Uncapped #14 | Dan Feder from the University of Michigan

0:00and the phraseology that Donald Rumsfeld made popular, there are known, known, unknown, known, known, unknown, and unknown, unknown, and things that are not known are not knowable as the realm of uncertainty. And that is where I think venture capital has its real power. All right. Today I'm here with Dan Fader from the University of Michigan and this is the first time that we've ever gotten to have an LP on the podcast and you're one of the most interesting, thoughtful people that I've gotten to learn from in this industry and so I'm really excited to get to do this with you today. Well, thanks for having me, but first of all, you have to get out more then.

0:38I need to get out more. Yeah. That's a problem for me. My listeners probably are going to be less versed in sort of LP land than sort of VCs or founders. So could you start by just giving a little background? So not have to be long, but just kind of orient us to sort of a little bit about you and how you've gotten to where you are. Well, it's a long story. So I'll keep it really, really short. I started out my career as a lawyer. So I had no idea about being an investor and certainly had no idea about what an endowment was or endowment management. And I got to endowment management really by accident.

1:10I was having lunch with a private equity manager who took a liking to me and he said, I think you'd like an endowment management. This is in the year 2000. And I said, that's fantastic. What's that? And he, like I said, super kind, private equity manager, great investor and Paul Levy introduced me to a person for whom he was doing guest lecturing a Yale. And that happened to be Dave Swenson. And Dave was also really, really kind. And he didn't have anything at Yale. And he introduced me to Andy Golden at Princeton. And at that time, Andy was the CIO at Princeton and was bringing all of the non -marketable asset classes back in house.

1:49They had been outsourced. And we just got to know each other over a period of months. I had zero experience doing what he wanted someone to do. And at the end of getting to know him and him getting to know me, he brought me in to lead venture and private equity at Princeton. And that, you know, itself informs a lot of how I think about hiring people, working with fund managers and investing because when we got toward the end of the process, I just said, look, you know, I don't fit the spec of what you're looking for. I'm happy to come in at a lower level and see if I'm right for you in your, you know, and this is right for me.

2:30And he said, it's fine. I'd rather hire somebody with a fast processor than a full hard drive. And that has stuck with me ever since then. And it informs a lot of my thinking and a lot of what I learned there in terms of thinking about investing has informed everything that I've done from Princeton to wash you where I was in a similar role. And now at the University of Michigan, and then a couple of stops along the way. You called it endowment management. Obviously, you know, there's a sort of a broader bucket of just being like an, you know, an LP, generally speaking, but talking about endowment specifically, can you talk about like what are the building blocks of the way that endowment thinks about constructing itself?

3:16So like, let's say you zeroed out and, you know, Michigan went fully liquid and you had to rebuild all the way from there. What would be the considerations, what are sort of the requirements, what are the must -evoids? Like, how does an endowment build its portfolio from, you know, the bottom up? So I think the starting point that you describe in particular around going fully liquid is a great place to start. So endowments have to do a few things. First of all, one clarifying point. And endowment is not a single endowment. It's an endowment pool comprised of many, many endowments. So at the University of Michigan, the endowment is comprised of over 13 ,000 separate endowments that each have their own sort of mandates.

3:58Think of it as a mutual fund and each endowment has a certain number of shares or units in the, in the fund. And so the scholarship to support first -gen students will have some number of units depending on, you know, size relative to the overall endowment pool, but it is, it is its own separate endowment. And that's something that gets lost in a lot of the conversation about endowment. What the endowment pool is intended to do for those endowments is are really three things. One, support spending and spending is typically defined as sort of four to five percent of overall value over some period of time.

4:37So averaging over three, four, five, or so years, keep up with inflation and for endowments, it's higher edge inflation, which is a higher than CPI to preserve spending power. And then if possible, make a return above that. But really it's to keep up with spending and inflation and support those programs in a way that supports them with intergenerational equity. So not too much ups and downs. And your starting point of going fully liquid is probably the right starting point. Because if you're going to do that, which kind of solves out to a eight -ish percent nominal return for a period of forever without too much volatility, there aren't too many ways to do that or probably are no other ways to do that other than having an equity orientation.

