Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: Because if you just all sudden go to that example – it's a really good example – of the horse saddle. All of a sudden, if you don't have a factory that can produce 100,000 on the artisanal side, you're not ever having to think about it. You could have an industrialization of the asset side, but if you're liability constrained, you're not going to change behavior because you don't have the capital to go do that. You'll run out of money in five days. So it's got to start on the liability side where you raise all the money. Then you have it, then the behavioral change starts. These two things, it's first liability side, it starts the industrialization and as a result of that, it goes to the asset side. [00:00:00] S0: Which is interesting because if you add up every conversation I've ever had with an investor, 98% of the time spent is on the asset side. What are you investing in and why? [00:00:00] S1: Exactly. By the way, that's okay. If you have perfectly matched assets and liabilities, it's okay. But let's imagine a world where every investor you spoke about had a term in their agreement – after three years, the investor had the option to call their money back. That would probably be something you wouldn't be talking about a lot. And by the way, prior to 2018, going back to the financial system, the private capital part was pretty perfectly matched assets and liabilities.
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: Exactly. By the way, that's okay. If you have perfectly matched assets and liabilities, it's okay. But let's imagine a world where every investor you spoke about had a term in their agreement – after three years, the investor had the option to call their money back. That would probably be something you wouldn't be talking about a lot. And by the way, prior to 2018, going back to the financial system, the private capital part was pretty perfectly matched assets and liabilities. [00:00:00] S0: It would seem if everything was frictionless and I was a GP, I would of course have matched liabilities. If I could just snap as much capital as I wanted into existence – yeah, of course, I want to have no problems. So what's the series of events starting in 2018? What were the first examples of this and then how has it evolved?
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: The first signal is underwriting. Because investing or lending, you can invest as much money as you want. You can lend as much money. That's not the skill. The skill is investing. It's that artisanal behavior. Everyone talks about private credit, but we started to see it in every asset class. We started to see it in real estate. We started to see it in infrastructure. We started to see it in private credit. It wasn't actually bad, but we started to see behaviors, like terms that you would never do. Because obviously when you lower your underwriting standards, guess what happens? Your deployment pace can go up. You have an origination engine. You're sourcing all these deals and let's say you're an artisanal. You might have a hit rate of half a percent you look at. If you lower your underwriting standards, your hit rate on deals that you might do might go to 2% or 3%. It's literally all in your control. So I think we started to see it, but it was just something where we started to notice changes in behavior, but it wasn't full-fledged factory model industrialization. COVID happened. And then post COVID, it was game on for the factory model, both on the liability raising side and also on the asset side. Literally that behavior started to accelerate in incredible ways right after COVID. [00:00:00] S0: The capital, the liability has come from lots of different pockets, but my mind goes to like the wealth channel that everyone's talking about now, institutional channel as well. Maybe put a little more color on where it actually came from and is coming from.
· Alan Waxman
[00:00:00] S1: What started to change in 2018 is there are these things called SMAs, so separately managed accounts. Prior to 2018, for the most part, the private capital ecosystem was basically funneled through funds. So think about commingled funds, lots of investors come into one fund to pursue a certain strategy. And all of a sudden, there started to be – every conversation with every LP was basically, "We want an SMA. We want a Fund of One, just to do XYZ for us." You go to an LP, you basically say, hey, we're going to raise $500 million or $100 million and we're going to do direct lending, or we're going to do private equity, or we're going to do real estate. And all of a sudden, there started to be a proliferation – where literally three years prior, it was not in any conversation – every conversation was SMAs. And what it is, it was just the industry starting to raise capital from the institutional channels. So not wealth, the institutional channels, so pension funds, sovereign wealth funds, to some extent endowments. Raised as much capital as possible in the simplest form. Started on the institutional side with SMAs, but the growth in institutional SMAs started to really taper off. The next place where the industry started to go was the wealth space. And the wealth space in general, just from a historical perspective, it is typically the easiest to raise, the simplest to raise. It's typically the cheapest. That doesn't mean that they're not smart, just the cheapest. But the other characterization of the wealth space is that it's always easiest to raise in the procyclical environments when things are going really well. But when things start to not go well, the wealth space, or retail, or individuals want their money back quickly. I just want to level set on that, it's an important concept. And that's where it started to go. And that got us to one of the symptoms that are here today. But the one thing I want to point out, and we'll talk about the current moment, is that the SMA was a symptom. What's going on in the wealth system? The wealth system is a symptom.
· Alan Waxman, Patrick O'Shaughnessy
When you think about some of the stuff you see in stuck private assets, where there's so many assets around the world in private real estate, private infrastructure, private equity, that literally were companies or assets that were bought in post-COVID, in sort of '20, '21, early '22 – paid way too much. They're stuck assets. All that stuff is symptoms. The root cause of this is the change of behavior patterns of the factory model. That's the root cause. And again, one of the things that's – not frustrating but unfortunate, is that everything that is covered in the media is just talking about the symptoms and not actually getting to the root cause. And again, when you think about history, people talk about the symptoms, but when you start to diagnose what happened and how we got there, it had to do with the root cause. And I think that's something that hopefully this conversation provides some greater clarity on. [00:00:00] S0: So if I think about this model, and we've talked about – maybe you can mention the multiples that markets had been putting on asset management companies that we can look at in public markets and see everything transparently. How much markets were willing to pay for the equity in multiple basis, what the multiple is of that drives the incentive to raise money.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: So if I think about this model, and we've talked about – maybe you can mention the multiples that markets had been putting on asset management companies that we can look at in public markets and see everything transparently. How much markets were willing to pay for the equity in multiple basis, what the multiple is of that drives the incentive to raise money. [00:00:00] S1: The story of the factory model starts to correspond with FRE multiples. What is FRE? FRE stands for fee-related earnings. Fee-related earnings is basically your management fee profit. So you raise a fund, it's got a management fee on it, you got a set of expenses, and what's left over, that is your fee-related earnings. These things for our industry started trading between, let's say early 2010s, call it 10 to 15 times FRE. In 2018, when all this started, it stepped up to – call it 15 to 20 times, obviously depends on the comp set. Before this current moment, we're at 25 to 30 times plus. That's where it is. And by the way, if you go back to the early passing of Basel III and Dodd-Frank, there was a massive secular opportunity to fill the gap that was left from commercial banks being constrained. And then the system found its steady-state place, but in order to keep growing – and again, it's the whole industry. What did they do? Many participants adopted the factory model.