfolio mixology. Because we have a full spectrum offering, we can do that for you. We can deliver it to you in a single wrapper. We can deliver it to you in a consistent client experience. while still benefiting from the world-class investing acumen that each of these individual

43:30Luke Sarsfield:teams deliver. And so I think it's, you know, like all things in life, balance is really important. You need that investing autonomy. You need to have those teams delivering world-class outcomes, but they need to do it and be able to do it in a way that's integrated and seamless from a client experience perspective. As private wealth becomes a bigger part of the market, what do you feel needs to change for alternatives to truly fit more retail investors? I think it's really important first to define what we mean by retail, right? Because my guess is, not my guess is, I can tell you, it's very different if you're, you know, a ultra, ultra high net worth individual who for all intents and purposes looks a lot more like an institution relative to, you know, an accredited investor who's, you know, experiencing alternatives in their portfolio for the first time.

44:25And so I want to be really careful. The first thing I would say is I don't think it's going to be a one size fits all thing, right? I think you're going to have a gradation of things that at one end of the spectrum look a lot more institutional and at the other end of the spectrum look a lot more like traditional retail. The next thing I would say is I think we have to be, we as an industry have to be really careful about, you know, educating the clients about the use case of these products, but also the challenges and constraints of these products, right? And that goes to client education, that goes to client suitability, and certainly it goes to nomenclature, right?

45:07And so one thing that I will tell you, just I personally have not liked, I hate the phraseology semi-liquid, right? I know a lot of these products have been referred to as semi-liquid. I hate that because I think the reality is when your average client hears that, they hear the liquid and they often miss the semi, right? Or they don't understand what we mean by semi-liquid. And they don't understand that that might mean 5 % a quarter and capped at 5 % a quarter. And so I think terminology is important. I think product design is important. I also think where these products are owned is important, right?

45:41And so one of the things I think a lot about is that you should generally have long-dated assets where you have long-dated liabilities, right? And so for most individuals, their longest-dated liabilities are generally in some sort of retirement plan, a 401k, an IRA of sorts, right? You would think it would be very natural to have a lot of longer-dated assets arrayed to help them to fees over time those longer-dated liabilities. And so I think where you own the product is also really, really important. Look, this is still very new, right? These are innovations that are within the last decade. I think the industry is continuing to get better about this.

46:24I think the industry is really focused on talking about it and educating clients in a way that I think will be accretive for the clients and accretive for the industry. But I think it's really important to remember that at the core, when we talk about private markets, there is a sum or a meaningful, depending on the product, element of illiquidity to many of these products. And so I think we just need to think about how that fits into the overall mixology and portfolio construction that the client is doing.

46:58Luke Sarsfield:And probably a big part of it is to try to minimize the risk of a negative surprise, meaning the clients go in thinking there's some level of liquidity, even though the underlying assets may not be liquid because it's presented in a structure that may be something they're more used to. But then they get surprised when the liquidity isn't what they expected. So that's probably something to try to minimize. Absolutely. And I think there's a lot of really, really smart and creative people who are thinking about ways to structure these in ways that will be able to afford that to some degree. But I do think it's important for us not to also confuse the clients that these are just like a public mutual fund or a public credit fund or an ETF or whatever it is they own.

47:48they are fundamentally different. They have their use cases. Obviously, the use case is predicated on there being a superior risk-adjusted return to compensate the client for that illiquidity. But I think it's really, really important that the industry is working with the clients and their advisors to really make sure that they understand it and that it's appropriately sized and that it obviously fits in their overall portfolio mixology.

48:16Luke Sarsfield:Luke, you've been very generous with your time. I just have one last question, and it's a higher level one. When you think about what separates great investors from average ones, what are the most underrated traits? I would say that there's one word that immediately springs to mind for me, and it probably surprises you because oftentimes I think when people think about great investors, they think about them as they're masters of the universe and they can do no wrong and they're seeing what's going to happen next. The word I would actually use is humility. I think great investors have a fundamental humility about them.

48:52And they're always entertaining the possibility, and in most cases, the probability that they're going to be wrong. And when they are wrong, they have the guts to acknowledge they were wrong and to learn from that mistake. And by the way, they'll probably make new and different mistakes, but they won't make that same mistake again. I think great investors have that fundamental humility of understanding that as much as they've tried to see around every corner, as much as they've tried to assess every probability and every likelihood, they are going to miss things. I think average investors oftentimes just say, well, the world doesn't get it.

49:33The market doesn't get it. I'm just going to wait for the world and market to come around and be more sensible. The great investors say, that may be true, but what's that old Warren Buffett saw? You never know who's swimming without a swimsuit till the tide goes out. And I think great investors are really, really attuned to that and have that just fundamental humility in their approach.

49:56Luke Sarsfield:Yeah, I think it's a great insight. And when I look back with the guests that we've had on this podcast, the ones who have been investing for 50 plus years, it's interesting. You would think they'd be more confident, but in many ways, they've been slapped in the face so many times that it introduces a greater sense of humility and appreciation that you're not gonna get everything right. You're gonna miss a lot. You're gonna miss a lot of big things. And versus somebody who's maybe younger and happened to live through a favorable stretch, maybe more confident. And you would think it would be the opposite, but I think what you just said is the reason why.

50:30Yeah, I think if you run into an investor who thinks they've got it all figured out, you should be cautious.

50:35Luke Sarsfield:Luke, I appreciate you joining us, sharing all your insights. I thought it was a fun conversation and I hope our listeners did as well. Thank you. Alex, so great to be with you. Thanks for having me and really, really enjoyed the conversation.

51:00Luke Sarsfield:tax, investment, or business advice. It is not a solicitation, recommendation, or endorsement. All opinions expressed by participants are their own and do not necessarily reflect the views of the Evoque Advisors Division of MAI Capital Management, LLC, or Evoque, its affiliates, or any companies mentioned. Information shared has not been independently verified by MAI or its affiliates. MAI Capital Management, LLC, or MAI, is registered with the U.S. Securities and Exchange Commission, SEC, which does not imply any particular level of skill or training. Certain information contained herein has been obtained from third-party sources and such information has not been independently verified.

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52:18Luke Sarsfield:Non-traditional assets carry significant risks and may not be suitable for all investors. Decisions should be based on individual objectives, risk tolerance, and circumstances. Statements herein are general and may not reflect an individual's or entity's specific circumstances or applicable laws, which vary by jurisdiction. Further, speakers' views are personal and may differ from evoke and MAI recommendations and are not specific investment advice, and do not consider client objectives, risk tolerance, and diversification. Guests may have current or past relationships with Evoke and MAI, its affiliates, or the host, including as clients, service providers, or business partners.

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