5:21So the logical starting point is fully liquid public equities. And you start with the deepest and most efficient markets. And then that might be it. That might not be enough in terms of volatility or dampening volatility. So you add other asset classes or other assets into the mix and take advantage of the framework around modern portfolio theory, which says that if you properly diversify a portfolio, you can actually get less risk to find its volatility for a unit of return or vice versa. So a lot of it is preservation of capital access to like free cash flow. Those things are very important constraints beyond just driving good returns.

6:03Right. It's a pretty modest liquidity requirement. So you have four to five percent a year is something that's pretty manageable. So that's what enables endowments and pools like this to be able to go into asset classes like venture and private real estate and private equity and other liquid or semi -liquid and illiquid areas. So from this zero -based budget hypothetical where you're in some mix of let's just say like the S &P 500 and bonds. And now you're deciding to peel out of that into a liquid stuff like venture capital, private equity, I don't know commodities, whatever else. What is the driver that gets more dollars allocated there?

6:45Sort of without taking aside all of the sort of natural momentum that we all know has happened. What from a theoretical standpoint gets you to wanting to put X number of dollars in these different buckets? Well, there's pretty well traveled math around how you do that optimization. So the most simple form of that is a mean variance optimization among some specified asset classes. And when you look at the correlations and the volatility of each of those asset classes come up with a mix that meets a return objective at a level of risk that is tolerable. Yeah. So then inside a bucket. So like private equity and venture gets whatever bucket it's going to get.

7:24There's sort of this concept of like allocating I guess, which is like this decision of like what slice of the pie should go into this whole thing, which is separate from investing, which I think of as like what you're picking inside that slice of pie is that is that the right way to think about allocating investing? I think so because I agree. But there really is a difference in my mind between allocation and investing. There's overlap for sure. But that asset allocation process is really a risk -based process. So in deriving what a model portfolio would look like, what you would do is look at return streams and correlations around those asset classes and arrive at that mix.

8:04But everything that you're looking at is risk -based in the sense of you're looking at the past to predict the future about what it would look like you think in the next several years. And so that is investing of a type, but it is it's a risk -based framework. And it's it is a great framework for how to direct assets to different areas. It's also a super important behavioral framework. So we'll get to that later, but it asks a class like venture capital. You can have a lot of confidence or overconfidence and whether you're good at something. And so setting some parameters around how much or even how little of something to do, you take away some of these behavioral problems of doing too much or too little and guiding the portfolio into this state where the idea of that state, that model portfolio state, is that if you were dropped in from outer space after being away for a year or two and told, put together a portfolio to do these things, this is more or less the portfolio you would put together knowing nothing else.

9:06So behaviorally, that's what you should sort of gravitate toward. I guess like trying to make an analog here to venture like, you know, from the GPs perspective, the way I kind of think about allocation would be as though I were to go into a new fund and say, I'm going to have this percentage see this percentage A and this percent for later follow -ons. I'm going to do this percent B to B, this percent in hard tech, I'm going to do this much in US, etc. When I think about that for myself, I imagine it to be very hard for that to be where I got or at least that I would, I feel like I would need to do on natural things to make that end result happen.

9:42And I guess either I'm thinking about the equivalence, or there's just some difference between, you know, the two ways that investing happens or maybe the constraints are in fact good, but like, how would you react to the equivalent sort of allocation for a venture manager? I think venture is an extreme case among all the asset classes. And so therefore, it's a good case to talk about. Venture is really not in my mind that amenable to an allocation and of itself and then allocations within it based on risk metrics. I'm an allocation in itself, meaning from an LP. From an LP in terms of the the allocation to the area, I think that's fine for the reasons we talked about, which is, you want to direct the capital to places where you think it makes sense on this risk -based system.

10:27But in terms of what one should invest in, risk -based investing or risk -based systems really don't align in my mind with what venture capital really is or what it ought to be thought of as being. So there's an economist named Frank Knight who, when I read his work, it kind of changed a lot of the way I thought whose central thesis is that there is a very big difference between concepts of risk and uncertainty and the phraseology that Donald Rumsfeld made sort of popular. There are known -nones, unknown -nones, known unknowns, and unknown unknowns. And things that are not known or not knowable is the realm of uncertainty.

11:09And that is where I think venture capital has its real power. And if you set up a system that's risk -based so around these knowns or knowable things, you're not going to know how to deal with or incorporate those unknown unknowns into your portfolio in a sensible way. So what does not know and unknown look like? It looks like an entrepreneur working on a problem that only he or she knows about, and therefore it's not known to other people and the project itself is not knowable. And if you can invest with that founder or in that founder based on information that others don't have, you would have an ability to make in a sustainable way real economic profit over time.

11:55Whereas risk -based investing that alpha or trade or advantage around trade gets absorbed by the market over time. It's not durable over time. So when I think of venture capital or illiquid investments in the context of an endowment portfolio, the act of or illiquid and if that spectrum really ought to be pushed to investments that have aspects of uncertainty to that. Because that is where if you can traffic in that well, you can make durable economic profit. First of all, I love the framework and I want to talk about that more. But does this also work when you're thinking about what venture managers you're going to invest with?

12:36Like, is there some equivalents here where investing in uncertainties good framework as an endowment? Or is this really only applied to VCs investing in founders? The founders are where it all, where the rubber meets the road. And so the VCs or business partners with whom we invest, whether it's in a fund or outside of fund, in my view, have to have some ability to access opportunities in a way that is advantageous. So information about who these people are, access to who they are, and some legal inside information about the opportunity. A lot of these types of investments, I think, don't get made because they look weird for a long time.

13:14And it seems to me that they're sort of like a cascading herd thing that happens where the things that are clear and sort of in that risk area that you talked about. People know those will keep getting funded. They'll keep getting marks. They'll always have capital available, etc. And I'd imagine that for LPs also, there's some thing here too where certain things are going to look better for longer periods of time. And I'm curious just to hear your take on like the incentive structures inside LPs in the short and long -term orientations and all the rest of it. There's something that's been bugging me quite a bit.

13:49I haven't really thought it through fully, or even if I did, I'm not sure that it would be any better than what I'm going to tell you. The notion that venture capital is an asset class in the first place bothers me because I don't think it is, and it just violates the characteristics of what an asset class is. But more to the point is that where we started with venture capital years and years ago is very different from where we are today. So in 1946, Ben Oschmitt Sr., who was one of the founders of J. H. Whitney, one of the first venture and private equity firms, came up with the term venture capital, but it was a shortening of the word adventure.

14:29And so I think if we went back to a construct and we said, look, let's just put venture capital as a term off to the side. And let's look at two categories of investing within an adventure capital and then capital for ventures. And it could clarify, I think, what it is we're talking about. Things that are uncertain where the founders doing something hard and ambitious, whereas really risky where the future is not known, not really knowable and requires going out on an adventure. And that takes away also the idea that we look at things through the lens of seed, early, later, et cetera, because even a company that is at a later stage can still be doing things that are adventurous, highly ambitious, and new.

15:18And then it also can clarify that a lot of what goes on in venture capital is what I think a lot of VCs just don't want to admit, which is that, and this is why you and I are you especially, you know, dressed like this is because you don't, you don't want to be confused with the, just like no, no, no jacket. Well, you don't want to be confused with the cufflink crowd. And this, the sense that this is about financing companies. And doing finance is not a bad thing. It's a good thing. And it's, I think it's okay for VCs. It's more than okay to admit that what they're doing for companies that have gotten past the stage of being truly adventurous is that those companies need capital and there's still opportunity to do value add with those companies.

16:05But it's different. And where we, because it really does align better with our portfolio, shine our spotlight is more on the end of the adventure end. And I can go into that. But that's that aligns better with our time horizon, our networks of information and opportunity and sometimes our ability to influence outcomes, even as an LP. How do you set up the team culturally or with incentives or structurally to have the, what I assume is a longer term orientation to do, you know, the uncertain bucket versus the risk bucket. It's really hard because the, the practice of endowment management has changed quite a bit over the last, blah, blah, blah, blah, blah, blah.

16:50Over the time I've observed it, which has been the last 25 years. And so endowment management was a place where people found themselves in it without really knowing what it was. It's kind of a, it really wasn't a known career path. They really, and they really was not a career path to get to endowment management. So people who came to endowment management came from oddball places and were in those seats because they have sense of alignment of mission and a view that this is where they wanted to be. And there's I think there's also a really powerful intellectual draw to doing investing in the context of an endowment where you have a long time horizon, at least for the time being, no, we're very little tax efficiency to work at.

17:35But and more importantly, an alignment of interests in terms of governance that is not available in many other places, all the way from trustees to boards to people, in the investment offices and so forth. And so it was much easier in that context. So I think one of the, the, the insidious things that crept into the system is that endowment's got larger, as the classes got more popular, more capital flowed in. And now there's a career path in endowment management, which is good. It's nice that there's a career path. But it's also, it comes with, with a downside and the downside is that now that there's a career path, there's more of a premium on demonstrating a track record to move from one place to another.

18:22Can you talk quickly what is that career path? Like what are the things that you need to prove? Let's say you graduated, you know, from school and you're joining an endowment for, you know, first time, what is, what are the, what are the central unlocks to get from there to where you are? A way to do it is to go from, as it is the case in any other financial enterprise or fund or what have you, go from analysts to associate to principal to director to MD to CIO or or had an organization. And a lot of times that will involve moving from place to place to create your own promotions. And it is mostly aside from organizational things is the way to get promoted to, is it to be in good names, is it to get markups, is it to find a good thing early, is it to support your managing director on a great investment?

19:11Like what is it? I think it's probably all of those things, but it's to demonstrate relevance, I think at the end of the day. And I think this is also the case within VC firms and other other institutions. But when you start looking at metrics that are visible in relatively short time frames, you are focused more on the outcomes of those, of every decision or everything that you've been involved in. So you're more outcome focused and less input focused. If you're much more long horizon in your thinking, you're, you're going to tend to be more input oriented. So what will that look like in venture?

19:51A way that we do, or that I look at venture investing is just to spend a lot of time listening to people who I think are smart. And if we were going to tell me what's coming next and what we'll do is put in motion a number of ideas with people is not like a spray and pray. There's some areas where we'll start paying attention and put some conversations in motion. And it might take years for those to percolate to the surface. And when they do, it seems like it's fairly obvious that they were good ideas, but those ideas themselves may take years to mature into something that looks good. That's what I mean by sort of input versus outcome or output focus.

20:30That is the way that I think we really compound in our knowledge and our networks and what our advantages are with time horizon. But if we are looking at even single or multi -year periods, we're going to tend to be more focused on what does that look like any year from now. And VCs are here to help. They spin up fantastic narratives. And they themselves are incentivized, I think internally, to fund high momentum trends. And in all the slides, so that there's a sort of a self -feeding process where the provider of the product is producing something that provides outcomes. We've kind of talked about this that like I felt as a little bit as a founder now that I'm in an investor seat, I can really sort of see even more of the dynamics of how it's more of like a craps table than a poker table.

21:25Like everybody in some levels kind of like winning together and losing together. And there's a lot of incentives where everybody just wants all the numbers to all be going up all the time. And so you get these overinflated moments collectively. We obviously have in the last 10 years gone through a bunch of these moments. And then it kind of goes down all together. But everybody's in on the conspiracy in their own ways. And it's like nobody's fault. But all the incentives seem to be driven towards acceleration up and down. I like the poker versus craps table. We like to play cards in the sense that when we're putting together these ideas or we're following them for a period of time, what we're doing is basically we're building our hand.

22:07And then when things come together, we start playing that hand. And we're playing for a different position. We already have relationships with people with whom we trust. They'll start guiding us to things that we should invest in and not to other things. And that just works really well. When you're backing managers, obviously you're backing a lot of venture firms and individuals who think really different things from each other. And most venture investors have their own internally consistent set of ideas. Whether it's early stage, on late stage, on concentrated, on broad, on cyber, on B2B, on heart, whatever.

22:47And you're listening to that individually and thinking, this is really good. But then you're backing other people who are thinking sort of embedding in a different way or perhaps even the opposite way. And so I'm curious what's the mindset as an LPs sort of thinking in general about how you're going to work with people given that these strategies that you're backing can simultaneously be at odds. Yeah, you're describing my own sort of tortured life basically. It sounds like it could be like a chaotic headspace. Most of the time I'm walking around, maybe all the time I'm walking around in a state of cognitive dissonance.

23:25And I'm trying to make sense of that. And also trying to determine whether I'm actually just completely undisciplined and have no point of view and just investing in everything. And it's just one big mess. But the cognitive dissonance is exactly that, which is we're constantly investing with people who have very different views of the world. We have specialists and generalists. We have soul GPs. We have firms. We have larger firms and the passion and the drives that these people have. They're super smart and really accomplished. They believe this is the right way. And in many cases, the only way and the other ways are wrong.

24:05But yet we back the people who we think are smart, think are wrong and vice versa. You know, each of them thinks the others wrong. And a great thing about investing, at least it's a great luxury for us, I think, is that in investing, you don't have to be right about everything. You just have to be right enough about the things that matter in terms of being right about them. And it can be the case. And it is the case that there are approaches that are different among groups. And it's also part of what we need to do as an investor in a portfolio that's supposed to be resilient over time. And the way that I look at our portfolio construction is pretty concentrated.

24:48So we have across venture and private equity, 36 active relationships, only nine of those are in private equity, 27 and an adventure. And it's a large scale portfolio. So it's a concentrated roster of firms or people. And one of the advantages of intentionally constraining the number of relationships is that it forces you to pick among groups that do something specific. So instead of taking the approach of we're going to do a diversified allocation and select five groups that basically do the same thing in the hopes that we catch the one that is the exceptional one and the other ones will be good.

25:31We focus on picking the one. And then since we're picking the one in that area, that means that each other area, what we're looking for are people in groups that do something that is different. They'll overlap a bit, but it will be complementary or distinct in terms of where the returns come from and how they're derived. And it's an uncomfortable position. But it also really forces that sort of torture and existence of now you have to really concentrate into a few dozen groups that disagree with each other. I'm curious your view on just like venture as an asset class overall. Like, you know, you're going through all this torture.

26:12You could just buy QQQ and call it a day. Like what's your opinion on this whole asset class and why you're putting it in your overall portfolio? We're supposed to. Yeah, that's a non -existent answer. Yeah. What else? I think that's why most people do it. Do you think that is really the reason you don't think it's that people think that they can outpeak or something like that? I think that if you were to go out on the street and ask 100 people whether they're above average driver, 98 of them would say that they are. And I think that that sort of dynamic applies adventure. The dispersions of returns, even though they've narrowed considerably, are still pretty broad.

26:52And it is a pretty lousy area to invest. Unless you are investing or getting exposure to the underlying companies that really matter. In which case, it's obviously very good. It's very, very, very good. Yeah. But this isn't like, well, we're gone and not all the children are above average. Yeah. But they also think they are. Yeah. It's probably also the thing you mentioned about like GPs are, you know, good at narratives and firms have learned over long periods of time how to tell the right narrative. It's one of those magical things. I mean, yeah. LPs love a good story and GPs love to tell a good story.

27:24Yeah. How do you think about like you're investing in machine? You know, you said, I didn't mean to sound that. No, of course. No, it's not. I mean, I think this is true in general in sort of business is that there are narratives, you know, drive a lot of, you know, capital movement. But given that, you know, you're not just sort of at a place in your career now where you're investing because you have to, you are doing, you know, you're setting strategy. Like what is the overall framework for how you think about investing at Michigan? I mean, you talked about the managers, you know, breakdown and, you know, the concentrated portfolio approach.